Buying TimeSlowly and cautiously, utilities are moving back into growth mode.
The air is buzzing with talk of mergers and acquisitions (M&A). It can be heard in the boardroom and on the trading floor. Bankers hear it, and they see their deal backlog beginning to grow. Fund managers hear it, as they hunt for the best buys in the market before strategic investors snatch them up. Financial advisers and lawyers hear it, too; their phones are ringing more than they have in years.
But is it for real? Is the buzz just a lot of talk, signifying nothing more than wishful thinking from Wall Street? Or is a wave of utility M&As truly on the way?
"There was a noticeable increase in comments about M&A in the June earnings conference calls," says Jim Hempstead, vice president and senior analyst with Moody's Investors Service in New York. "The primary rationale behind M&A is to pursue earnings growth through scale and scope, but impediments to that rationale exist."
Utility mergers are complicated, costly and difficult to justify-to ratepayers, shareholders, and regulators alike. Nevertheless, many of the fundamental drivers that favor M&A are moving into place. Debt costs are low; many utilities are in a strong cash position; and investors are beginning to apply pressure as they look for growth opportunities exceeding utilities' low organic growth rates.
These drivers, combined with the prevailing "back-to-basics" mindset among utility investors and regulators, are pushing the industry toward consolidation. Whether and when companies go along with that push depends on their ability to develop a business case that makes sense. And they seem to be in no hurry.
"The industry is in an interesting state of change," says Marc S. Lipschultz, a partner with Kohlberg Kravis Roberts & Co. in New York. "Companies have gone through some wild gyrations over the past five years, and now a lot of people are taking time to assess where to go next."
Economic forces are putting pressure on gas and electric companies to pursue growth again, after about a three-year period of contraction, cleanup, and restructuring.
"Obviously credit quality has stabilized," says Mike Haggarty, vice president and senior credit officer at Moody's. "Liquidity has improved over the past two or three years." This improvement has resulted from companies refinancing debt and liquidating assets-especially unregulated assets.
"The average U.S. electric and gas utility is pretty solid today, with ratings in investment-grade territory," says Peter N. Rigby, a director with Standard & Poor's in New York. "The ones that managed to stay out of merchant power and telecom exploits a few years ago maintain higher ratings. Many are in the A and A+ categories, and are quite strong in many ways."
The key to this recovery has been companies' ability to retire debt and refinance it at lower interest rates. Economic stimulus provided by the Federal Reserve, in the form of rock-bottom interest rates, has given the industry the financial flexibility it needed to survive the disaster of Enron's collapse and everything that followed it.
"Power companies can tip their hats to the debt market because now they have strategic choices regarding where to take the company," says Frank A. Napolitano, managing director and co-head of the global power investment banking group at Lehman Brothers in New York. "The amounts, terms, and pricing of available debt have been much better than anyone could have predicted, based on the profile of an industry experiencing a declining period. In many cases, companies whose ratings had declined were able to borrow money at lower rates than they could when they had higher ratings."
As a result, utility companies' financial positions have stabilized, with better credit and stronger cash flow. In fact, some utilities, finding themselves flush with cash, have been repurchasing shares or boosting dividends (). But as investors begin seeking stocks with stronger returns, utilities will begin feeling pressure to put that cash into growth opportunities rather than shareholder payouts.
"The industry has been trading at high P/E multiples compared to historic trends, even considering the dividend tax cut," says George Bilicic, a managing director with Lazard in New York. "If we get overall economic growth and interest rates rising, utility stocks will experience a compression of multiples. Investors will be less interested in the yield component of utilities and will be looking more toward growth" ().
In recent months utility stocks have been performing better than the S&P 500. With current price-to-earnings ratios in the 15x range, utility stocks are considered strongly valued, which means the run-up in share prices is unlikely to continue. Going forward, the 1 percent to 3 percent organic growth rates that many utilities are projecting will not satisfy increasingly growth-minded investors, who are seeking returns in the 7 percent to 12 percent range. To compete for capital, utilities will be forced to find ways to increase their share value.
"A lot of utilities and their bankers are starting to talk about growth," Lipschultz says. "If back-to-basics was the thing to talk about for the past two years, then growth is the thing they are starting to talk about today."
