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Utility M&A: How Many Deals, and How Soon?
By opening the field to far-flung deals, PUHCA’s repeal changes the merger game.
higher return expectations." This trend might be exacerbated by Hurricane Katrina, which added inflationary pressures by constraining fuel supplies.
Over time, inflation translates into scarcer and more costly capital for utilities, as investors shift their money toward investments that are more attractive. To avoid this outcome, utilities are seeking ways to bolster their earnings, and M&A transactions rank near the top of the list of alternatives.
Consolidation likely will occur first among top-tier utilities with balance sheets and credit depth sufficient to support major transactions. "We don't think consolidation is unique to larger companies, but major transactions may happen first," Marks says. "Small, medium and large companies will see increased consolidation over time."
In theory, these transactions will be driven by peer pressure, as utilities and their investors see better performance at larger, merged entities. "The concept of mergers comes into the psychology of small and medium-sized companies when they begin asking how they will produce the returns the Street wants," says Frank Napolitano, managing director with Lehman Brothers in New York.
The trick, of course, is turning theory into reality—and that's not a trick many utilities have fully mastered. "Our perspective and experience has shown that utilities haven't achieved the synergies they set out to achieve," says James Hempstead, Moody's vice president and senior credit officer. "They tend to come up short and the synergies take longer to realize than expected."
While companies have migrated away from growth-oriented businesses in the past few years and toward dividend-oriented areas, this trend seems to be reversing itself as more companies emphasize growth expectations in response to investor pressures. "It's not just about dividends," Napolitano says. "Companies will bifurcate into those that have a good earnings-growth story and those that don't."
Companies in the latter category seem unlikely to sit around waiting to become acquisition targets. Instead they will target other companies that have even lower earnings growth, and that provide a good match in terms of operational, financial or strategic characteristics.
"For them, the PUHCA question is very important," Napolitano says. "Their likely dancing partners aren't next door, but maybe two wheels away. PUHCA's repeal creates a regulatory option they didn't previously have."
In the post-PUHCA era, more utilities will consider long-term consolidation strategies that begin with mergers between relatively far-flung companies. Over time, such merged companies will seek to incorporate intervening territories. "A prime example is Ameren," Tirello says. Ameren was formed through the merger of Central Illinois Public Service Co. and Union Electric Co. in 1997. Ameren later bought Central Illinois Light and Illinois Power. "Illinois was fragmented before, but now the southern half of Illinois is under one management structure," Tirello says. "This is more efficient in a million ways. Instead of the truck driving 50 miles to get to the next part of the territory, it's all one."
Recent proposed mergers fit the same mold, only on a bigger scale. After Exelon merges with PSEG, subsequent mergers with First Energy and NiSource would result in a single territory from Chicago to New Jersey. Similarly, a merged Duke/Cinergy