Global energy markets offer tremendous opportunity. Is the timing right for U.S. utilities to look at international markets? If so, which countries offer the best opportunities, and which U.S. utilities or holding companies will take advantage of these opportunities? How can the risks they take be quantified?
We posed these questions to two partners at the international law firm of Chadbourne & Parke LLP, and an equity analyst for the electric utility sector at Morningstar, Inc.
Adam Wenner, partner, Chadbourne & Parke, LLP, has been active in the energy industry for more than 25 years. He represents power generators, traditional electric utilities, regional transmission organizations, lenders and other financial institutions in energy transactions, as well as regulatory hearings and litigation.
EL&P: Is the timing right for U.S. utilities to look at international markets?
Wenner: There is a factor that has come into play, and that’s the repeal of PUHCA, which becomes effective on Feb. 8. U.S. utilities had been shackled by PUHCA in their ability to acquire U.S. utilities, at least when they weren’t in the same region. Those shackles will be removed as of that date. And that will mean that a lot of U.S. utilities, especially those that are flush with cash or otherwise in a position to make acquisitions, now have opportunities. And they will be looking in most instances first to the U.S. market.
Of course, there are already some big acquisitions going on. Duke/Cinergy and MidAmerican/PacifiCorp, for example, would have faced difficulties without PUHCA repeal. Those companies might have looked elsewhere, but now they are focusing on U.S. acquisitions.
I recently participated in a utility Merger & Acquisition panel. One lesson that was driven home to me was that getting through the regulatory process or processes-even though you don’t have the SEC any more, you have FERC and many state commissions-is so time and attention-absorbing for utility companies that besides using up your financial resources, it takes up the focus of your company. You’re not going to be able to do that and look for non-U.S acquisitions at the same time.
Here’s an interesting point. The representative on the panel from Exelon said they don’t even look at smaller acquisitions because the amount of regulatory effort is really the same for small acquisitions as for large acquisitions, and it’s really not worth their while.
So, there are those U.S. utilities that will focus on the U.S. market, and if they are doing that, that will drain their corporate effort. And then there are some utilities like Exelon that have said they are just not particularly interested in going overseas at this point.
EL&P: Which U.S. utilities or holding companies do you expect to take advantage of the opportunities in international markets?
Wenner: That [PUHCA] restriction applied to the registered holding companies, so the companies that were really affected by that and that would be in a position to make overseas acquisitions would be companies like Entergy and Southern Company and American Electric Power. AES of course, in particular, is active outside the U.S. But companies like Duke and others have beaten a retreat from foreign investment.
This is another good point that was made by the utility executives at the M&A conference: There’s panic and fear in utility boardrooms because of the repeal of PUHCA because the mentality, correct or incorrect, is sort of “Eat or be eaten.” Many of the smaller companies are trying to figure out what they can do to protect themselves from being acquired, whether it’s looking for a partner on their own or adopting poison pills. I would find it doubtful that they would focus too much attention on acquisition of non-U.S. utilities.
You could define it as a set: the big, financially strong companies, that are not otherwise involved in a big acquisition, especially those that are holding companies that have been freed from PUHCA. If anyone is going to do it, I would expect it to be them.
Lynne Gedanken is a Washington, D.C.- and London-based partner at Chadbourne & Parke. She has worked in the electricity sector for more than 25 years. Ms. Gedanken is a member of the project finance group and advises private companies and governmental entities on matters relating to the privatization of utility assets and systems, and tenders for existing companies, assets and greenfield projects. She also advises developers and lenders with respect to the full range of project, equity and loan agreements for and the structuring of independent power projects.
EL&P: Which countries offer the best opportunities for U.S. investment?
Gedanken: There is a tremendous amount of opportunity in Africa. There are some countries that have fairly high levels of access to electricity. South Africa is fairly high, Egypt is fairly high, in terms of people actually being able to get an electrical connection. There are countries where less than 10 percent of the population has access to electricity, which is shocking in the modern world. We’re not even talking about how much electricity those who have access have access to, but simply where the lines are and where you can have a connection to central station electricity.
