After a lull of several years, mergers in the utility sector are on the rise due to stronger balance sheets, improved stock performance, and in certain cases, utilities seeking growth and scale.
Since January 2004, with the latest being the announced acquisition of KeySpan Corp. by National Grid, there have been eight announced utility transactions with a combined value of more than $64 billion. In the preceding two-year period, there was only one announced transaction, valued at $1.4 billion. It was eventually withdrawn.
After a period of “back to basics”-getting rid of non-core assets and streamlining costs – and more than a year of returns that outperformed the S&P 500, the electric utility sector has begun to rebound from its post-Enron plummet. As might be expected, utilities are becoming more active in the merger market. Certainly, the repeal of the Public Utilities Holding Company Act (PUHCA) in August 2005 removed one barrier to consolidation.
end of an era
PUHCA was the Depression-era act passed by Congress to clean up the 1930s equivalent of today’s Enron scandal. The act targeted utility holding companies that were not regulated by any state or federal authority. PUHCA reforms, though popular at the time, had a significant impact on how the industry subsequently organized. In particular, two provisions of PUHCA had the largest impacts on mergers and acquisitions.
The first was the requirement that holding companies and their subsidiaries limit business activities to electric or gas operations. This provision prevented non-utility buyers such as ExxonMobil or GE from acquiring utilities. In addition, the Act’s requirement that each utility owned by a holding company must be contiguous and interconnected also had an impact. This provision effectively prevented distant utilities such as Con Edison in New York and Pacific Gas and Electric in California from combining.
With the inclusion of one single line in the Energy Policy Act of 2005, PUHCA was repealed in August 2005. With PUHCA behind us, and its myriad obstacles removed, the question that many analysts have asked is, will this result in a new consolidation wave?
At first blush, PUHCA’s repeal appears to have opened the door to future consolidation with other parts of the energy industry, as well as private equity funds and other financial players expanding utility industry investments.
growth through acquisition
One reason utilities might consider a merger is that capital markets have priced earnings growth assumptions of 5 to 10 percent into stocks. These long-term earnings growth rates are significantly greater than the utility industry’s historical low single-digit organic growth rates. If interest rates begin to rise, investors will expect these higher growth rates, and companies that can deliver the growth will be rewarded. Those that cannot will be penalized.
For the utility looking to achieve such growth, few options exist. Investing in higher growth businesses outside of the utility’s core strength is highly unlikely since it was non-core ventures in the 1990s that created the problems from which the industry has just emerged. The back-to-basics strategy will not yield high-growth either. It was an effective strategy for restoring investor confidence and bringing the industry back on solid ground, but did not significantly impact earnings growth.
To meet Wall Street’s expectations, all signs point to mergers of complementary utilities that can achieve synergies in excess of the amount paid for acquisition premiums. And with at least one regulatory hurdle removed, we have begun to see several large transactions.
Exelon’s $16.5 billion bid for Public Service Enterprise Group (PSEG) remains the largest transaction proposed to date. With combined revenues of $26.9 billion, the combination of Exelon and PSEG will create the largest utility in the United States.
Exelon’s Chairman and CEO, John Rowe, pointed out in an interview that “…in a low-growth industry, merger or consolidation is almost always the most obvious way to grow. But also you have to be very careful in how you do it. Our investors are very clear that they will only support merger and acquisition activity if it is accretive on a basis such that cost synergies pay the merger premium.”
Given that caution, then, it is not surprising that Exelon expects to generate synergy savings of $2 to $3 billion on a net present value basis, which far exceeds the 12 percent premium of approximately $1.8 to $2 billion that PSEG stockholders will receive.
Following Exelon’s lead were four other blockbuster utility transactions: the Duke acquisition of Cinergy, MidAmerican’s acquisition of PacifiCorp from ScottishPower, the Constellation and FPL merger, and National Grid’s acquisition of KeySpan Energy.
