What type of merger strategy should energy companies pursue in light of new industry uncertainties?
For the more strategically intrepid acquirer, opportunities abound in the utility and energy industry. However, they are strategic, and anyone thinking he or she can earn a quick basis point will be mistaken. The opportunities come in two varieties, but there are also investments to be avoided. These are the neighborhoods in which only the most energetic and visionary acquirers should play.
This article will first describe the nature of the mergers and acquisitions activity that might be expected within the natural gas, power and energy utility sector, and then explore the associated drivers and risk factors. This will include an analysis of the trends in price/earnings ratios (P/Es) for 79 companies that R.J. Rudden Associates, Inc. (Rudden) has grouped into five categories based on each company's current strategic position within the industry. Finally, we will identify a number of companies that we believe are good examples of the kinds of enterprises that might be active acquirers in 2002 and 2003, keeping in mind that "acquirers" can often become the "acquired."
The first of the two types of opportunities mentioned above pertains to the strategic acquisition of utilities that have significant unregulated operations, as well as non-utility energy companies that conduct upstream businesses in predominantly unregulated power and natural gas markets.
Using relative P/E ratios as the metric, the prices of these acquisition targets are currently attractive, and in some cases, at the lowest levels in recent history. Of course, prices are low for a reason: risk premiums are currently high, and the underlying uncertainties within the energy sector remain formidable. In fact, the near-term upside potentials for utilities and diversified energy equities will be somewhat modest at best. However, acquirers who are willing to make investments with a long-term focus and clear vision of the end state will be winners. These acquirers will need to stay the strategic course over a bumpy and winding road of changing industry economic policy, and through potentially punitive scrutiny by state attorneys, legislators, and regulators; severe boom-bust cycles in both the capacity and commodities markets; and uncertain transmission policies.
Conservative Investments and Horizontal M&A
For the more conservative investor, the traditional local (and still vertically integrated) utilities, and the pipes and wires businesses that acknowledge themselves as just that, remain viable investment options. In these times, they offer some very attractive risk-adjusted returns. The fundamental value of these securities, backed by their managements' clear end-state visions of the industry, as well as an arguably better-defined regulatory future, make them solid performers in any conservative portfolio. As cash generators, they also represent excellent acquisition targets. Remember, research indicates that in the majority of acquisitions, the most measurable and immediate benefits accrue to the shareholders of the acquired company.
But the middle ground-the bad neighborhoods-will remain a somewhat risky place for investors. This is the never-never world in which utilities remain fundamentally regulated, but fancy themselves as competitive as they meander towards an undefined future. They do a "little bit of this and some of that" in a hit-or-miss pursuit of the "right" strategy that will enable them to eke out a few basis points more on their returns. They wander reactively from one state or federal regulatory proceeding to another, without strategic clarity, thinking that tweaking a few rules and regulations constitutes competition. The equities of utilities in this sector will be punished by sub-par P/Es and higher volatility. Acquisitions of these companies by predators at less than maximum shareholder value will lurk in the alleyways, always ready to pounce on the unsuspecting and weak.
That the market for energy-type utilities has become less interesting for investors as a whole, at least until recently, is not news. Figure 1 shows the trend in the Dow Jones Utilities (DJU) index relative to the Dow Jones Industrial (DJI) index over the last 30 years. In the last two years in particular, the DJU has become more volatile relative to the DJI. In the wake of the California energy crisis, the PG&E bankruptcy, and the Enron implosion-all pursued by the stammering and stuttering of law and regulation-the market has come to attach high risk premiums to the companies that populate the DJU.
Further, the market has punished some of the more diversified, competitive energy concerns, perhaps because of the market's often misguided perception that they are similar to Enron. Rudden conducted a comparative analysis of the P/E ratios in March 2002 and March 2001 of 79 utility and energy companies engaged primarily in natural gas and power operations. The "strategic position" of these entities ranged from traditional local utilities (both pure distribution and vertically integrated) through upstream, deregulated (competitive) energy producers and marketers. The 79 companies were each categorized according to one of the five following strategic positions:
- Regulated Local Utilities;
- Regulated Regional Utilities (predominantly multi-state regulated operations);
- Diversified Utilities-Regulated Bias (with relatively more regulated than non-regulated operations);
- Diversified Utilities-Competitive Bias (with relatively more competitive, non-regulated operations); and
- Competitive (primarily upstream natural gas and power production, marketing and trading).
The "strategic position" of each of the 79 companies reflects the nature of its business as it existed in March 2002, and not necessarily the direction in which each company plans to move in the future.
Figure 2 shows the approximate percentage of the 79 companies that are represented by companies in each of the five categories.
