Utility Mergers and Acquisitions, Part 4: Why Should Shareholders Be Skeptical?

by: Sandy Cohen

Welcome to Part 4 of our discussion of the merits of what may end up being a new "hot" strategic trend:  Utility mergers and acqisitions.  In case I have not been clear yet,let me make it crystal clear:  Generally, I do NOT think M&A (with an emphasis on the "M") is in the best interests of utility shareholders.

So ... if mergers within the industry are not in the best interest of shareholders, why is there periodic pressure from so many sides for utilities to merge?  And what evidence could be cited to warn investors that healthy skepticism over announced mergers should be the rule?

In Part 1 of the exploration of the M&A theme, I briefly raised the issue of the "wave" that may be coming, and my brief view of the shareholder benefits (fewer than many believe) ... and linked some random views from different media sources (see:  Part 1: A Wave of Utility M&A is Coming ... Is it Good for Shareholders?).

In Parts 2 and 3, I first cited the Bull Case and the Bear Case (Part 2), and then gave some in-depth comments on each point (Part 3) .  Follow the link to read that (Just Part 3, since Part 3 provides all the points of Part 2, plus more:  Utility Mergers and Acquisitions, Part 3: The Bull and Bear Cases Deconstructed).

My focus in this, Part 4 of the discussion, will be to walk you through the remarkable history of the wrong strategic choices the electric utility industry has made over the years, to put in perspective why shareholders should be incredibly skeptical whenever the executives and advisors of this industry proudly announce the next "must do" direction.  Be forewarned, this post is rather lengthy, as I rant about the folly of the industry.

I do need to emphasize that I am NOT against change, and that indeed I heartily support any merger that actually makes strategic sense, or any choice a utility makes that makes strategic (or even financial) sense.  But utilities have an incredible track record of making famously bad choices.  And the advisors to utilities (investment bankers and management consultants) have a track record of taking care of themselves first (by pushing choices that lead to ever higher advisory and consulting fees), at the expense of their clients.  Of course, it is no one person's or groups' fault ... the utility executives, and their advisors, are all human.  But the nature of investment bankers in particular is to:  a) never change the way they do business if it has garnered fees; and b) to copycat ANY idea that look like it could make fees.

As a result, the advisors to the electric utility industry have succeeded in stampeding the group (with the ready compliance of senior utility executives who fear being left behind competitors who are trying each new "hot idea) into one bad idea after another.  And I should know:  I made plenty of money as an advisor myself ... though I made the money helping utilities fend OFF the other advisors ... i was the guy who was hired as an outside advisor who would say, "No!"

Let's walk through some of the history of the bad choices utilities have made ... and how each time the utility industry seemingly learned a lesson, it appeared to be the WRONG lesson.  I am only going to go back 25 years:

  1. The "hot" idea was nuclear generated power, as the consensus forecast was that oil was going to exceed $100 per barrels in the near future, making many of the industry's power plants uneconomic.  And since there was forecasted electric power demand growth in excess of 5% per year (basically the last 25 years straight-lined up, with no sophisticated sensitivity-based forecasting models), the utilities saw a huge need for power, but fossil plants seemed to be going to be uneconomic.  So, nuclear power became the mantra of the day.  Even after the 3-Mile Island nuclear accident, when environmentalists and political activists geared up over fears of nuclear accidents, the industry kept planning and building large nuclear plants.  So what happened?  First, electricity demand fell off quite a bit due to poor economic conditions.  Second, the activists delayed the nuclear plants, substantially raising the cost of the facilities.  Third, oil prices did not skyrocket, but INTEREST rates did, which DRAMATICALLY increased the financing costs of these large facilities (in the end, for example, one plant, the Comanche Peak nuclear plant, ended up costing $10 billion, of which 70-80% was financing costs).  Fourth, when the power plants finally came on line they were rather large blocks of power (it is uneconomic to build a small nuclear plant), so many utilities could not justify the need for the entire output of the plant, even over the following 3-4 years.  As a result, regulators routinely were faced with the prospect of approving rate (or price) increases of 40-% to 80% IMMEDIATELY.  Regulatory law (established in the "Hope" case in the 1940's) entitles utilities to "earn a reasonable rate of return on prudent investment."  Prior to the 1980's the words of that law were never parsed very much.  But facing HUGE rate increases, regulators began to much more closely evaluate what the words "reasonable" and "prudent" meant.  Without going into great detail and history (which could go on for pages), the regulators basically forced utilities (in aggregate) to write-off against shareholder equity more than $15 billion over a 10 year period, plus deferred recovery of billions of dollars more of investment.  In aggregate, the utility industry wrote off against equity 15% of its $100 billion bet on nuclear power, never to earn a return for shareholders of that investment.
  2. Stung by the regulatory penalties for building nuclear plants, the utility industry basically vowed never to build another power plant of any type.  The lesson the industry learned from its nuclear experience was never build another power plant, when the lesson that should have been learned is never build another NUCLEAR power plant.  As a direct result, the utilities decided to provide any incremental electric power needs from the new "hot" idea of PURCHASED POWER.  Purchased power is power that utilities do not generate for themselves, but rather buy from another generator of power.  Most purchased power came either from newly formed independent power companies, or other utilities with excess power -- many utilities had reserve or capacity margins (the difference between the power they needed to serve their own customers and the amount of power capacity they actually had) exceeding 35%, when a margin of 15% was normally considered adequate.  What was the problem?  Utilities' earnings growth completely stagnated.  The reason this occurred is that utilities generally were not allowed to earn a profit on any incremental electricity sales that came from purchased power (don't ask why here, just believe!) -- purchased power was treated as a fuel cost pass-through most of the time.  And to compound the problem, for most utilities with EXCESS power, even selling their excess electricity to other utilities did nothing for profits because at the time profits from sales at the WHOLESALE level (to other utilities) were generally considered as belonging to the ratepayers (who had paid for the power plants), and any profits therefore flowed directly to the ratepayers in the form of reduced rates or prices, not to the shareholders.  One additional problem:  The independent power producers, by both law in some cases, and by contract in all other cases, would only build the power plants with iron-clad long-term contracts from the utilities.  Which meant that the utility industry's balance sheet basically financed these IPP's, who made a FORTUNE by levering their companies as much as 90% debt-10% equity ...because their debt and contracts were secured by double-A and single-A rated utility balance sheets.  And for years the utilities got away with it until beginning in 1991 or 1992 the rating agencies began to bring the rather large obligations to those IPP's onto the utiltiies' balance sheets.  Which meant that the utility industry faced a vicious circle of stagnant earnings and ever-lower credit, leading to higher capital costs on which they were never able to earn an EQUITY return, as the purchased power was not in rate base on which the industry could earn returns ... and they were stuck with these 10-year, 15-year and in some cases 25-year contracts.
  3. So ... stuck with very long-term obligations, and flat earnings, while their dividends kept rising (in order to attract capital, utilities had to keep promising growing dividends), the utilities faced rising dividend payout ratios (dividends as a percent of earnings), which reduced their long-term sustainable earnings power (which is essentially a function for any company of sustainable return on equity multiplied by retained earnings -- after dividends paid).  So the new "hot" idea the utility industry's advisors came up with was ... DIVERSIFICATION!  If the industry's earnings growth slowed, the companies had to enter into DIFFERENT businesses that could help grow their earnings ... and away from regulatory scrutiny.  Forget Michael Porters' famous (and still accurate) study that indicates that ALL diversification efforts across ALL industries has an 80% failure rate.  No ... the utilities must grow.  So utilities started to take their excess cash flow (since they stopped building/investing in power plants, their cash flows rose) and invested it in many, many different types of businesses.  