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Wall Street's Egalitarian View

Investors are making little distinction between regulated or unregulated business strategies. One banker suggests it will be difficult to stand out.
Fortnightly Magazine - April 2006

It seems history does repeat itself all too often. In the late1990s, a common complaint by utility CEOs was that utility price-to-earnings (P/E) multiples did not take into account whether a com- pany was a pure-play regulated utility, a diversified utility with a merchant subsidiary, or something else. Many say investors at the time just didn’t understand the different business models that were emerging after electric restructuring.

It was not until after the Enron debacle, the California crisis, and the merchant overbuild that investors began to fully understand the risks.

Moreover, as many have observed, stock prices have performed extremely well across the sector for three years running. In fact, utilities continue to outperform the Standard & Poor’s index. To a great degree, over the last few years, the earnings multiples have reflected the true value and risks of each business model.

But that was then. These days, valuation levels again are converging as they did during the 1990s, which is quite a surprise after investors’ previous educational experience.

Laurie Coben, managing director and co-head of the Energy & Power Group, Merrill Lynch, identified this new trend in her presentation at Exnet’s 19th Annual Utility M&A Symposium. “On a relative basis, companies with different strategies are trading at a very little difference in P/E multiple,” Coben said.

“You see a less than one-point multiple difference between integrated utilities, merchants, integrated transmission and distribution [T&D] utilities and LDCs,” she explained (see Table 1). “The same is true on a P/E total return basis. Multiples have barely moved for each group” (see Table 2).

Naturally, there are significant implications to the industry if such a trend continues to be true. First, if valuations are in fact converging, it means that mergers will be more difficult to justify, because investors are saying they are indifferent (and will not assign a premium) to mergers with even higher growth segments of the industry.

But there is some question as to whether this is the case.

Convergence in P/E multiples could just mean that a new class of investor (such as hedge funds or private-equity investors), with billions on tap to invest, does not really understand the risks involved in each segment of the industry, and their sheer investment strength is blurring the lines among industry segments. If true, utility executives will once again have to figure out what strategies really do produce shareholder value.

A Skeptical View

Leonard Hyman, senior associate consultant at RJ Rudden Associates, a Black & Veatch company, adds a cautious note on whether energy company valuations are converging. The P/E chart may not be reflecting the cyclicality of the merchant industry, he says.

“The volatility in the LDC data makes me question whether the chart [presented by Coben] really indicates convergence,” he says.

In addition, Hyman says looking at P/E multiples may not be