And while there are other options being looked at in terms of more local options, at the end of the day if you’re going to have industry, if you’re going to have large users of electricity like factories, resorts or hospitals, you’re going to need central station electricity. With the initiatives by both the British and U.S. governments vis-a-vis Africa, where development there is a priority, I think you will also be seeing more opportunity in the power sector both for generation and for distribution and transmission projects. That’s already been happening, but I think there will be more of that.
There’s a tender right now in South Africa for 1,000 MW of peaking capacity. That’s a bid that’s already in progress. There was a recent bid in Kenya, another recent bid in Ghana, and there are going to be more of those. There’s a huge need in Uganda.
Nigeria has a massive need for power. Nigeria is the biggest country in Africa, and their power demand is large. Their nominal capacity is much greater than their actual capacity because a lot of what they have is in very, very bad shape. In North Africa there are opportunities as well. Algeria and Morocco are looking for more power for instance.
In Eastern Europe, markets are opening up, and there are real opportunities in the power sector. AES is active there and in Africa-but they are pretty much all over the world.
There’s also Globeleq, a company headquartered in Houston with British origins. Their market sector is emerging markets. They have three divisions, Latin America, Africa and the Middle East, and Asia. They are just doing power and they are just doing it in emerging markets. They have been very, very active.
Russia is very active and will become a more active market. We see Pakistan and India becoming more active. Pakistan will be open to foreign investment and India as well, although a lot in India is being done by Indian companies but they are not excluding foreign companies.
In the Middle East, there are projects happening throughout the region, in the Emirates, Saudi Arabia, in Oman, in Jordan. We are hearing things in Lebanon, and I’ve heard rumblings about projects in Syria. I don’t know if that would be particularly attractive to U.S. investors, but other parts of the Middle East certainly would be.
These markets are getting to be fairly established in the sense that there are contractual precedents. Deals are getting done so it’s not a question of these being first deals in many of these countries.
EL&P: Can you quantify the risk involved?
Gedanken: There’s actual risk, and there’s perceived risk. Those are often not the same thing, but either one can be an obstacle.
For example, a lot of companies, when they hear “Africa,” they think, “That’s just so unstable and so far away and so, well, foreign.” I call that perceived risk. But I would say you are talking about countries that have legal systems that are based either on British Common Law or on the civil code; where you have business and government and legal sectors that work from the same paradigms and concepts as people do in the West; where there are many Development Finance Institutions (DFIs) that are very interested in working with the private sector to develop projects, which can serve to mitigate risk.
It varies tremendously from country to country. When people talk about political risk, for instance, they often raise California as an example. In Africa, there are countries with A credit ratings and countries that don’t even make the list at all. But in many places in Africa, I think the risk, with appropriate credit support, is no greater than it would be in perhaps more developed markets.
When you look at the Middle East where there are projects that have been successfully done, where there are forms of contracts that have been used to finance projects, that certainly reduces the transactional risk, so that is also encouraging. Where you have countries that have gone through the process already, where there have been problems that have been resolved satisfactorily, that tends to reduce the risk.
It’s a different kind of risk than a U.S. utility would be taking in the states, but I’m not sure that it’s significantly more risk. Certainly it’s more in some countries, but there are many countries where things are sufficiently predictable that projects should be very do-able. It is a challenge because, for most companies, I don’t think Africa is the first place they look.
John Kearney is a stock analyst covering the utilities industry at Morningstar. Prior to joining Morningstar in 2004, he worked as an associate at Banc One Capital Markets in the company’s Structured Finance division and spent two years at State Farm Insurance Companies as an equity research analyst.
EL&P: Is the timing right for U.S. utilities to look at international markets?
Kearney: In general, I’d say no. Most of the utilities are still trying to repair their balance sheets from the destruction caused by the growth-motivated phase in the late 1990s when they were getting into things like telecom and other international investments and trading businesses. The industry created over the past few years has been “back to basics” for most utilities as they reestablish their business models and try to return to the steady income producers that the companies have historically been known as. So we don’t really think that expanding into those international markets, where a company has little or no experience, fits into that back-to-basics mold.
