One simple line in the recent Energy Policy Act sets the stage for broader geographical ownership by current utilities and easier ownership from outside industries.
Readers know very well that one line calls for the repeal of the depression-era Public Utility Holding Company Act, more commonly referred to as PUHCA. With PUHCA repeal, a major feature of the recent act, many pundits have stated that a wave of mergers and acquisition activity is now imminent.
The last 12 months have seen four major utility deals announced (see Table 1). All four have had similar pricing ratios, with multiples of 8x-11x recurring earnings before interest, taxes, depreciation, and amortization and 1.5x-2.1x book values. If we truly see a group of energy acquirers step off the sidelines and a wave of new markets entrants, logic would seem to indicate that pricing ratios will rise in the face of more competitive bidding situations.
Critics of PUHCA repeal have warned that energy companies will squander capital and put reliability at risk in the quest for higher growth. Other critics warn that financial players will leverage up holding companies and put their financial health at risk. Critics also point to Enron and capital squandered in the gas-fired merchant power buildout of recent years.
Some of these arguments hold water, but most are unfounded. Utility mergers are still a local game, and the removal of PUHCA barriers does not diminish that fact. Successful acquirers still have to deal with possibly thorny state regulators.
State regulators recently scuttled two deals. In March of this year, the Oregon Public Utility Commission rejected Texas Pacific Group's bid for Portland General Electric Co. Regulators in Arizona nixed Saguaro Utility Group LP's bid to acquire UniSource Energy Corp. Both Saguaro and Texas Pacific—private equity funds with very deep pockets—were attracted to steady cash flow streams and could afford to invest in troubled or under-performing companies. Local regulators saw carpet baggers who would suck the utilities dry and then sell them off at a later date, never concerning themselves with customers.
Back in 2000, Texas-New Mexico Power (TNP) went private through a leveraged transaction, only to be resold to PNM Resources in 2004. Actual realized electric rates dropped for consumers during the period. Even though concerns with its deregulated affiliates kept TNP on various ratings watch lists, it emerged from private ownership largely unscathed. However, Arizona and Oregon state regulators seem largely to have ignored the TNP example.
Private equity will not be a major player in utility acquisitions for the next few years, but what about other financial players? Berkshire Hathaway already has an existing utility vehicle in MidAmerican Energy Holdings, and therefore a track record with regulators that bodes well for its recent announcement to acquire PacifiCorp from Scottish Power. Its well-known chairman, Warren Buffet, has since said that the firm intends to continue to invest heavily in the sector. Goldman Sachs already has a sizeable presence in the power industry through its acquisition of Cogentrix and other generation assets. AIG and others have invested heavily in the regulated pipeline sector. Are Goldman, AIG, and other well-known financial houses interested in owning utilities? Who's to say? Instead of creating financial danger for utilities, their very strong credit ratings and capital markets access should lower the cost of capital for acquired companies and lead to increased financial strength, which state regulators can dictate.
Some industry observers have commented that foreign energy companies may be interested. However, foreign companies without a domestic track record would be wise to heed Scottish Power's experience. The company has said it underestimated the amount of expertise and energy required to deal with state regulators when it first acquired PacifiCorp.
The Federal Energy Regulatory Commission (FERC) also addresses market-power issues with every merger announcement. PUHCA repeal doesn't give the largest energy companies carte blanche to gobble up other utilities. Witness the 6,600 MW of actual and "virtual" generation divestitures required by FERC as part of the Exelon/PSEG merger. In the end, the most likely acquirers will continue to be large, healthy holding companies on a case-by-case basis where premiums can be recouped through realistic cost savings. The credit crisis that gripped the industry post-Enron is fresh in every CFO's mind and should keep management teams from overpaying for other companies.
Merger and acquisition activity for generation assets continues at a rapid pace. SNL Energy tracked 86 significant U.S. power generation asset deals (for which financial terms were disclosed) from the beginning of 2004 to present, totaling more than $10.3 billion in transaction value. More than half of that value has been announced in 2005 (see Table 2 and Figures 1 and 2).
For the second quarter 2005, overall transaction value fell slightly, even as deal count increased 40 percent over the previous quarter. Median dollars per kilowatt of nameplate capacity values also rose quarter to quarter, and average dollars per nameplate kilowatt returned to more normal levels.
Average and median transaction value/nameplate capacity values typically move in relative tandem. However, Danielson Holdings' acquisition of American Ref-fuel's six waste-to-energy plants valued at $4,804/kW in 1Q 2005 inflated average values for that period. Through the first two months of 3Q 2005, aggregate deal value appears to be lower, but prices in $/kW are still in the mid $400 range.
Two recent deals of note are AEP's purchase of the 519-MW Ceredo plant from Reliant Energy Inc. for $193/kW, which follows a similar deal to buy the 821-MW Waterford plant from PSEG in May. That deal was valued at $268/kW. Both deals involved gas-fired peaking facilities that will be rolled into a rate base. These types of deals were predicted at the height of the merchant financial crisis a couple of years ago and represent the low end of the market.
On the high end of the market, nuclear assets continue to command a premium, as evidenced by FPL Energy's recent purchase of a 70 percent ownership share in the Duane Arnold Energy Center for $818/kW through a competitive auction process.
Overall, YTD 2005 median dollars per nameplate kilowatt implied values have declined from 2004, continuing their descent from 2003. As of August, year-to-date domestic generation aggregate transaction value already was challenging the lofty totals of full-year 2004 (based on a strong first half), though deal flow was relatively modest in comparison. Capacity sold has been comprised primarily of gas-fired technology as continued high natural gas fuel prices make plant operation expensive and divestiture tempting. Against this trend of declining plant valuations, 2005 has seen an increase of renewable power facility and project deals, especially from private sellers, including Zilkha, Navitas Energy, and Luz Solar Partners. Disclosure of operational data or financial terms often is lacking in such transactions and likely would stem the tide, if only moderately, of apparently declining implied values.
Several large capacity portfolios sold in 2004, including Duke's Southeast merchant gas facilities and AEP's 10 plants (primarily gas), effectively diluting 2004 implied values. However, these portfolio sales have been matched quite differently in 2005 through corporate combinations of diversified utilities Cinergy and PSEG, and through the use of well-valued buyer shares as deal currency. Such combinations are excluded from our 2005 numbers here, as the companies did not allocate transaction value to the generation assets. However, interest in, and buyer demand for, baseload nuclear assets has risen dramatically with energy fuel costs, and PSEG's nuclear operations likely would have garnered a premium if sold on a stand-alone basis.
Looking forward, mandatory plant divestitures relating to the Exelon-PSEG merger will put an additional 4,000 MW of primarily gas, coal, and oil-fired capacity on the PJM asset market, not including 2,600 MW of "virtual divestiture" capacity. This glut of capacity for sale should continue to give buyers a distinct edge in the sales process and drive asset valuations lower in late 2005 and 2006.
As discussed earlier in this article, PUHCA repeal does not mean that FERC-imposed market-power tests will be eliminated; in fact, they may be imposed more severely in an attempt to mollify critics of PUHCA repeal. In any event, a wave of utility mergers and acquisitions may reverse the pricing trends of the last two years if more valuable baseload power in the form of coal and nuclear assets is pushed into the market through mandated divestitures.