Like a physician with her stethoscope at the outset of a check-up, astute shareholders and directors should use the level and trend of a utility’s market-to-book ratio (MtB) as one of the first...
Banking on the Big Build
The need for many hundreds of billions of dollars in capital expenditures creates huge opportunities and challenges, especially in a more challenging credit environment.
in France. Rothschild acted as financial advisor to Constellation on the transaction.
Another interesting example, involving the freeing up of capital from “non-core” areas, involves the announced commodity trading joint venture between Sempra Energy and Royal Bank of Scotland. The transaction will allow Sempra to free up over $1 billion of working capital from its trading business, which can be used for reinvestment in the business and/or for balance sheet management, including share repurchases.
Many infrastructure funds actively are looking for opportunities to invest capital in long-term, low-risk asset classes that allow them to match their long-term liabilities effectively. The utility sector is a natural fit for them. Where regulatory frameworks allow, they are interested in investing directly in specific projects. Many of the funds also are interested in acquiring whole utilities (following Macquarie’s acquisition of DQE), with subsequent rate base investment opportunities allowing them to average down their effective purchase price as a multiple of rate base.
To meet the challenges of financing their multibillion dollar capital expenditure programs, utilities will need to thoroughly evaluate their existing use of capital to ensure that it is being allocated most efficiently. For example, utilities that continue to own international businesses may consider monetizing these to help fund investments in their core business closer to home.
Mergers & Acquisitions
The funding of large capital expenditure programs is especially daunting for small and medium-sized utilities, which typically find it difficult to attract attention from Wall Street and are the first to suffer when conditions in capital markets deteriorate, as they have done recently.
If Wall Street firms decide to reduce their exposure to the sector, whether because of “hung bridges” or a more general reduction in risk appetite, it is likely to be the smaller companies who feel the pain first. These same companies also will suffer from the fact that individual capital projects likely will be lumpier and have a bigger impact on their cash flow and leverage ratios than they would for a bigger company. It is noteworthy that both DQE in its sale to Macquarie, and NorthWestern in its failed sale to Babcock & Brown Infrastructure, cited access to capital for future investments among their reasons for pursuing sale transactions.
Utilities with lower credit ratings also will feel increasing pressure to merge. In the current credit downturn, as in previous cycles, the cost of debt has increased and access to capital markets has deteriorated more for companies with weak credit ratings than for those with strong investment-grade ratings. The prime consideration for stronger companies contemplating mergers will be to avoid dragging down their own credit ratings and impairing their access to capital through any such mergers.
The need to fund large capital expenditure programs should therefore accelerate consolidation among utilities, with large well-capitalized entities being the partners of choice. But even for mergers between smaller companies, credit rating agencies generally attribute some benefit to size. They also see benefit in the increased diversification and lowered risk profile that often come with mergers.
Even with progress on all the issues above,