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Utilities get the urge to merge
A wave of buyouts is expected to sweep the utilities industries. Investors with the right stocks in hand will be the winners. Plus: 10 utility stocks that could be targets.
By Michael Brush
Widows and orphans, fasten your seatbelts.
The utility sector -- once a sleepy corner of the market known for safety and predictable dividends -- is about to catch takeover fever.
Widows and orphans shouldnt mind, though, because the expected wave of buyouts should bring decent gains for people holding the right stocks.
A dozen or so utilities are already hitching up, including: Exelon (EXC, news, msgs) and Public Service Enterprise (PEG, news, msgs), Duke Energy (DUK, news, msgs) and Cinergy (CIN, news, msgs), and FPL Group (FPL, news, msgs) and Constellation Energy (CEG, news, msgs).
More deals will follow, thanks to some fundamental changes in the sector. I think this merger movement is going to sweep the land, predicts Jim Rogers, author of Adventure Capitalist.
Below, Rogers and other sector experts offer tips on the best way to play the trend. But first, heres a look at why more utility companies will soon be rushing to the altar.
Fewer legal roadblocks. For years, the Public Utility Holding Company Act of 1935 stifled mergers among utilities. The law was part of the trust busting crusade against big cartels during the Great Depression. But Congress repealed that law last year with the Energy Policy Act of 2005, and the rollback took effect early last month.
Synergies. Managers behind empire-building, ego-driven mergers often overpromise and underdeliver on savings. But it should be different with utility mergers. The sector is so fragmented, companies have many opportunities to cut overhead on things like billing systems, call centers and even executives, says Dot Matthews of CreditSights, an independent research group. The sector is one of the last remaining ones to rationalize, and we don't think tiny fiefdoms of small utilities make sense, says Matthews.
When utilities get larger, they gain the power to negotiate lower prices on fuel and equipment. The latter matters because utility companies will spend billions of dollars to upgrade transmission grids and plants over the next several years, says Merrill Lynch analyst Steve Fleishman.
Related news and commentary on MSN Money
In some cases, one utility has an expertise it can deploy at another one, to boost profits. Morningstar analyst Mark Sadeghian thinks Exelon is better at managing nuclear power plants than the utility it is buying, Public Service Enterprise Group. So he believes that when Exelon applies its superior fleet management skills at Public Service Enterprise Group nuclear plants, it will produce an additional $70 million in annual pre-tax profits.
Better buyout currency. Another reason to expect more mergers in the space is that many utility stocks have already had a good run. Since utilities typically use their own shares instead of cash in takeovers, this makes it more tempting to orchestrate buyouts.
Utility-sector experts offer the following tips on identifying potential targets in the group.
The retiring CEO
One trick is to look for situations where a chief executive is near retirement age, says Tim O'Brien, portfolio manager for the Evergreen Utility & Telecommunications Fund (EVUAX), one of the top-performing utility funds over the past three years. If you have a chief executive in his mid-60s who owns a great deal of stock and has no clear designated successor, thats worth taking a look at, he says.
The stars were aligned in this way at KeySpan (KSE, news, msgs) before the announcement of a takeover proposal from National Grid (NGG, news, msgs) last week, says OBrien. He says two utilities that match this criteria now are Energy East (EAS, news, msgs) and Allegheny Energy (AYE, news, msgs), both positions in OBriens portfolio.
Unregulated power plants
Another approach is to hunt for companies that have a collection of well-run, unregulated power plants, OBrien says. With unregulated power plants, utilities can keep more of the cost savings from mergers, instead of passing them on to customers. So owning unregulated plants makes a utility a target.
Besides, having a more diversified portfolio of power plants means a utility can better manage swings in demand or make money by selling into the wholesale market.
Potential targets with unregulated generating assets include FirstEnergy (FE, news, msgs) which has a desirable portfolio of nuclear power plants that Exelon might want to own, OBrien says. Another is PPL (PPL, news, msgs), which serves Pennsylvania but also has a power business in the United Kingdom. They have an attractive wholesale generating facility, plus a U.K. operation that has been a home run, OBrien says.
Past candidates
OBrien also suggests looking at companies that came close to getting hitched in the past. The same logic that says they have been for sale once argues they will be for sale again, he says. In this group, he includes: UniSource Energy (UNS, news, msgs), based in Tucson, Ariz.; Southwest Gas (SWX, news, msgs) in Las Vegas; and Oneok (OKE, news, msgs) in Tulsa, Okla.
The scattershot approach
Rogers strategy is more straightforward. He believes that the larger utilities will gobble up the smaller ones, making them the most likely buyout targets. So hes bought shares in about three dozen of the smaller utilities. A couple of them have been bought already, and I suspect the rest will go in the next five years, Rogers says.
Just remember that the larger utilities can be targets, too. In buying Public Service Enterprise Group, for example, Exelon is purchasing one of the bigger utilities, one with a market capitalization of $17.4 billion.
The 'Takeover 10'
CreditSights designed a more complex approach. The research group first came up with a short list of the traits it believes acquirers are seeking. Then CreditSights sifted through the utilities group to find other utilities that have these characteristics.
Desirable traits include: relatively high free cash flow before dividends, relatively low debt levels and low valuations. CreditSights also gave points for high ownership of coal, nuclear or other "low-cost" power sources -- basically anything but natural gas that has shot up in price over the past few years. Proximity to other utility companies is also a plus, as opposed to operating in the boondocks.
Here are the finalists on the CreditSights top 10 list: Alliant Energy (LNT, news, msgs), Pinnacle West Capital (PNW, news, msgs), Westar Energy (WR, news, msgs), Empire District Electric (EDE, news, msgs), Energy East, Great Plains Energy (GXP, news, msgs), OGE Energy (OGE, news, msgs), DPL (DPL, news, msgs), Pepco Holdings (POM, news, msgs) and Allegheny Energy.
Its worth noting that two utilities high on this list -- Alliant and Westar --operate near the Iowa-based MidAmerican Energy Holdings, a utility purchased by Berkshire Hathaway (BRK.A, news, msgs) a few years back. Berkshire Hathaways Warren Buffett has said he would consider buying more utilities if the Public Utility Holding Company Act was ever repealed, says CreditSights Matthews. She believes that because Alliant and Westar are near a utility that Berkshire Hathaway already owns, those two could be Buffett targets.
Risks
A takeover wave in utilities may not be great news for bondholders, warns Matthews. She believes utilities with relatively little debt could see their debt loads go up as the utilities buying them take advantage of their financial strength to borrow more money. That could add risk for bondholders if the extra debt weighs on credit ratings. And if a takeover frenzy gets out of hand, utilities might resort to buying with cash. That could threaten credit quality as well, and hurt bondholders.
What would a wave of buyouts mean for consumers? Although the recent legal changes in the sector cut back on some federal oversight, utilities are still heavily regulated by states. The state watchdogs are likely to extract benefits for customers -- like rate cuts or promises of rate freezes -- in any deal. For deals to be successful, there has to be something in it for the customer, says OBrien.
But other observers arent so sure. One way of looking at this trend, perhaps extreme, is that the smart money is consolidating the cheap generation sources of the country, so the benefits flow to shareholders rather than ratepayers, says Matthews at CreditSights.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.
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