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Fulfilling the Value Proposition

The Next M&A Wave: If mergers are once again a potential strategy for accomplishing growth objectives, the previous round of transactions offer several lessons.

Fortnightly Magazine - May 2005

recover in an improving economy and as interest rates rise just as the utilities industry refocuses on refurbishing the nation's infrastructure, the challenge of protecting lofty multiples becomes more acute.

The earnings profile of many companies is presented in Figure 5. With the consensus earnings growth rate for utilities in the range of 3 to 5 percent and averaging around 4 percent, it would seem that a low threshold for success has been set. However, even with this low growth rate, the challenges to the sector are considerable. As this figure shows, average indigenous earnings growth of the typical utility's core business is a modest 1 to 2 percent, coming from increased load and new customers. This leaves at least a 2 to 3 percent gap in meeting average growth expectations, which must be filled via other means.

Of course, attacking the cost structure is a fundamental method available across any economic cycle and can provide for some portion of the gap closure. This tried-and-true approach has served managements well in downturns, but less so in expansion periods. Moreover, it is not uncommon for approximately 50 percent of base non-fuel costs to be attributable to wages, salaries, and benefits. These labor-related costs are escalating at almost 5 percent annually given the normal 3.5 percent contract wage change provisions and the double-digit growth in health-care costs. Thus, managing costs becomes a table-stakes action just to avoid eroding earnings and not the growth backfill that has been counted upon.

Certainly, companies can invest in rate base for growth or to solidify the infrastructure, and this will provide a solid source of incremental earnings. Yet, given the attrition that has built up over time, the continuing escalation in operating costs, and the uncertainty over allowable rates of return in today's economic environment, it is by no means certain that rate-case decisions will assuredly produce new revenues at the level expected. Recent allowed returns on common equity have been awarded in the unsettling ranges of 9.5 to 10.5 percent rather than the 11.5 to 12.5 percent range that many companies have enjoyed over preceding years, potentially constraining revenue levels. Thus, adding to rate base has its vulnerabilities as well.

Where meaningful organic growth cannot be counted upon and challenges exist even to maintaining current earnings levels, then other inorganic sources of growth must be tapped. Individual assets from companies continuing to rationalize their business or to improve liquidity are plentiful in the market, but often lack the requisite contracted outputs that make these facilities attractive. Further, many assets have been secured by financial buyers, thus raising the cost of acquisition to strategic buyers.

Predictably, there are substantial impediments to following only purely organic and targeted inorganic paths to achieve planned earnings growth. These facts are well recognized by companies and their boards, which has reignited M&A as a topic and potential growth strategy. Couple the real limitations on organic growth with a highly fragmented and diffused industry of more than 70 free-standing investor-owned electric companies and the ingredients for consolidation are present.

Thus, delivery of adequate