The Constellation and FPL merger creates a $27 billion entity with synergy values of between $1.5 and $2.1 billion, enough to offset the premium paid to Constellation and the premium paid to shareholders.
The Duke-Cinergy combination, which recently closed, resulted in a utility with a market capitalization of approximately $31 billion. Duke anticipates that the merger will be accretive in its first year of operations and ongoing continuing operations will show earnings per share growth of 4 to 6 percent per year.
Existing Cinergy shareholders received a 13.4 percent premium of approximately $1.1 billion. That compares with estimated annual gross synergy savings approaching $400 million per year within three years of the transaction’s close. Although the integration of the two companies will require time to complete, the company is already focused on future consolidation in the industry. Duke Energy Chairman Paul Anderson has indicated that the successful integration of the two companies will provide the scalable platform the company needs to participate in more consolidation of the sector.
In May 2005, Warren Buffet’s MidAmerican utility acquired PacifiCorp from ScottishPower for $5.1 billion, resulting in a company with $32 billion in assets worldwide. In commenting on the transaction, Warren Buffet noted, “The energy sector has long interested us, and this is the right fit. We are excited to be making this long-term investment, through MidAmerican, in the premier energy company in the West. PacifiCorp is a great company with outstanding assets.”
This investment may not be the last for Buffet, as he has indicated in the past that he would be willing to invest upwards of $15 billion if allowed.
future of utility M&As
While the door has been opened, it may be only slightly ajar. For all the changes that the repeal of PUHCA has brought about, it did not eliminate state regulatory approval, which in many instances is the highest hurdle that combining companies have had to face.
Not long ago, state regulators decided against utility acquisitions by two private equity firms, Texas Pacific Group’s planned acquisition of Portland General, and KKR and JP Morgan Capital Partners’ planned acquisition of Unisource. In both instances, the state commissions did not consider the planned transaction in the best interest of the consumers. More recently, regulatory concerns have slowed the Exelon-PSEG merger and may cause the scuttling of the Constellation-FPL merger
The state commissions involved in these transactions have focused on aspects of transactions that they believe may put customers at risk of higher rates or even worse, a failed merger. Regarding private equity firms, commissioners have expressed concerns related to private equity’s short-term investment approach. The concern is that a private equity buyer’s sole focus would be on improving short-term results so as to extract as much cash as possible out of the utility, while neglecting the long-term needs of the utility and its customers.
Corporate deals bring with them regulatory concerns over such matters as elimination of headquarters, loss of jobs, and the allocation of planned merger savings between regulated and unregulated entities. Privately, utility executives have said that some regulators are holding up their transactions until a meaningful concession is obtained from the combining entities. In the past this may have meant a greater allocation of synergies to the benefit of the customer. Today, it may also mean extending an existing rate freeze. Utility executives will have to weigh the costs of these regulatory agreements to determine if their transaction still generates the same value to their shareholders before agreeing to these concessions.
As for the convergence of the broader energy industry, this is an open question. Will the oil majors be interested in acquiring a utility and become skilled at interacting with regulatory commissions? It’s just too soon to tell.
In the final analysis, utility transactions that generate net cost savings for the buyer that exceed premiums paid to the seller are the ones that make the most sense. Of course, the real challenge for the combined entity is to complete the integration and ensure that the estimated synergies are achieved. That requires seamless blending of financial, tax and legal elements to help capture the expected value. In the end, integration remains the greatest challenge of a successful merger.
Joseph Fontana is the utilities industry leader for Ernst & Young’s transaction advisory services practice. He has more than 20 years of corporate finance and transaction experience, focusing for the last 15 years on power generation and the utility industry. He has led transactions for leading energy companies and some of the largest private equity investors in a number of sectors including electric and gas utilities, independent power producers, electric and gas marketing companies, gas pipelines, LNG plant construction projects, gas storage, and T&D outsourcing. You may contact Mr. Fontana at email@example.com.