Furthermore, we don’t think the typical utility investor really wants his or her utility to go international. Typically, these investors buy utilities for the consistency and predictability of the dividends not because they are searching for some above-average growth story. Really, the companies putting those dividends at risk, chasing that international growth, would almost be doing a disservice to the shareholders.
Over the long term, utilities can typically expect to grow 3 to 5 percent, and companies that have tried to exceed that in the past by moving into higher growth opportunities-àƒ la international investments, telecom, proprietary trading-have generally experienced disappointing if not disastrous results.
So I don’t think you’ll see a lot of activity on that front, at least with the companies that I follow.
EL&P: If they were to look overseas, which countries offer the best opportunities?
Kearney: As with other sectors, emerging markets have typically been seen as a good opportunity for growth. Areas such as Latin America or China come to mind, areas that utilities have looked at in the past. The problem with these markets has generally been geopolitical or regulatory risk. Changing laws or regulations associated with emerging markets can create big challenges for a U.S. utility going into international markets.
As one example, Alliant Energy a few years back went into both China and Brazil, and right now they’re looking for an exit strategy to get out of both those markets and investments. If you look at Western Europe it offers a little more political stability, a little more like the U.S. as far as operations goes. The problem here is that we don’t really think the market has that much growth potential, as opposed to the emerging markets where there is a lot of growth potential. So the question is whether you are really gaining that much by going across the ocean when you could get the same 2 percent growth here in the U.S. without the added international risk.
That leaves the third area, which we think is a little bit attractive, which is Eastern Europe. In general, the markets here have been fairly developed and have been or are in the process of being liberalized from the state governments, with annual economic growth rates of 4 percent for the last four years, countries like Bulgaria and Romania. These kinds of growth rates are basically double what you would get in Western European countries.
EL&P: Which U.S. utilities or holding companies do you expect will take advantage of these opportunities?
Kearney: AES is one of the more obvious. Their business strategy has been built around expanding around the globe, becoming a worldwide utility almost. They just announced that they are going to be undertaking a power plant project in Bulgaria, and they are involved in taking one of the Romanian electricity distributors private from the state government. To my knowledge, AES is the only company aggressively pursuing international expansion at this time.
CMS has some international investments, but they have had some problems with their international portfolio, so I don’t know if they are going to be looking to expand that aggressively. DTE said they would be open to international expansion, but at this time I don’t think they are aggressively pursuing that either.
Constellation, with a couple of other private equity shops, was recently looking to acquire the Drax Plant, a 400 MW coal-fired power plant in the U.K., but this could be a one-off opportunity instead of a sign that they are changing their strategy but I’m not sure what their plan is. [Editor’s note: This interview took place before FPL Group Inc. announced its intention to buy Constellation Energy Group Inc. ]
EL&P: Can you quantify the risk involved?
Kearney: This is how we do it at Morningstar. All the utilities that we cover are valued using the discount cash flow model. So the way we try to quantify the risk is reflected in our cost of capital rate that we use to discount the companies’ cash flows.
If Company A and Company B had the same financial structure, the same cash flows, and were alike in basically every single way, except Company A had a large percentage of its earning stream coming from international operations whereas Company B didn’t, “A” would actually have a lower “fair value estimate” because we would be using a higher discount rate to discount those cash flows.
There’s another way we look at it, which is what we call our margin of safety. Typically when we tell investors to purchase stock, we usually tell them to purchase it at some pre-specified discount to our fair value estimate. The margin of safety is based on the company’s business risk. So if we thought Company C’s international exposure pushed the company’s business risk above the average risk of the companies in its universe, we would require a higher margin of safety for that stock. So if Company C and B had the same fair value estimate according to our discount cash flow model, Company C, going international, would have to trade at a larger discount per fair value estimate in order for us to consider it a buy stock. That creates a larger margin of safety and protects the investor from the added risk of having that international exposure.