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Utility M&A: Buying Time

Buying Time
Fortnightly Magazine - October 2004

Not everyone agrees that this is a problem, however. "Utility mergers are financed with equity, on a stock-for-stock basis," Morash says. "These transactions are relatively straightforward," allowing companies to combine their equity in a way that values each appropriately.

Even so, utilities with high P/E ratios are finding they cannot expect to receive the big acquisition premiums that some companies enjoyed in the 1990s. The current market's lower growth rates and conservative strategies, combined with utilities' continued aversion to debt, limit the potential for leveraged buyouts.

Other factors also will serve to constrain merger activity. Namely, heightened sensitivity regarding corporate governance issues has increased the level of due diligence that companies must undertake in the merger process.

"People are doing their homework," Napolitano says. "Corporate managers view their own companies as well as potential acquisition candidates, whether assets or companies, with a more stringent and diligent eye. There needs to be prudence in the statements they make about their companies and their prospective transactions, and that means an awful lot of work goes into every step."

Finally, the social and political factors that have historically caused utility mergers to drag on for months and years remain in full force-and indeed might be even more onerous today, in the wake of the Enron meltdown and the California market debacle. Regulators and the public alike will scrutinize utility mergers with a more skeptical eye than ever.

These forces may drive companies toward smaller mergers. "People want to go back into growth mode, but they want to do so without betting the ranch," Lipschultz says. "They want to add something to their business, so they may look at acquiring smaller utilities."

Most attractive will be companies with relatively low P/E ratios and relatively high cash flows (). And in some cases, acquisitive investor-owned utilities (IOUs) are eyeing electric cooperatives and municipals (). In June, at the national conference of the American Public Power Association, the organization's president and CEO, Alan Richardson, acknowledged that IOUs might be interested in acquiring municipals. "As private power companies abandon their diversification strategies pursued in hopes of higher profits, they will search for other ways to grow their business. Financially strong public power systems are likely acquisition targets," Richardson said.

Public utilities present some unique acquisition challenges, but ultimately they fit into the prevailing trends in the industry-a continued focus on "back-to-basics" strategies, combined with pressure to grow in a conservative and incremental way.

"To the extent companies are still in the process of strengthening their balance sheets, embarking on a heavily financed transactions may not fit with that strategy today," Hempstead says. "But lots of companies are looking into the strategic benefits from acquiring contiguous or complementary companies to capture synergies and earnings growth. But we've noticed that synergies may not always be realized in the amounts or the time that management originally expected."

In short, utility M&As are in the air, but companies are not allowing themselves to get drawn into transactions without having a clear understanding of the risks and rewards they face. They are scrutinizing all