Utilities on Steroids


What's behind today's oddball mergers?

Fortnightly Magazine - July 2005

Look at the gargantuan, gerrymandered service territories you would get with the latest pending merger deals: Exelon-PSEG, Duke-Cinergy, and Warren Buffet's bid to combine PacifiCorp with his MidAmerican Energy. Now ask yourself if they make any sense.

Some engineers say that merging two widely distant electric utilities, connected only by a highly tenuous contract path, betrays the mind of a "raving lunatic." But we've heard that before.

More than one M&A expert has told the Fortnightly the non-contiguous mergers of the late 1990s also appeared a bit screwy, with their physical and geographic obstacles to rationalizing labor, capital, operations, maintenance costs, technology, and assets.

One merger expert-involved in almost every major utility merger since the early 1990s, and speaking on the condition of anonymity-says a non-contiguous merger such as Duke-Cinergy would sacrifice as much as 10 percent of the savings otherwise available if the two utilities could claim a significant common boundary.

Yet many equity research analysts have said on-the-record that the gerrymandered mergers that built today's AEP and Exelon have in fact achieved a high level of efficiency, performance, and cost reduction.

No Strategy, No Problem

In his bestseller Good to Great, Jim Collins warns, "Two big mediocrities joined together never make for a great company.

"Mergers and acquisitions play virtually no role in igniting a transformation from good to great."

Consider the merger of Exelon and PSEG. The parties cite the economies of scale of applying world-class nuclear skills across a larger collection of assets. But opponents warn of a contentious cross-fertilization of low-cost nuclear capacity from the Midwest, with a beckoning, high-cost, and capacity-short retail market on the East Coast.

Naturally, this potential mix has elicited hundreds of pages of protests from competing utilities filed at the Federal Energy Regulatory Commission (FERC), worried that the huge new company would stifle competition in the PJM region. (At press time, FERC was to decide whether it would hold hearings on the merger's effects on market power. In the meantime, Exelon sweetened its divestiture offer to FERC to avoid such hearings.)

Critics have called for the federal government and state regulators to reject the merger summarily so as to not upset the balance of power in PJM. But a more fundamental objection is the lack of any good idea supporting the deal, other than that it would make for a larger utility.

Also of concern is the Duke-Cinergy merger. In a report titled We Really Don’t Get It, released on May 9, Deutsche Bank Securities analyst Robert Rubin writes:

"We do not believe the merger … makes sense. We do not believe that the most meaningful strategic rationale outlined here, the ability for [Duke] and [Cinergy] to combine MW in the Midwest, is a reasonable foundation for a deal.

"Further, we are not more comfortable with [Duke] being run by [Cinergy] management."

Rubin said he was maintaining his Duke rating at "hold."

That brings us to Warren Buffet's bid to buy PacifiCorp and combine it with his privately held utility, MidAmerican Energy. Here, too, industry experts fail to see a clear strategic rationale. Maybe Buffet wanted to park his money and earn a steady return on a larger utility entity?

Prior to his investment, Buffet said, "We'd love to have [an acquisition] in the $5 billion to $10 billion range. At the moment we've got more money than brains, and we hope to do something about that."

Critics can be forgiven for not seeing any attempt through the merger to create a more rational electric utility or service territory. But many believe the billions in capital investment promised to PacifiCorp may provide the real value. Moreover, Buffet has said he would invest more if the Public Utility Holding Company Act (PUHCA) were repealed-so he may have a more elegant combination in mind.

Furthermore, other types of companies like private equity firms and banks also would be able to invest more in the industry if PUHCA were repealed. Most Washington insiders believe that PUHCA repeal may happen in Congress this summer, given the political pressure and the fact that the three deals depend on PUHCA modification, but if not, the Securities and Exchange Commission is expected to relax its interpretations of PUHCA and allow the mergers to go through (See PUHCA Debate - Again). But in a world where PUHCA is repealed, according to what guidelines will the industry consolidate?

Size Over Synergy

The Exelon, Duke, and MidAmerican deals offer quite a contrast to the mergers of a decade ago. Who can forget the utilities announcing their strategic combinations of telecom, international, power marketing, generation, and transmission plays? It seems many utilities today believe numerical superiority will trump synergy, and even, in some cases, common sense.

More than one chief executive interviewed for Fortnightly’s June cover story proclaimed the manifest destiny of corporate growth. Bigger is better, they said. Consolidation will happen. But this strategy has been met with mixed corporate performance in other industries. What is most startling about such declarations is the scant criticism or critical discussion they receive given the impact such changes would have.

The fact that many utility industry analysts and utility executives predict that someday it won't take more than five utilities to run the country's power infrastructure means a fantastically different industry than we see today.

George Bilicic, managing director at investment bank Lazard, envisions a utility some day twice the size of Exelon-PSEG. That would mean a utility of 100,000 MW and, best guess, a market capitalization of approximately $60 billion to $80 billion. If such an entity were to exist, most agree there would be no hope for competitive markets.

Imagine a behemoth of 100 GW. That would not surprise anyone in banking or telecom, where deregulation has led to relentless consolidation. But many question whether utilities are comparable.

One staffer at the U.S. Securities and Exchange Commission speculated at the recent Exnet M&A conference in New York that, in the absence of PUHCA, utilities might consolidate along the current boundary lines that divide the Eastern and Western Interconnections. If this type of large-scale consolidation were to take place, then non-contiguous mergers pursued by Exelon, Duke Energy, MidAmerican, and AEP may make great sense.

In fact, in the context of a larger merger wave, such non-contiguous utilities would be best-positioned to take advantage of consolidation in multiple regions-perhaps proving that the decision to conduct a contiguous or non-contiguous merger may be as fine a line as the one between genius and insanity.