To identify utility companies that could be targets for a leveraged buyout, two useful criteria are a free cash flow yield sufficient to cover the LBO equity and debt returns, and a ratio of enterprise value to EBITDA below the levels of previous deals.
Utility targets should generate free cash flow (cash from operations before interest and taxes, less cash used for investment) equivalent to around 10% of EV. This test yields only a few takeover candidates, even when considering a ten-year time horizon. The reason is that increases in capital expenditures have eroded the average FCF yield of the U.S. utility industry.
In recent years, the valuation for attempted or completed leveraged acquisitions has averaged about 8.5x on EV/EBITDA for regulated utilities, and 7.8x on EV/EBITDA for unregulated utilities in the United States. Even assuming a 20% buyout premium, there are a number of companies with estimated EV/EBITDA multiples below these industry averages.
Two examples of firms with attractive EV/EBITDA multiples are Exelon (EXC) and Constellation (CEG). They agreed in April to merge for $7.9 billion in stock. The merger has been approved by shareholders of both companies, but regulatory approvals remain pending. Together, the two companies will become the largest American generator of competitively priced electricity.
Other U.S. power companies that could be potential acquisition targets based on their free cash flow yields or EV/EBITDA multiples, or both, include:
AES Corp (AES): AES is active in both the generation and utilities aspects of power generation. Its plants generate electricity from various sources - including coal, gas, fuel oil, biomass, hydroelectric, wind, and solar - which is sold to wholesale customers such as utilities and other intermediaries. AES utilities distribute, transmit, and sell electricity to end-user customers. As of the end of 2010, AES owned electricity generation and distribution facilities with a total capacity of approximately 40,500 megawatts (MW) and distribution networks serving approximately 12 million people in 28 countries.
AES, which has an equity value of $8.54 billion, is on an expansion trend. It is about to complete the $3.5 billion acquisition of DPL (DPL), a regional electric supplier in Ohio. The AES trailing twelve months (ttm) EV/EBITDA value is 5.23, which places it among the unregulated utilities whose EV/EBITDA ratios, including a 20% control premium, would fall below the historic average buyout level of 7.8x. Its attractivess as an LBO target is enhanced by its free cash flow, which was over 10% of its estimated enterprise value in three out of the last 10 years.
Cleco Corp (CNL): Cleco generates, transmits, distributes and sells electricity to approximately 279,000 customers in Louisiana. As of December 31, 2010, it had ownership interest in three steam electric generating stations, a gas turbine, and a combined cycle unit with a combined name plate capacity of 2,539 MW, and a combined electric net generating capacity of 2,372 MW. CNL also owns a combined-cycle natural gas-fired power plant and a natural gas interconnection system.
Its market cap is $2.05 billion. Based on trailing twelve month EBITDA and capex, CNL’s free cash flow yield currently exceeds the 10% hurdle rate for a potential LBO takeover. It is also a leading takeover candidate based on its EV/EBITDA multiple. CNL’s trailing twelve months EV/EBITDA ratio is 7.00. With a 20% buyout premium added in, the ratio would be just below the 8.5x average of previous regulated utilities deals.
GenOn (GEN): GenOn provides capacity, ancillary, and other energy services to wholesale customers in the United States. It also operates as a wholesale generator of electricity produced from coal, natural gas, and oil, and engages in proprietary trading, fuel oil management, and natural gas transportation and storage activities. GEN operates 47 generating facilities in 12 states with a total generating capacity of 24,237 MW.
Its clients include independent system operators, regional transmission organizations, power aggregators, retail providers, electric-cooperative utilities, other power generating companies, and load serving entities. GEN’s market cap is $1.98 billion, and its FCF/EV has been over 10% in five out of the last 10 years, which makes it a good takeover target. However, considering GEN’s trailing twelve months EV/EBITDA of 10.76 and a 20% premium, it would not be a prime candidate judged by its enterprise multiple alone.
Edison International (EIX): Edison International supplies electricity through its transmission and distribution network primarily to commercial, residential, industrial, and agricultural customers, as well as to public authorities. Its distribution system consists of approximately 60,000 circuit miles of overhead lines, 43,500 circuit miles of underground lines, and 700 distribution substations located in California.
EIX also owns coal, renewable energy, and gas-fired electric generating facilities. In addition, it trades in power, fuel, coal, and transmission congestion. As of the end of 2010, EIX owned or leased 39 operating projects with an aggregate net physical capacity of 10,979 MW, and owned four wind projects under construction totaling 480 MW of net generating capacity. Its market cap is the largest among the potential power LBO candidates with $12.31 billion. With its EV of $25.46 billion and its ttm EBITDA of $3.89 billion, it is a top buyout candidate on the list of regulated U.S. utilities.
NRG Energy (NRG): NRG Energy is a wholesale electricity generation company that develops and operates power plants running on natural gas, coal, or oil. It is also active in the production of nuclear, solar, and wind energy. As of December 31, 2010, it had a power generation portfolio of 193 operating fossil fuel and nuclear generation units with a total generation capacity of approximately 24,570 MW, as well as ownership interests in renewable facilities with an 470 MW generation capacity. It is expanding its solar capacity in particular.
Its recent agreement to purchase solar project developer Solar Power Partners will add 30MW of distributed solar projects. NRG also has a district energy business with steam and chilled water capacity of approximately 1,140 MW thermal equivalent. In addition, NRG sells and trades in fuel and transportation services, as well as energy, capacity, and related products. Its equity value is $4.32 billion.
In nine out of the 10 past years, NRG has generated a free cash flow yield on enterprise value of over 10%, making it an attractive LBO candidate. With an EV of $13.45 billion, and assuming an acquisition premium of 20%, its enterprise multiple is only slightly above the 7.8x average for U.S. utilities with significant competitive generation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.