Business & Money
Is the industry on the verge of a new consolidation wave? Should it be?
The question of whether this is the year for repeal of the Public Utility Holding Company Act (PUHCA), or the "35 Act," as it is also known, is now an age-old one for industry participants. Although those supporting repeal may again experience disappointment, as a result of the 2003 Northeast blackout or otherwise, circumstances suggest that repeal is more likely than it has ever been. PUHCA was originally enacted in 1935 and served a public policy purpose for some time thereafter. However, the enactment of various laws directed at the utility and power industry, together with the general applicability of other bodies of law to industry participants, have eviscerated the original public policy purpose of PUHCA. Congress has recently acknowledged as much with both the House of Representatives and the Senate adopting legislation to repeal PUHCA. The Securities and Exchange Commission, the regulatory body that administrates PUHCA, has also taken the same position, from time to time, recommending repeal.
Although PUHCA has been flexibly interpreted in recent years, its existence, even in its flexible state, has some effect on transaction activity, especially for "out-of-industry" entities, and following the court challenge to the SEC's decision under PUHCA relating to the AEP/CSW merger. Accordingly, PUHCA repeal should enhance the probability of certain transactions occurring and of certain entities participating in transactions; yet, industry consolidation activity should not materially change as a result of repeal. As discussed below, PUHCA repeal should have certain specific consequences on consolidation activity.
First, state regulators and perhaps federal regulators might in the short-term scrutinize more carefully the activities of regulated utilities, including the area of consolidation. This additional scrutiny would come from those regulators concerned that a regulatory gap has been created by PUHCA repeal when, in fact, after considering the rules and regulations still applicable and the actual substance of PUHCA in today's world, it would be extremely difficult to credibly identify any such regulatory gap.
If PUHCA repeal occurs, financial buyers and entities such as Berkshire Hathaway and GE Capital would find that the primary regulatory impediments to conventional acquisition structures in respect of regulated utilities had been eliminated. In addition, non-U.S. companies with U.S. regulated businesses would find it easier to consummate follow-on transactions in the United States. (It is important to note that PUHCA is not really a fundamental impediment to these companies right now.) In particular, the requirement under PUHCA that a follow-on utility acquisition be interconnected with the existing owned utility would no longer be applicable. Other non-U.S. companies, while perhaps not currently interested in the United States, would also be able to pursue acquisitions here, without concern about participation in non-utility businesses, ownership structure, or other PUHCA restrictions. U.S.-regulated utilities, such as Duke Energy, which have preferred not to be regulated under PUHCA, or which have a particular problem under PUHCA in respect of potential transactions as a result of their location (e.g., TXU) or otherwise would be free from such concerns.
Strategically appealing, albeit not compelling, transactions that faced PUHCA issues as a result of the interconnection requirement would be able to occur without concern (although PUHCA issues in this area were quite surmountable). For now, though, if PUHCA is repealed, a West Coast utility will not then merge with an East Coast utility in response because such a transaction (as well as many others that had faced actual PUHCA impediments) will not be viewed as making strategic sense in this marketplace, especially given all of the other consolidation opportunities available.
Furthermore, those registered holding companies that faced serious PUHCA issues in previous mergers, and which are concerned about such issues being revisited as part of a new transaction, would no longer have this concern. Last, over time utilities would find it easier to diversify into non-utility businesses (e.g., to buy water businesses).
Recent Historical Consolidation and Future Trends
Consolidation activity in the utility and power industry has been essentially non-existent in recent years following robust activity in immediately prior years (see Chart 1).
Consolidation activity was robust in earlier years because many industry participants recognized, among other things, the fundamentally consolidating nature of the industry-that is, some of the best opportunities for growth in the industry may be realized by combining two companies and capturing associated cost savings. Other reasons supporting consolidation included the benefits of receiving a premium for shareholders at levels reflecting fair value, and strategic justifications ranging from portfolio diversity to geographic diversity to increased investment flexibility to many others.
Notwithstanding these benefits, consolidation activity has slowed to a halt for a number of reasons. Those reasons include a focus by utility and power companies on alternative opportunities that had been considered more attractive, especially merchant energy and business diversification. Also, some industry participants soured on consolidation as a strategy because various transactions found limited acceptance in the marketplace or unwound as a result of changed circumstances. Additionally, a concern about suffering from the "dead money syndrome" (i.e., lack of market interest during the pendency of a merger) caused some to become discouraged about consolidation. On a related point, as some observed the regulators taking action to materially impair the economics of transactions or delay transactions far beyond what was expected, further concerns about consolidation developed.
Furthermore, the dramatic fallout from the downturn in merchant energy and related balance sheet crises has chilled consolidation activity. Most recently, the focus of many utility and power companies on improving operational performance ("back to basics") has prevented serious focus on consolidation strategies. Of course, now that the balance sheets in the industry have recovered, or are recovering, and the back-to-basics cycle is continuing, it is reasonably possible to imagine a re-emergence of consolidation activity.
