When will utilities see the next round of deals?
With the substantial decline in utility mergers and acquisitions (M&A) activity since the heady days of 2000, it's time to ask when M&A activity might return, if at all. Business combinations provide a potentially important means for a utility to enhance its earning and growth prospects, and one of the few alternatives available to achieve these objectives at an acceptable risk.
The elements conducive to an increased level of activity are either coming into place or, in the case of regulatory clarity, have the prospect of coming into place within the next 12 to 18 months. One reason we at Morgan Stanley expect M&A activity to increase over the next cycle is the increasing level of meaningful dialogue among senior management of companies in the industry (. 58).
In the future, transactions likely will shift in form compared with the previous cycle, with more emphasis on moderate premium acquisitions or no/low premium MOE (merger of equals)-type transactions, in contrast to the higher premium deals of the past cycle. Also, while we expect the level of M&A activity to increase, a return to the pace of 1999-2000 is unlikely.
The significant decline in M&A activity since 2000 was not unique to utilities. Overall M&A activity in the United States fell from more than $1.9 trillion in 2000 to about $830 billion in 2001 and $540 billion in 2002. It was not until 2003 that activity started to increase, and then only gradually. The decline in overall M&A activity was due to a number of factors, including the low-growth economic environment subsequent to the market "bubble," the reduced level of confidence among CEOs, and the fragility of the financial markets with the concurrent reduction in equity values. Many companies across varied sectors of the economy became inwardly focused and put their strategic agendas on hold.
Utility companies encountered most of these issues, as well as several specifically related to the sector, including a sharp contraction of the principal growth engines (the merchant generation and trading businesses); the impact of the Enron meltdown and the deterioration of credit quality of companies in the merchant business; the tightness of the credit markets; and the ever-changing status and outlook for deregulation. As a result, many companies in this sector-similar to their industrial counterparts and perhaps more so-turned their focus inward, putting strategic plans on hold.
During this period, the utility sector has focused on other matters, such as:
Improving operations; Reducing costs; Stabilizing credit quality; Increasing the transparency of earnings; and Generally pursuing a "back-to-basics" strategy. With these priorities, it is not surprising that M&A activity by potential acquirors has taken a back seat. Of the more recent utility transactions, most have occurred as a result of sales processes motivated by the financial considerations of the target utility or its parent company (e.g., Illinois Power, Portland General, NUI, TNP, and Mountaineer Gas) ().
Changing Developments
A number of developments have begun to enhance the environment and prospects for M&A transactions.
The call for growth. For the last several years, institutional holders of equity have been reasonably patient with utilities' back-to-basics strategies, given the challenges that utilities have faced. However, with the prospects for an improving economy and rising interest rates, there will again be pressure on utility managements to deliver earnings growth. With intrinsic growth in the utility sector averaging less than 2 to 3 percent, approaches for achieving an enhanced return for investors are limited. After years of cost-cutting, it will be difficult for utilities to achieve sufficient long-term growth primarily through a cost-efficiency strategy, especially in view of the cost impact of potentially higher interest rates and increased inflation upon utility profitability.
A small number of companies have the potential for higher intrinsic growth in their service territories as a result of investment in regulated generation, investment in enhanced transmission and distribution, or higher-than-average customer growth. But even in these cases, the opportunities may not be sufficient to satisfy investors' requirements.
A still highly fragmented sector. The opportunity for consolidation is significantly greater for the utility sector than most other sectors, because the utility sector is one of the nation's more fragmented industries. In this regard, the top five and 10 largest utility companies account for less than 25 percent and 40 percent, respectively, of the sector by retail customers. This compares to the telecom sector, where the top four companies provide essentially all local telephone service and where the number of significant companies has been cut in half over the last decade as a result of mergers. While the commercial bank sector is considerably less concentrated than the telecom sector, the market share of the top 10 commercial banks (as measured by deposits) has doubled in the last five years as a result of mergers, and the trend of substantial consolidation continues. Increased consolidation in the utility sector is clearly possible, offering the potential for utilities to achieve lower cost, greater efficiency, and increased long-term growth.
Improved stock price levels. Although utility stock prices are generally below 2000 levels, utility prices have risen significantly from the trough of late 2002. Utility prices (as measured by the Dow Jones Utility index) rose approximately 35 percent from year-end 2002 through August 2004. Higher stock prices provide acquirers with a stronger acquisition currency, a more attractive means of raising cash for a deal, and financing flexibility if additional capital is needed in connection with the transaction. Higher stock price levels in the marketplace also permit sellers to undertake transactions that are priced off more favorable benchmarks. As a result, it is not surprising that the overall level of M&A activity has been positively correlated with the stock prices ().