Companies are not likely to abandon their back-to-basics strategies, however. Investors and regulators alike continue demanding that utilities focus on their core businesses, preferably regulated ones. This leaves utility companies with few growth options.
"Utility executives face a Hobson's choice right now," says Michael Zimmer, a partner with Thompson Hine LLP in Washington, D.C. "They are being rewarded for concentrating on fundamentals, but Wall Street is sending signals that it will only continue supporting companies that are growing at 10 percent per year."
So utilities face three main options for growth:
Some companies are investing in new power projects, gas pipelines or transmission and distribution (T&D) assets to meet projected demand growth-and, to some degree, to support rate cases before state utility commissions. "To the extent the territory is growing and local regulators understand that and want to keep up with that growth, then regulated cap-ex is the best way to spend your money," Napolitano says. "That's the number one, no-regrets way to grow."
However, many utilities have avoided rate reviews for several years, because their costs have remained stable or have decreased. Utilities' cost of capital, for example, has fallen along with lower interest rates. Thus, going to the commission now can be a risky prospect.
"Will utilities get the rate increases they are asking for, or something less?" Rigby asks. He points to Idaho Power's recent experience as a cautionary example. The utility sought a 17.7 percent increase in average rates in October 2003, but the Idaho PUC approved only a 5.2 percent increase.
Many utilities have been perusing power plants on the auction block to find distressed merchant power assets and other unregulated power plants that could be brought into rate base. "There's no question; all around the country utilities are buying power projects in various stages of development," says Jeff Bodington, principal of Bodington & Co. in San Francisco.
Several such deals have gone forward, including Oklahoma Gas & Electric's acquisition of NRG Energy's McClain power plant. But that deal and others have raised challenges from FERC, which is concerned about how putting wholesale capacity into the utility rate base will affect wholesale market competition ().
Additionally, utilities that plan to leverage their acquisitions of power plants or other horizontal assets will face questions from rating agencies, which are keeping close tabs on their levels of indebtedness. After having extricated themselves from a morass of debt, utilities are in no hurry to leverage themselves again.
This is the approach that seems to represent the greatest opportunity for increasing share value and profits (). "There's likely to be a pickup in the consolidation of utilities," Morash says. "The best prospects at the regulated utility level probably will involve neighboring utilities merging to capture operating savings."
The challenge will be to do so without hurting either company's financial position. Accomplishing this in today's still skittish market will require utilities to take an excruciatingly careful approach to due diligence and planning. Those that can manage it, however, will be rewarded in the capital markets.
"Growth by itself wouldn't necessarily affect credit quality if done prudently, and with a balanced use of debt and equity," says Haggarty of Moody's. "If a company can put forth a compelling business case and it's within their field of expertise, we would probably look favorably on such a transaction from a ratings standpoint." He points to the example of Ameren Corp., which received FERC approval this summer for the $2.3 billion acquisition of Illinois Power Co. "We confirmed Ameren's ratings, even though they are buying a smaller and weaker utility," Haggarty says.
Getting to 'Yes'
Despite the economic drivers, utility mergers today face a variety of impediments that likely will prevent utilities from clumping together very rapidly.
First, while utilities' current financial strength puts them in a position to begin considering growth opportunities, it also means that many acquisition prospects are priced at a high premium. "We've heard rumblings that utilities are considering M&A, but we haven't seen a lot of evidence, partly because there aren't a lot of good buys out there," Rigby says.
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 their options, and listening carefully to major stakeholders before making any significant moves. "Boards and management teams are being very cautious," Bilicic says. "The message they are delivering to shareholders is that they will work to grow the company, but that they will be very careful stewards of their capital."
Cost efficiencies are the primary economic driver for utility mergers and acquisitions (M&A). However, not everyone agrees about whether the savings are real.
"Some companies merge on the hope that there will be synergies that result in cost savings, but history has shown they often aren't achievable," says Peter N. Rigby, a director with Standard & Poor's in New York. "With some mergers, years have passed and we are still looking for the cost savings that were promised. The market will be more skeptical about realizing those synergies."
Others, however, argue that most utility mergers have yielded good results. "The data is quite compelling in terms of the savings utilities have realized," says George Bilicic, a managing director with Lazard in New York. "The problem is that if you look at share prices and how companies have performed following mergers, it's hard to determine what factors are affecting those prices."