As expected, the results of our research indicate that the market has attached significant risk premiums to utilities and other energy companies that have entered headlong into competitive markets and have diversified upstream. () The P/E ratios of these entities in 2002 are not only less than those utilities that remained more or less traditional regulated entities, but have also plummeted since March 2001. This is no doubt attributable to the same external factors that drove the increased volatility of the DJU described above, but it is also driven by the near-rampant confusion over the end state of the industry and to a general crisis of confidence in the ability of the states and federal government to reconcile their differences on deregulation, especially as they relate to market power and design, transmission expansion, and RTO policy.
There are a number of additional risk factors that are either implied in those previously described, or otherwise related. While some of these will be reduced significantly during the upcoming year as the Enron fallout settles, others will remain unresolved for perhaps another two to five years. These factors are significant, and acquirers who will be active in 2002 and 2003 will need a clear vision and a true commitment to the strategic wisdom of their acquisitions. Otherwise, they will have difficulty weathering the potential blistering criticism of shareholders and analysts.
Many of the near-term risks relate to the industry's intense focus on ensuring that "Enron doesn't happen here," and on convincing others that this is so. The resulting diversions and under-valuation of the equities markets should resolve themselves soon. However, other longer-term risks will endure including:
- A lack of a clear and common vision of the industry end-state;
- The potential regulatory reactions to the growth in real and perceived market power resulting from further consolidations of generating assets;
- Federal vs. states' rights issues, and a patchwork of state regulatory approaches to deregulation;
- Uncertainty of regulations regarding market-based rates, regulation of financial derivatives, and rational financial incentives for regulated entities;
- Increasingly intense boom-bust industry cycles;
- Commodity price volatility;
- Capital market challenges, including providing for growth into a 30-33 Tcf natural gas economy by the 2010-2015 period-driven primarily by the needs of the generating markets;
- Uncertainties regarding expanded FERC assertion of jurisdiction over transmission, and a lack of clarity on RTO policy;
- Uncertainty over PUCHA reform or repeal; and
- A lack of a coordinated, broad federal energy policy.
Implications for Mergers & Acquisitions
As indicated at the outset of this article, two distinct trends in future M&A activity are emerging:
1. Aggressive strategic acquisitions by companies with strong competencies and convictions, as well as the balance sheet to back them up. These acquisitions are made economic by the comparatively low P/Es of the diversified, competitively positioned, mid and upstream targets that operate in the more competitive markets.
2. Conservative horizontal mergers of pipes and wires companies, focusing on steady growth, cost synergies, and dividend policy. These are activities associated with the "back to basics" strategies of traditional domestic and certain international utilities that will operate, hopefully, under a higher quality degree of rational diversification and enlightened regulation.
The first group of acquisitions can and will be made by only those diversified utilities with strong balance sheets, experience in diversified energy operations, preferably a good currency with their own stock's strong P/Es, an appetite for the short-term risks required to achieve longer-term upsides, and the tolerance for potentially rocky roads. Companies like Duke Energy, Dominion, Entergy, and possibly AEP would seem philosophically inclined and strategically situated to take advantage of the current market.
In addition to domestic utilities, a number of cash-rich foreign companies appear focused on establishing strategic beachheads in the United States, both upstream and at the local distribution company level, even at the cost of premium acquisition prices. However, given that the present prices of acquisition targets in the more competitive, upstream sectors are low, the total acquisition prices could still represent great buys even if premiums must be paid. And, of course, there are always the huge international oil companies that wait in the wings.
It is a bit more difficult to guess at who the potential acquirers of the second group of opportunities might be. They are likely to include: (1) companies with a proven "customer acquisition" strategy where the intrinsic value of acquisition goes beyond the return available on regulated operations and to the value of the non-regulated stream of consumer value from "interconnectivity" products and services; (2) U.S.-based utilities that are very good at owning and operating energy distribution companies, and that have probably already made some sound acquisitions, but remain interested in further combinations of regional, market, climactic and regulatory diversity, as well as critical mass; and (3) cash-long foreign utilities.
All of these acquirers are likely to be companies that know how to maximize their regulated returns, understand the value of good regulatory relationships, have demonstrated their capabilities to the financial markets, and have been rewarded accordingly. Some examples of utilities that could fall into this category include Centrica, NUI Corporation, Piedmont Natural Gas, Southern Union Company, Energy East, FirstEnergy, E.ON, RWE and possibly Con Edison and HydroOne.
Despite the recent difficulties that the energy industry has had finding its way in the dark abyss of legislative inaction and uncertain regulation, a number of opportunities exist for companies that have the wherewithal to launch sustained acquisition campaigns. Many acquisition targets are arguably under-valued, and the time seems ripe for some aggressive moves. The acquiring companies will, however, need to endure an uncertain near-term future dominated by a variety of risk factors, and cannot expect immediate positive recognition by the financial markets. The market is changing dramatically, and only after the fundamental wisdom of each acquisition has been demonstrated will the market attach the premium prices desired by shareholders.
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