And, unerringly, the utilities managed to invest in each "hot" business idea at the PEAK valuation of those new industries.  Utilities invested in Oil and Gas E&P just before oil and gas prices entered a decade-long decline in prices.  They invested in real estate just as real estate peaked (or even bubbled).  They invested in airplane leveraged leases just as the airlines deregulated and the excess capacity for airplanes reached a peak (and as new technology made obsolete the older planes that were part of the lease portfolios).  Some famously invested in Savings and Loans banks just before the S&L crisis, and in the Insurance business just before that industry entered into a decade-long decline.  The industry also made large investments in international power and utility properties, without having the faintest knowledge of the risks they were taking (either political, or currency).  Some invested in cable, industrial processes, retail telecommunications, railroad, other transportation, drugstores, appliances, mining ... you name it, if it was hot, utilities made the investment.  Of course, not all these efforts failed.  But inevitably many did fail, or declined.  And naturally, the utilities' appetite for losses with already high dividend payout ratios was limited, so time and again, the utilities sold these businesses, or shut them down, at the trough.  Classically, the utilities bought high and sold low, almost in every major case of diversification from the mid-1980's to the late 1990-s.  And I would say that the cost to shareholders was more than $5 billion in aggregate for the industry over that timeframe, between write-off's and operating losses.  Even worse, the industry always tried to say the businesses were related.  One company famously said that the insurance business was related because it served a lot of elderly people, and their utility service territory had a lot of elderly people in it, so they were used to dealing with people of that age group.  That same utility justified investing in South America because they spoke the same language (many of the company's employees spoke Spanish).  A different utility argued in favor of investing in the cable business because it also sent out monthly bills to its customers, making it a similar business to the electric utility business, which also sent out bills to customers.  Sigh ... what can you say?
  4. Finally, the utility industry began to de-emphasize its "diversification" efforts, just in time for DEREGULATION.  So the new "hot" idea was now deregulation, and all the new UTILITY-related businesses that could come from that trend.  In the mid-to late 1990's, the industry did begin to pursue power-related investments, unregulated (what is known as "merchant") power plant development.  But to really make the returns on those investments that investors desired, it required power trading platforms, something that is more related to Wall Street and commodity trading skills than building and operating power plants.  and the industry also saw how "hot" technology was, including telecommunications, broadband, Internet-related businesses and technology software businesses.  So the industry also invested somewhat heavily in those ventures as well.  And though a number of utilities did not invest unwisely, few had a real understanding of the implications of an unfettered commodity driven marketplace (as the chemical and steel, and paper industries, for example).  Most utilities did not take into account the likelihood of overbuilding, or the possibility of a slowdown in the economy that could dampen electric demand.  In other words, they ignored the typical implications of the boom-bust cycles that are inevitable in a commodity driven business.  And because the merchant generation and trading business became caught up in the bubble and hype of the Internet economy, investment bankers pushed (successfully for the most part) for IPOing the nascent businesses long before they were ready to stand on their own 2 feet as long-term businesses.  This had the effect of providing nearly free capital for the development of unregulated power plants (because the IPO's were selling for ridiculous P/E ratios), which along with some bad rules (mainly in California), some greed (leading to manipulation of markets), and slower than expected deregulation, led to investment getting ahead of the market in a huge way.  And we know what happened as a result of THAT!  A major commodity bear market just as utility investment in the area reached its peak.  So, once again, billions of investor dollars were lost (either from operating losses, or write-downs of the value of power plants, or write downs of the value of the equipment that was ordered, but could no longer be put into power plant development because the market no longer existed) ... and utilities were forced to exit the business, again at the trough.  To say nothing of the utilities' investments in telecommunications, Internet and broadband businesses.
  5. NOW, utilities are generally retrenching, saying they are heading back towards a more stable, regulated model (I am working on a survey identifying what percentage of utility earnings are from regulated businesses versus unregulated businesses).  And many utilities are beginning to reinvest in the regulated business, especially to beef up regulated transmission and distribution assets.  This is beginning to lead to more rate cases, especially as a series of rate freezes put in place as part of deregulation efforts are beginning to end.  And what is the utilities' timing?  They are going in front of regulators to ask for rate increases just as fuel prices are skyrocketing (I believe coal has doubled in price in the last 18 months, and gas prices remain above $7/mmcf versus under $3/mmcf of just a few years ago).  And while fuel cost increases are generally a pass-through to customers, it is never very good to ask for rate increase just as rates are rising sharply due to fuel cost increases.
  6. And of course there is the new "hot" idea:  M&A, and the creation of "mega-utilities."  Given the industry's track record, should investors have any faith in the shareholders benefiting from these decisions?  I'd say that some utilities will do well, but most shareholders of most utilities pursuing this "hot" strategy will be disappointed.

Part 5 will follow next week.