THE NEW UTILITY DEAL WAVE
by Roger Conrad
Editor, Utility & Income
February 25, 2006
With a flurry of major deals announced in the past few weeks, a new round of global utility mergers and acquisitions is well underway.
The latest deal is KELDA GROUP'S (London: KEL, OTC: KELGF) sale of its US water operations--the former AQUARION WATER--to Australia's MACQUARIE BANK. That sale is almost surely the precursor to another sale or spinoff of the New England-based water utility, once needed regulatory approvals are received later this year.
Kelda's decision to exit the US market follows a similar move by German giant RWE (Germany: RWE, OTC: RWEOY), which announced its intention to sell its AMERICAN WATER WORKS unit last year. American remains the largest US water utility and its component parts are in high demand, though RWE's investment bankers still seem set on selling or spinning off the company as a unit. Germany's EON (NYSE: EON) has also been the target of speculation that it may unload its US utility operations, which mainly consist of Kentucky's dominant power company LG&E ENERGY.
Not everyone is exiting America, however. Britain's NATIONAL GRID is currently in negotiations to buy KEYSPAN ENERGY (NYSE: KSE), for a rumored price tag of $42 a share in cash. The KeySpan properties--which include gas utilities in Brooklyn, Long Island and New England--mesh well with Grid's extensive properties in New England and New York. The combination is likely to sell KeySpan's valuable New York power plants, given Grid's exclusive focus on managing electricity and gas networks in the US and UK.
Europe too is heating up with deals. GAS NATURAL'S offer to buy ENDESA (NYSE: ELE), Spain's biggest utility, had won regulatory approval despite the latter's opposition. But its current bid has been trumped by a considerably higher offer from EON. The result is a likely continued bidding war for Endesa, which was featured as a takeover play in the February Utility Forecaster and is also discussed in the March issue (available at http://www.forecaster.com as of Saturday).
The biggest potential deal of all is a brassy rumored plan to divide French giant SUEZ (NYSE: SZE) between France's VEOLIA (NYSE: VE) and Italy's ENEL (NYSE: EN). Veolia would acquire Suez' massive water assets, creating a dominant global water industry behemoth. Enel, meanwhile, would advance its power generation franchise in both France and Belgium.
The common thread of all of these deals is strategy. Utility stock valuations are well off their lows of three years ago. And while earnings are rapidly catching up to share prices for more than a few companies, this is generally not a bargain market for buyers. The average distribution utility I cover in UF, for example, currently sells for more than twice book value. For the typical water utility, that figure is 2.6 times book.
Price is a big reason why there hasn't been an explosion of new deals in recent months, despite the elimination of the Public Utility Holding Company Act last summer and its final phase-out last month. And it's why premiums on deals to pre-merger prices have been meager. Even the KeySpan deal, for example, is expected to come off only slightly above the current price of the shares.
Deals that advance long-term strategic goals, however, make more sense than ever. In fact, it could well be now or never, as the industry enjoys extremely favorable regulation at the moment. In the US, as the Bush administration's handling of the takeover of the manager of America's Northeastern ports this week showed, rarely have government officials been so willing to quickly approve deals.
Utility deals like DUKE (NYSE: DUK)/CINERGY (NYSE: CIN) have been quickly approved over the past year with little rancor and few conditions attached.
Overseas, European governments still occasionally succumb to the temptation to build "national champion" companies. Spain's support of Gas Natural's bid for Endesa--and disparaging remarks about EON's much higher counterbid--is but the latest manifestation.
The ability of national governments to block deals in the new Europe, however, is far more limited than in the past. The European Union has already warned Spain against attempting to block the EON bid. Instead, the key regulatory hurdle for merging companies to overcome is to prove their deal won't stymie competition, or create a situation where one company has untenable market power. As long as they measure up on that score, national borders are not boundaries.
One characteristic of all of the deals now in progress is their tight focus. Enel, EON and Veolia are taking the next step towards expanding in Europe, each within its respective industry. None are trying to expand their product line to other sectors, often a disastrous strategy. National Grid is taking the next logical step toward expanding its wires and pipes network in the US Northeast, a move that's almost certain to be followed by purchases of other utilities in the region. Even Kelda's sale of its US water assets is strategic: It's retrenching back to its home UK market.
