Some big utilities are looking to get bigger.
When Morgan Stanley last October asked 30 of the top 50 utility chiefs whether they expected to merge with another company in the next two years, two-thirds of them said they did. Asked whether they expected to merge within the next five years, the utility chiefs unanimously said yes.
"The big will get bigger and the strong will get stronger. We fully believe that the winners will get differentiated," said Jeff Holzschuh, managing director, and head of the global energy and utilities group at investment bank Morgan Stanley.
Speaking at the Exnet Utility M&A Symposium in late January, Holzschuh said merger considerations, like utility balance sheet considerations, are following a "back-to-basics approach," only in investment banking parlance it's "M&A 101."
"M&A 101 [is] taking synergies out, providing revenue opportunities, cheaper access to capital-all the things that you think of M&A as a tool to do," Holzschuh said.
But the success of mergers will depend on how the market understands strategic combinations and how that combination will play a role in growth, Holzschuh explained.
Of course, growth, he admitted, has been a taboo word in the industry for the last 18 months. But as the general market begins to rebound, he predicted growth would again be in investor's sights. Also, experts believe that some utilities exhibiting anemic 1 to 2 percent organic (internal) growth will need to explore other sources of potential growth.
"We see that power utilities have been placed in a box shaped by many factors. Despite these many obstacles, the market's growth expectations are far in excess of what the utility core businesses are capable of delivering," says George Bilicic, managing director and group head at investment bank Lazard LLC.
Bilicic says the first step to meeting growth objectives is self-help by developing the best stand-alone strategy possible. Self-help strategies involve cost cutting, improved regulatory relationships, optimizing capital expenditures, divesting non-core or under-performing assets, capital market strategies, aligning liquidity, and growth. Much of this falls under the heading "back-to-basics," he says.
"But self help … is [not enough] shareholder value creation to provide between 5 percent, 7 percent or 8 percent growth [in shareholder returns]," Bilicic says.
Furthermore, the pursuit of non-regulated strategies such as telecommunications, billing, energy technology, and security may not provide greater returns, as it is not viewed as a core utility competency by investors. Not to mention that the industry has a track record of abject failure in regard to its non-regulated ventures, an expert says.
"Merchant energy strategies may work in one-off opportunistic situations but require significant investment scale to achieve meaningful returns. It would also invite significant market and regulatory skepticism, and would be difficult to implement in the current market environment. Neither of these options is viable for most companies," says Bilicic. Instead, Bilicic believes that if self-help is inadequate or non-regulated strategies are not viable, a consolidation strategy is likely one of the only growth vehicles for power and utility companies.
"Receiving a premium … may deliver immediate shareholder value in excess of long-term growth potential. . Scale in itself can be a catalyst for growth. It provides synergy benefits, mitigates operating challenges [and] also gives regulatory and market diversification. Furthermore, it enhances credit capacity, business diversity, and there is more room for error."
But a consolidation strategy is no cakewalk. Bilicic says an M&A strategy carries its own challenges, such as the proper time to buy, the bringing together of two once independent cultures, the review of earnings and credit impacts, the design of a new corporate structure, shareholder protections, and, of course, overcoming regulatory scrutiny.
Yet, before a merger wave is to take off, most utility executives and bankers agree that valuations of the industry must stabilize, given that most utility stock indexes were down 35 percent last year and 20 percent the year prior. The most often asked question is when.
Morgan Stanley's Holzschuh believes that while valuations will stabilize within the next year, volatility in reported earnings will continue. "On a P/E [price-to-earnings] basis, clearly there is a big desire to have stable earnings and be predictable to get some of the volatility out of the valuations," he says.
Generally, investment bankers believe strategic M&A activity will be available only to the strongest credit quality utilities, which may not be many companies. Almost 40 percent of utilities are still on some type of negative credit watch.
"For those being challenged by credit issues, it's expected to get worse before it gets better," Holzschuh says.
Rodney Miller, managing director, Credit Suisse First Boston (CSFB) and global head of The Power Group, says, "Credit quality will be the key. M&A will not be a solution to a liquidity crisis." But to those that have a good credit rating, the money will be there, Miller says.
"The real key is, show me the money. What we are finding in this current environment is the fact that utility M&A is no different than any other. M&A is driven by money. That's what is going to drive the deals," he says. Miller explains that as the cost of capital has increased for utilities, and traditional lenders have backed away, private equity and institutional investors have taken up the slack as lenders to the industry (see "The New Utility Lenders: No Need To Buy Them Steak," March 1, 2003.) "Whether you look at several of the deals of last year, there is a broad body of thoughtful, well-informed, educated investors looking to put money to work in this industry. Take advantage of it," Miller says.
After a Perfect Storm: Reading the Signs of Recovery
Much of the debt restructuring in reaction to credit rating pressures and management changes are precursors to a fair amount of strategic activity, Holzschuh says. For example, according to Morgan Stanley, of today's top 50 utilities by market capitalization, only 39 percent of CEOs in 1997 still have their positions. Furthermore, only 17 percent of CFOs in 1997 still have their positions.
"[In addition], looking at the difference between U.S. and non-U.S. deals as a function of a number of transactions, they have been about the same for the last three or four years. We have had about 40 some transactions in the United States, and 75 internationally. The number of deals haven't really changed, but the volumes are substantially less and the deal sizes are dramatically smaller," Holzschuh says.
In fact, according to the investment bank, in 1999 and 2000, the average transaction was about $1.5 billion per deal. Last year, in North America, it was about $350 million. Furthermore, in 2002 overall M&A activity was 25 percent of the volume of 2000, a peak year. Many of the deals in 2002 were much smaller and involved all cash, which will continue to be a prerequisite in the current market environment for utilities, he says (see Chart 2). Holzschuh predicted M&A activity would be in the $75 billion to $100 billion level in the states going forward, and that European utilities would play a more prominent role in U.S. acquisitions.
"International buyers could come in as their own markets have become limited in growth. There is $100 billion in these five European companies alone in what you call headroom [for possible M&A]," says Holzschuh. In fact, he believes that in the years to come the Exnet Utility M&A Symposium at which he spoke will have to be conducted with translators. Sprechen sie Deutsch?
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