In our continuing effort to understand the investment implications of the newest, "hot" strategic trend, we move on to Part 3 of our discussion about Utility Mergers and Acquisitions. We have no doubt the trend will continue, pushed hard by investment bankers and management ego. This piece will amplify on Part 2, where we discussed the Bull and Bear case for mergers.
We have our doubts this movement towards merging is positive for shareholders of the utility companies. Though certainly SOME will benefit, experience should tell investors that there are many hurdles, much risk, and not enough benefits for shareholders to be supportive of a movement towards mergers and acquisitions.
In Part 1 of this theme we set up the discussion, provided some random links to various articles, and briefly highlighted my philosophical views on what appears to be an inevitable trend (see: Part 1: A Wave of Utility M&A is Coming ... Is it Good for Shareholders?).
In Part 2 of this thematic debate we set up the Bull Case and the Bear Case for utility mergers and acquisitions (see: Utility Mergers and Acquisitions, Part 2: The Bull and Bear Cases).
In this, Part 3, we will flesh out the discussion of these Bull and Bear Cases.
Bull Case For Utility Mergers:
1. Significant economies of scale can be achieved. This is POSSIBLY true. There are certainly SOME economies of scale that can still be achieved, even in mergers between large companies (certain administrative functions can still be combined). But no one really knows what the tipping point is ... in other words, no one really knows how big is big enough to OPTIMIZE cost savings (as opposed to MAXIMIZE). I would argue that for the largest of utilities, let's say the top 12-15 companies that exist now, the economies of scale have generally been achieved more often than not ... regardless of the merger announcement made by those companies.
2. Cost savings from mergers can be an important tool to reduce the pressure of rising costs. This is certainly true. I cannot argue with this point at all. But understand that the entire direct benefit that flows from this issue flows to the RATEPAYER (or customer), not the shareholder. The shareholder benefits to the extent that the regulator does not use rising cost pressures as an excuse to reduce allowed rates of return to lower the costs to the ratepayer. But the shareholder does face the risk of a regulatory review of earned versus regulatory returns during the process of the merger review ... which is generally NOT a good thing.
3. Shareholders of weaker utilities can benefit from merging with a stronger utility both by getting paid a premium, and by being part of a utility with fewer weaknesses (financial or otherwise). This is also true, and may be the most justifiable reason to pursue M&A. In situations where this point applies, the shareholders and ratepayers both have a reasonable chance to benefit both near-term and long-term.
4. Strategic combinations can diversify risk, and provide new opportunities for acquirers to improve operations and find new markets for growth. This is partially true ... but partially untrue. I agree that operating risk can be diversified by appropriate mergers and acquisitions. For example, a company heavily loaded with coal-fired generation, may want to reduce its proportionate exposure to environmental risk by acquiring a utility with nuclear, hydro-electric or gas-fired generation. Or, perhaps a company heavily loaded with low margin, mobile industrial customers may want to add a greater portion of higher margin, less mobile residential customers. And operational improvements can be had also. A company with poor customer service, or poor generation or transmission operations, would likely benefit from combining with a company with proven abilities to do those things better. And the shareholders would potentially benefit from the improvement in these areas as well (at a minimum with improved good will from customers and regulators). But new markets for growth? Well, I suppose that if one company with customer growth of 1% per year bought another company with 2% customer growth per year, there is an improvement in growth ... but is it really worth the risks of a merger?
5. With the likely repeal of PUHCA, new players and new capital will flow into the utility industry, paying healthy premiums for existing utilities, and freeing capital for greater innovations. Well this is an interesting point. I agree that new capital will TRY to flow into this area, and that new players (like the integrated oils, other global energy companies, and private equity investors) will try to acquire utilities should PUHCA be repealed. Is this good for utility shareholders? No. Though some would hope for significant premiums to be paid, I am extremely skeptical that will happen in most cases. Why?
- First, these buyers are much more sophisticated than most utilities, and are less likely to make the mistakes by overpaying that other utilities might make.
- Second, the regulators will not allow significant premiums paid to be recovered from ratepayers (thus lowering the return on capital to pretty low levels).