Tight focus should go a long way toward assuring these deals ultimately work, even as favorable regulation boosts the odds dramatically that they'll ultimately be approved. One of the ironies about today's utility merger wave is that the deals themselves are far larger than those of the 1990s, yet they're likely to start paying off for long-term shareholders much sooner.
The mega-mergers of AT&T and SBC to form the new AT&T (NYSE: T) and VERIZON (NYSE: VZ)/MCI last year were approved far more quickly than previous mergers attempted by SBC and Verizon, which were then much smaller companies. And both deals are already rewarding shareholders, as AT&T's strong fourth quarter earnings results attest.
Utility mergers as a rule tend to work better than unions involving other industries for several reasons. The companies have similar equipment, personnel and customer issues, so it's relatively easy to combine operations. Also, since the days of Samuel Insull--who played a key role early in the last century making electricity ubiquitous--utilities have been all about scale. The larger companies become, the more efficient they generally become in raising capital, deploying resources, making purchases and running assets.
Companies that own several nuclear power plants can use the lessons learned at one nuke to make the others in its fleet safer and more efficient. That was impossible in prior decades when consortia typically held nukes, with individual companies owning a partial share supposedly to limit their financial risk. Today, a handful of utes own the vast majority of the nation's nuclear plants, and the consolidation continues.
The fact that not one union of regulated utilities has ever come apart is the clearest proof that utility mergers work. Even deals between poorly managed companies with a history of bad operating performance--such as the FirstEnergy (NYSE: FE) union of the former GPU, OHIO EDISON and CENTERIOR ENERGY--have invariably improved their operating performance. That appears to be happening at FirstEnergy, less than four years after its Davis Besse nuclear plant nearly melted down due to corrosion of a container holding super-pressurized water.
This wave of strategic deals looks well on the way to paying off for all concerned. As appears to be the case with KeySpan/National Grid--and was the case with the three other mega-mergers in the US power industry Duke/Cinergy, EXELON (NYSE: EXC)/PUBLIC SERVICE ENTERPRISE (NYSE: PEG) and FPL GROUP (NYSE: FPL)/CONSTELLATION (NYSE: CEG)--the premiums paid by acquirers are small. That's disappointed some on Wall Street.
The Street also remains rather sour on utility mergers in general.
Credit rater S&P has routinely placed acquirers on its credit watch list and has not been shy about cutting ratings if it perceives a company taking on too much debt to do a deal. And it's been very slow to either remove a ute from watch or restore a rating, even if a purchase vastly exceeds expected performance. ONEOK (NYSE: OKE) saw its rating slashed from A- to BBB over the past year due to its purchase of assets from KOCH INDUSTRIES. But despite fourth quarter earnings showing the deal vastly exceeding expectations, the raters have taken no positive action.
As a result, share prices of merging companies may actually head south for a while after a deal is announced. That was certainly the case with Verizon, which sank from over 40 to under 30 following the announcement it was buying MCI.
Consequently, owners of merging companies should actually expect some underperformance. The key to these deals, however, is how they pay out over the long term. And the outlook for all of the above deals remains very promising for dividend growth and share price appreciation.
I plan to write more about utility deals in an upcoming issue of Utility Forecaster. For now, however, one low-risk potential takeover bet is ENERGYEAST (NYSE: EAS). The company's electric wires and natural gas pipes network is very complimentary to National Grid's, and in fact is adjacent to it in several areas. It's also a well-run company that enjoys generally favorable relations with regulators with a solid balance sheet and pays a safe and growing dividend of nearly 5 percent.
EnergyEast has been a recommendation in Utility Forecaster since January 2001, at the start of the worst utility bear market in a generation. But it has nonetheless averaged double-digit annual returns throughout, weathering the bear market and posting solid gains afterward. BUY ENERGYEAST UP TO 26.
As for the broad utility market, my advice is to be very selective with what you buy and hold. Sell any utilities with earnings growth less than 5 percent and which yield less than 4 percent. You'd do much better in a money market fund. The March Utility Forecaster has a list of other sells.
Interest rates remain restrained, but there's always the possibility we'll see a spike that will drive down prices. That's the time when you'll want to be buying. Until then, stick only to stocks trading below my target prices.
© 2006 Roger Conrad
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