Stable credit quality of the sector. Since 2000, the credit quality of utility companies has been more adversely affected than the corporate sector in general. From 2001 to 2003, the excess of downgrades over upgrades for the utility sector (parent and operating companies) averaged more than 100 per year. This pace has significantly moderated with net downgrades of only 18 in the first half of 2004 and only 3 in the second quarter of 2004. Although a high number of companies remain on negative outlook or credit watch negative, prospects for improvement are on the horizon, as certain credit ratios monitored by the agencies are starting to improve. Better quality credits will allow the possibility for acquisitions to be funded in part or in whole with debt, and will allow acquirers to more readily consider the acquisition of lower credit-quality companies.
Potential shift in premiums required. In today's more disciplined financial marketplace, which recognizes the difficulty of achieving meaningful intrinsic growth, there likely will be additional focus on acquisitions with more moderate premiums and no/low premium MOE-type transactions than in the previous cycle. This shift already is reflected in the overall M&A marketplace, where premiums have fallen from an average of more than 40 percent for the past 15 years to 38, 35, and 26 percent for 2002, 2003, and the first half of 2004, respectively (). Anecdotal evidence suggests boards of potential utility company acquirees may be more receptive to considering a lower premium transaction under the right circumstances.
Active financial players, flush with cash. Financial sponsors, which include both general funds and specialty utility/energy funds, have been purchasers of approximately half of the recently announced utility transactions. Recent announcements include purchases by ArcLight (Mountaineer Gas), KKR and JPMPartners (UniSource), and TPG (Portland General).
The funds raised by financial sponsors continue to expand. Morgan Stanley estimates that the largest 25 funds control approximately $100 billion, or about $300 billion of buying power if levered 3:1. In addition, more recently, some of the large investment fund managers and hedge funds have become increasingly interested in the power sector and may also become active in acquisitions of utilities.
Smaller company issues. While bigger is not always better, some smaller utilities have decided that maintaining independence is not necessarily the best path for maximizing shareholder value. Smaller companies often find it more difficult to attract institutional ownership given recent trends by institutions to prefer investments in larger companies with greater liquidity. Additionally, it has become more difficult for smaller companies to attract research coverage, especially given the contraction in the broker and analyst community.
Regulatory considerations. On a federal level, FERC market power issues and the 1935 Public Utility Holding Company Act (PUHCA) often have been significant impediments to merger transactions. Although energy policy has been deferred until after the 2004 presidential election, many believe it will be tackled early in the next legislative term. Clarity in federal energy policy would certainly be a significant help in fostering an environment conducive to mergers in the industry.
In particular, increased clarity regarding FERC's treatment of market power, and how it will be measured and potentially mitigated, would reduce potential obstacles to transactions between larger companies in nearby geographical regions. Also, any additional clarity in the application of PUHCA (or its continued existence) would serve to reduce uncertainty as to the ability to merge utilities in different geographical regions.
The potential repeal of PUHCA also would be constructive for a more active M&A environment because it would increase the set of potential utility acquirors by removing impediments to foreign companies and financial and other non-utility domestic companies.
With the need for utility companies to create value for their shareholders, corporate managements will seek to develop business combinations that can be structured to achieve attractive financial prospects for shareholders consistent with both the requirements of the marketplace and acceptable level of regulatory/implementation risk. An improved economic and financial environment, which appears to be in progress, and the potential for regulatory clarity will make it more practical to achieve these objectives.
Results of Morgan Stanley's corporate executive survey.
In late 2003, Morgan Stanley conducted an informal survey of utility CEOs and CFOs. The results are consistent with the view that corporate M&A activity will begin to pick up significantly. For example, when asked how many of the 50 largest electric utilities would remain independent for the next five years, 60 percent of the utility executives thought that about 40 would remain independent and almost all of the other executives thought that only about 25 of the top 50 would remain independent in five years. In response to another question, 75 percent of those responding thought that their company would be involved in a merger in the next five years. Also, 75 percent of those responding responded that their company would be the acquiror. Of course, developments on the business, regulatory, and economic and financial fronts will influence what actually occurs, but these are the views from those that make it happen. -K.M.
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