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Utility M&A: Buying Time

Buying Time
Fortnightly Magazine - October 2004

hats to the debt market because now they have strategic choices regarding where to take the company," says Frank A. Napolitano, managing director and co-head of the global power investment banking group at Lehman Brothers in New York. "The amounts, terms, and pricing of available debt have been much better than anyone could have predicted, based on the profile of an industry experiencing a declining period. In many cases, companies whose ratings had declined were able to borrow money at lower rates than they could when they had higher ratings."

As a result, utility companies' financial positions have stabilized, with better credit and stronger cash flow. In fact, some utilities, finding themselves flush with cash, have been repurchasing shares or boosting dividends (). But as investors begin seeking stocks with stronger returns, utilities will begin feeling pressure to put that cash into growth opportunities rather than shareholder payouts.

"The industry has been trading at high P/E multiples compared to historic trends, even considering the dividend tax cut," says George Bilicic, a managing director with Lazard in New York. "If we get overall economic growth and interest rates rising, utility stocks will experience a compression of multiples. Investors will be less interested in the yield component of utilities and will be looking more toward growth" ().

In recent months utility stocks have been performing better than the S&P 500. With current price-to-earnings ratios in the 15x range, utility stocks are considered strongly valued, which means the run-up in share prices is unlikely to continue. Going forward, the 1 percent to 3 percent organic growth rates that many utilities are projecting will not satisfy increasingly growth-minded investors, who are seeking returns in the 7 percent to 12 percent range. To compete for capital, utilities will be forced to find ways to increase their share value.

"A lot of utilities and their bankers are starting to talk about growth," Lipschultz says. "If back-to-basics was the thing to talk about for the past two years, then growth is the thing they are starting to talk about today."

Companies are not likely to abandon their back-to-basics strategies, however. Investors and regulators alike continue demanding that utilities focus on their core businesses, preferably regulated ones. This leaves utility companies with few growth options.

"Utility executives face a Hobson's choice right now," says Michael Zimmer, a partner with Thompson Hine LLP in Washington, D.C. "They are being rewarded for concentrating on fundamentals, but Wall Street is sending signals that it will only continue supporting companies that are growing at 10 percent per year."

So utilities face three main options for growth:

  • Some companies are investing in new power projects, gas pipelines or transmission and distribution (T&D) assets to meet projected demand growth-and, to some degree, to support rate cases before state utility commissions. "To the extent the territory is growing and local regulators understand that and want to keep up with that growth, then regulated cap-ex is the best way to spend your money," Napolitano says. "That's the number one, no-regrets way to grow."
  • However, many utilities have avoided