The back-to-basics strategy, however, while perfectly sound, cannot be a sustainable way to increase earnings over many years. Simply put, cost savings and efficiencies cannot be infinitely identified and realized as a means of growing earnings (there are only so many savings and efficiencies that can be squeezed out of an entity, absent an M&A transaction) or supporting system investment, so that eventually the back-to-basics strategy will stall, causing companies to look for alternatives.
In addition, for most utility and power companies, it will not be reasonably possible from a market or practical point of view to pursue earnings growth through merchant energy or non-utility businesses (such as telecom). For some, there would be no market acceptance of such pursuits, or near-to medium-term financial challenges to prevent efforts in this area. Also, more generally, the actual shareholder value proposition of certain of these pursuits may be difficult to identify. This may further cause companies to look for alternatives.
Additionally, as a result of changing interest rates, a possible rotation to growth stocks as the economy recovers, and a changing dividend policy in other industries in response to a change in tax laws, it is possible that the industry will experience significant pressure on stock price appreciation. These market pressures may produce an increased interest in taking other reasonable actions to catalyze share prices, including consolidation.
Moreover, as a result of the market expectation of earnings growth for regulated utilities based on Wall Street equity research estimates of 5 to 7 percent, companies may increasingly seek alternatives. However, the organic growth prospects of many utility and power companies fundamentally relates to demographic and macroeconomic trends, which suggest much lower growth rates. Some of this earnings gap expectation can be filled with effective implementation of a back-to-basics strategy, but the benefits of such a strategy will likely not be sustained over the long term.
By comparison, the cost savings and other synergies available from mergers have the potential to fill the earnings gap and otherwise create incremental shareholder value. If one considers the announced synergy levels from certain industry transactions and applies a reasonable price/earnings multiple to the net present value of such synergy levels, the potential economic force of industry consolidation becomes more evident (see Chart 2).
In many instances, it will be the case that the ability to access these synergies, taken together with organic growth prospects, will compare favorably to standing alone. If industry participants agree with this observation, consolidation activity will be more likely. Furthermore, some strategically logical industry mergers would have the effect of improving balance sheets of industry participants, thereby increasing the attractiveness of otherwise appealing mergers and presumably making them more likely to occur (especially as companies continue to focus on balance sheet questions and increasingly focus on system investment needs).
Certainly, the size of certain companies limits their ability to take advantage of some opportunities as they arise. In some cases, therefore, consolidation activity can be justified on the basis that increased size and scale will allow the relevant combined company to pursue investment opportunities the constituent companies could not beforehand. Continued recognition of other scale benefits, such as increased market liquidity, should also support consolidation activity. In addition, to the extent industry participants make effective use of selected transaction techniques that have, to date, not been used extensively in the utility and power industry, as compared to other industries, consolidation activity could be facilitated. These techniques include the use of various joint venture ideas, more direct approaches to engaging counterparties in merger discussions, and value bridging securities and transaction pricing.
Furthermore, and perhaps more important, consolidation activity would increase as public policy-makers recognize, or are educated by industry participants as to the benefits of industry consolidation, and a supportive merger policy could then be pursued in response to the 2003 Northeast blackout. It would be difficult, however, to have a high expectation for any such support to develop, even though equitably controlled consolidation generally should be viewed as fully consistent with public policy objectives of industry regulators. In particular, mergers that are properly structured should create entities that are strong financially and better able to serve ratepayers and invest in systems. Moreover, a private entity with responsibility for a broader region should be able to plan for reliability and investment in a more coordinated and comprehensive way (as compared to the multiple private and not-for-profit entities doing so today).
Finally, in some cases, CEO succession issues could reasonably be addressed as part of mergers that otherwise make economic sense. In this regard, a large number of industry participants are currently, or will be shortly, engaging in a change at the CEO level. Moreover, surveys conducted on the topic of industry consolidation, together with formal and informal dialogue on the topic, strongly suggest an acknowledgment among many in the industry that substantial consolidation activity is more likely than not.
A well-structured merger in the industry and with a sound industrial logic should be accepted in this marketplace. If such a "break-out" transaction is announced in the current environment and is, in fact, well received, it should act as a catalyst for renewed consolidation activity. This should be particularly true in areas of the industry where there is pent-up strategic demand. Chart 3 illustrates a selection of factors that have had, or are having, a material impact on the industry, together with realistic strategic courses left for industry participants.