- Third, since premiums cannot be recovered from ratepayers, the only way outside players can earn their returns is to slash costs--and KEEP those costs-- but these players lack the natural synergies to easily create operating cost savings, and most cost savings will have to be returned to the ratepayer anyway.
- Fourth, state regulators are going to look very, very warily at the efforts of non-utilities to buy the utilities they regulate (already regulators have rejected TWO efforts by private equity players to acquire utilities). This will mean lower premiums paid, as the regulatory reviews generally will be long, and the negotiations will be difficult.
- Fifth, players outside of the utility industry will be attracted to purchasing utilities because of the utilities' cash flow. This will make regulators even more wary about approving such acquisitions for fear that the buyer will suck all the cash out of the company, and not re-invest appropriate amounts into customer service and transmission. So regulators will be more likely to either reject the deal because they will fear they cannot monitor the situation, or they will put such stringent rules into place governing use of cash that the buyer cannot make the deal work financially.
- Sixth, for perspective, look at Pacificorp. Each time Pacificorp changed hands the price went LOWER. And Buffet bought Pacificorp at a HUGE discount to what Scottish Power put into the company. How does THAT benefit utility shareholders?
Bear Case Against Utility Mergers:
1. Two poorly-run and inefficient companies do not become better-run and more efficient just by becoming larger. Bingo, one of my central themes for years and years. One pile of crap combined with another pile of crap just means a larger pile of crap.
2. The regulatory hurdles for completing a merger take such a long time to leap over that much of the near-term benefit of any premium paid is reduced (and simply entering into a regulatory proceeding alone introduces plenty of risks). Think about the ROE (return on equity) issue, for example. Right now many utilities are coming out of rate freeze situations, facing regulatory proceedings anyway. And many utilities are earning ROE's above the level of what new ROE's would be granted (new ROE's will be at least partly tied to long-term interest rates, which are much lower now than they were at the time the ROE's were last set). While cost savings may be able to allow a decrease in the cost of electricity to ratepayers, still the allowed ROE will also be evaluated.
3. Many utility mergers are mergers of equal with little or no premium paid, resulting in little near-term benefit to the shareholders. This is absolutely the case in many mergers in this industry. Or at least only modest premiums are offered. I think Duke Energy, for example, offered Cinergy's shareholders less than a 10% premium (and even then DUK shares dropped each day after the merger announcement for 4 days). Are these modest premiums really worth the regulatory risk, the time value of money (many mergers take at least 15 months to complete, and some take more than 2 years), and maybe even more importantly, the DISTRACTION and DRAIN on management time?
4. Regulators will require much of the cost savings to be achieved to be passed through to the ratepayer and customer, leaving small earnings or valuation benefit for the shareholder. Bingo! In most cases (obviously not related to the unregulated parts of the business), the BEST case for shareholders is keeping 50% of the costs savings for the 1st 5 years. But after that, should ROE's rise above allowed regulatory returns, more cost savings must be handed back eventually.
5. Merging two companies with two different cultures can take a long time, and create substantial execution risk. This is the great, hidden risk that no one ever talks about. I should have put this issue first, really. And there is no way that most investors have any way to evaluate the extent of this risk. Understand that utilities are generally large organizations, filled with "lifer" employees, and often dominated by engineers. All three of those issues create environments that are very resistant to change. And since there are local community issues involved, as utilities are often the largest employers in the community, just firing people is not always so easy. Add to this issue that many utility workers are unionized ... well I think you might begin to get it. I know of 1 utility that bought a distressed neighbor. Everyone was very happy (the local community, the regulators, the politicians, the unions). Yet STILL, that utility is having real problems fully integrating the 2 utilities ... 4 years later.
6. Regulatory backlash against "financial" acquirers, rather than other utilities, could derail M&A. See the 5th point from the Bull Case, above ... I will not merely cut and paste. Let's just say I will believe it when i see it,and though there will undoubtedly be some financial acquirers, there will be fewer successful efforts than some think.
Parts 4 and 5 are still to come!