Additionally, utility mergers by their nature don't generate the kind of impact that mergers between some other types of companies generate-such as media or pharmaceuticals companies. This is due largely to the nature of the business itself, which is, after all, selling a rate-regulated commodity product. Utility mergers are often solid, accretive transactions, but they rarely represent truly transformational propositions.
"M&A certainly will be a vehicle for achieving growth," says Jeffrey Holzschuh, a managing director with Morgan Stanley in New York. "But this is fundamentally an industry that won't achieve high growth rates. Companies will have to squeeze out efficiencies and reduce costs" ().
As a result, utilities probably will never feel the kind of consolidation pressure that companies in some other industries feel. "If a utility doesn't do a merger, it's not like it's marginalized in its market," Bilicic says. "There isn't a lot of the strategic urgency that you see in many other businesses."
At the same time, utility mergers will continue, if only because utilities perceive the strategic and operational advantages of achieving a larger scale. "We're the only country in the world with so many comparatively small utilities," says Doug Dunn, a partner with Milbank, Tweed, Hadley & McCloy in New York. "We will have to see consolidation ... because electricity is such an important component of our [gross national product]. We need to put companies together to increase efficiency, lower costs, and improve reliability."
The New Long-Term Money
In the darkest days of the industry's recent crisis, two beacons appeared and brought utility companies back to the light of day. One was the Federal Reserve, which rolled interest rates back and flooded the economy with cheap debt. The other was the private equity market, which was flush with cash and looking for a good place to invest.
"When Warren Buffett jumped into the market in late 2002 and invested heavily in Williams and Centrica, a lot of other hedge funds saw what he did and jumped in after him," says Daniel M. Morash, managing director and global head of project finance for CIT Power, Energy & Infrastructure in New York. "As more investors entered the market, securities prices recovered. Companies could then sell their assets, restructure their balance sheets, and the industry could move on."
Since then, utilities' financial positions have stabilized, but private equity funds remain significant players in the industry. The reason is that energy assets that remain undervalued in the current market represent an excellent fit for the investment strategies of equity funds.
"Asset valuations have been driven by earnings, and there are lots of circumstances in which assets are probably worth more in a private buyer's hands than in the public market," says Jeffrey Holzschuh, a managing director with Morgan Stanley in New York. "Private equity has an advantage in these situations."
Indeed, private equity funds view the utility industry's combination of risks and uncertainties as an opportunity they are uniquely equipped to pursue. "When you are dealing with a lot of unknowns in your business and industry, it's tough to map out a strategy if you have to deal with a volatile capital markets," says Marc S. Lipschultz, a partner with KKR in New York. "There's a value-added role for someone who can provide patient capital and give companies the time they need to map out that strategy."
This value-added role has allowed private equity and hedge funds to buy into a significant number of energy and utility assets. The list of funds that have entered the market sounds like a who's-who of investment funds: Berkshire Hathaway, KKR, and Texas-Pacific Group, to name a few.
The entrance of these funds into an industry they've historically avoided has some analysts wondering how these funds expect to squeeze double-digit returns from assets that strategic buyers-mostly utilities-have generally shunned. The answer lies in the basic strategy that equity funds pursue.
Traditionally, such funds make money by taking control of businesses when they are having trouble, spending a few years turning them around, and then selling them to strategic investors when the business is in a better financial position. Equity funds are experts at maximizing value from distressed assets. They work to improve operations, and also to optimize financial structures, unbundling and re-bundling assets in ways that will increase their value.
"We have greater flexibility than a lot of the strategic buyers," says Dan Revers, a managing partner with ArcLight Capital in Boston. "As cycles occur, we can move to where the value is very quickly. We can buy a coal mine one day and a gas-fired power plant the next, without boards and shareholders and rating agencies to slow us down."
These funds look at investments on a 3-, 5-, or 10-year timeline. This investment horizon might seem short-term in the context of the utility asset lifespan, but it is actually a very long horizon compared with the hair-trigger behavior of public stock markets. This "patient" viewpoint allows equity funds to capitalize on large-scale business cycles that drive public-market investors away.
"Changes in the market always lead strategies to buy assets and shed assets," Revers says.
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