Possible Continued Impediments to Consolidation
Although many factors suggest a resurgence of industry consolidation, other factors suggest that industry consolidation will not resume. For example, many strategically logical transactions in the industry are best structured as merger-of-equals or modified merger-of-equals transactions (i.e., a transaction where no, or only a modest, premium is being paid). For example, if a merger is between two similarly sized parties and is driven by cost savings, each party may find the merger most interesting if the shareholders of both entities "share the premium"-that is, since no shareholder group is receiving a premium, each group shares pro rata in the financial benefits of a merger. In the case where a merger is structured as such, it is most typical (albeit not required from a legal or financial point of view) to split in an equitable way things such as combined company headquarters, utility subsidiary headquarters, board representation and, most importantly, combined company leadership.
While the treatment of these so-called social issues is particularly difficult in all industries, the impediments may be particularly acute in the utility and power industry as a result of the regulated nature of business (e.g., increases complexity of headquarters issue) and the long history of discussions between some strategically logical merger partners. Also, the fear that regulators will confiscate the economics of mergers or delay approval of mergers beyond what the market can tolerate is preventing, and may continue to prevent, mergers that are good for shareholders and also good from a public policy point of view. A company that is stronger financially should be able to serve customers more ably and invest more effectively in systems. To the extent mergers are not supported by regulators, various system investment opportunities that are readily accessible as a result of the financial benefits of mergers will not be realized.
Moreover, while the repeal of PUHCA (or failure to repeal PUHCA) should not have a material impact on industry consolidation, it is possible to imagine regulatory/legislative action (or inaction) on material topics having a chilling effect on mergers. For example, if as a result of the 2003 Northeast blackout or otherwise, transforming regulatory/legislative changes are suggested or actually enacted, consolidation activity could be stalled or impeded. Furthermore, continued concerns about how the stock market will react to companies that decide to enter into merger arrangements could impact consolidation activity. Many industry participants well remember a series of announced mergers that were ill-received by the equity markets. While these memories are good to retain, such reactions are better explained in terms of whether the relevant mergers were strategically and financially sound as opposed to the market voting in an absolute and adverse way on industry mergers.
There is also a concern about the time it has taken to close many industry mergers and a perception that such passage of time could impede consolidation activity. Adverse consequences identified include: the market will treat deal participants as "dead money" during the pendency of the merger; deal participants are unable to pursue other strategic alternatives during the pendency; and the circumstances under which the investment decision (i.e., the merger agreement) was made can dramatically change between signing and closing.
While it will always take a long time to close a utility merger, there are means available to mitigate the timing issues. These include an effective and sustained market communication program, continued implementation of strategic decisions during the pendency, accelerated preparation of regulatory filings, and reasonable approaches to regulatory issues. Effective use of the foregoing tools (and others) should make the time-to-closing issue less of an irritant.
Additionally, the increased focus of the marketplace and rating agencies on balance sheet quality will create concern about certain transactions that would have otherwise occurred in the not so distant past. Among other things, industry participants may be less able to utilize large cash components for merger consideration without experiencing ratings pressures and some market concern about credit quality. Accordingly, more equity will be necessary in the first instance, or visibility at the time of announcement regarding specific arrangements to "re-equitize" the balance sheet may equally be necessary. While the balance sheet question is manageable, this will make some transactions more difficult because of earnings-per-share dilution pressures associated with larger equity components and increased transaction complexity.
Furthermore, the restructurings and balance sheet rehabilitations over the past 18 months have allowed the industry to move out of a crisis stage. In that regard, many companies previously in a crisis or near-crisis situation are now in a position to exercise strategic leverage in transactions should they choose to pursue this course. However, while it is difficult to imagine the next crisis for the industry, it is equally not beyond the realm of imagination for another crisis to emerge, especially as the next cycle of maturities comes due in 2005-06 and beyond, especially in the case where industry fundamentals have not improved. New industry crises, albeit unexpected, could impede consolidation activity. As noted above, a "break-out" transaction could act as a catalyst for consolidation activity. Similarly, the absence of such a transaction may have the effect of stalling a revival of activity to the extent industry participants are concerned about testing this marketplace and regulatory environment.
On a somewhat related point, commentary from some academics and consultants suggest that most mergers have not created shareholder value. This generic commentary, which has become part of the refrain across all industries when mergers are discussed, may discourage industry consolidation. However, when utility and power industry participants consider the economic benefits of bringing logical industry partners together, a focus on why many of the mergers of the 1990s went bad (deal hubris, bad deal pricing, failed industrial logic) and a focus on avoiding mistakes of the prominent case studies may allow industry participants to be more comfortable with consolidation.
Although the potential repeal of PUHCA has raised the question of its effect on consolidation activity, such activity should not increase materially in response to repeal. Nonetheless, one should expect that industry consolidation will accelerate, and that it should do so since the benefits of consolidation to all constituencies are so compelling if transactions are properly structured. Moreover, the 2003 Northeast blackout has the potential to change the environment substantially (although it is too early to predict the means by which it likely could impact the environment), especially if regulators begin to identify mergers as a way to make the industry stronger. Material impediments still remain to consolidation activity in the industry, however, and these impediments could continue to chill consolidation.
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