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Dial M for Merger

When will utilities see the next round of deals?
Fortnightly Magazine - October 2004

years, institutional holders of equity have been reasonably patient with utilities' back-to-basics strategies, given the challenges that utilities have faced. However, with the prospects for an improving economy and rising interest rates, there will again be pressure on utility managements to deliver earnings growth. With intrinsic growth in the utility sector averaging less than 2 to 3 percent, approaches for achieving an enhanced return for investors are limited. After years of cost-cutting, it will be difficult for utilities to achieve sufficient long-term growth primarily through a cost-efficiency strategy, especially in view of the cost impact of potentially higher interest rates and increased inflation upon utility profitability.

A small number of companies have the potential for higher intrinsic growth in their service territories as a result of investment in regulated generation, investment in enhanced transmission and distribution, or higher-than-average customer growth. But even in these cases, the opportunities may not be sufficient to satisfy investors' requirements.

A still highly fragmented sector. The opportunity for consolidation is significantly greater for the utility sector than most other sectors, because the utility sector is one of the nation's more fragmented industries. In this regard, the top five and 10 largest utility companies account for less than 25 percent and 40 percent, respectively, of the sector by retail customers. This compares to the telecom sector, where the top four companies provide essentially all local telephone service and where the number of significant companies has been cut in half over the last decade as a result of mergers. While the commercial bank sector is considerably less concentrated than the telecom sector, the market share of the top 10 commercial banks (as measured by deposits) has doubled in the last five years as a result of mergers, and the trend of substantial consolidation continues. Increased consolidation in the utility sector is clearly possible, offering the potential for utilities to achieve lower cost, greater efficiency, and increased long-term growth.

Improved stock price levels. Although utility stock prices are generally below 2000 levels, utility prices have risen significantly from the trough of late 2002. Utility prices (as measured by the Dow Jones Utility index) rose approximately 35 percent from year-end 2002 through August 2004. Higher stock prices provide acquirers with a stronger acquisition currency, a more attractive means of raising cash for a deal, and financing flexibility if additional capital is needed in connection with the transaction. Higher stock price levels in the marketplace also permit sellers to undertake transactions that are priced off more favorable benchmarks. As a result, it is not surprising that the overall level of M&A activity has been positively correlated with the stock prices ().

Stable credit quality of the sector. Since 2000, the credit quality of utility companies has been more adversely affected than the corporate sector in general. From 2001 to 2003, the excess of downgrades over upgrades for the utility sector (parent and operating companies) averaged more than 100 per year. This pace has significantly moderated with net downgrades of only 18 in the first half of 2004 and only 3 in the