May 14, 2010
Ken Silverstein
EnergyBiz Insider
Editor-in-Chief
The recession's end is signaling the beginning of changes in the utility world. Declines in demand along with those of whole electric prices are prompting companies to revise their business strategies.
Now some notable players are buying and selling assets. The goal is to trim debt, increase revenues and raise stock prices -- as well as to prepare for the next sustained economic cycle. While mergers often take place during good times and when companies have ample cash to spend, the recent wave of activity is a reaction to what has been a relatively stressful time.
PPL Corp's would-be buyout of E.ON's U.S. operations in Kentucky and Tennessee, which involves Louisville Gas & Electric and Kentucky Utilities, would be the biggest merger in more than two years. It's a $7.6 billion deal that is expected to close by year-end if state and federal regulators approve it -- something that would grow PPL's generation from 10,000 megawatts to 20,000 megawatts.
Analysts say that PPL has taken a beating in the wholesale market in the last few years and that it longs for the regulated assets now owned by E.ON. Interestingly, most of the facilities are coal-fired, which may be stable and reliable but which are coming under tougher regulatory pressures.
German-owned E.ON is similarly hurt by the recession. Its tack, though, is to shed assets and trim debt. It announced a few months ago it would put its U.S. operations on the auction block and added that it would then grow its green businesses in the homeland. Its U.S. operations had a few suitors that include Duke Energy and some Canadian enterprises, although PPL came out victorious.
PPL, obviously, made a more attractive offer that includes $6.7 billion in cash and nearly a billion in assumed debt. Initially, it will take out a bridge loan before it can -- among other steps -- issue new stock. That, in turn, will dilute the value of existing shares. However, the company says that by 2013 the value of its stock will become "accretive," or increase the earnings per share.
"We are adding scale, creating a much stronger and more diversified enterprise while providing additional opportunities for regulated-business growth and, importantly, retaining the upside benefits of our competitive fleet when wholesale power market prices improve," says James Miller, chief executive of PPL. "Clearly, for PPL shareowners, this is the right deal at the right time."
The proposition, in fact, may be part of a broader trend. Already this year, Cleveland-based FirstEnergy Corp. made a $4.7 bid on Pennsylvania-based Allegheny Energy. Meanwhile, California-based Calpine Corp. is willing to pay $1.65 billion for power plants owned by Pepco Holdings, which wants to focus on its delivery business.
Next Wave
Regulated assets that generate power around the clock are desirable right now because they provide stable cash flows. At the same time, those same base-load plants -- often nuclear or coal -- are increasingly difficult to get permitted. That's why companies that own profitable assets are in a good position now.
In theory, acquisitions increase size and scale and the potential synergies help drive cost savings. Meanwhile, the utility sector remains largely fragmented with many smaller-to-mid-sized incumbents controlling their traditional territories. Those companies could likely wed without the fear of exercising undue market influence.
Potential suitors, however, will need to properly value the hard assets they seek. They must also analyze whether the utilities that they find attractive have upgraded their infrastructure and complied with environmental rules. Also important: ensuring that prospective partners have been able to revise their rate structure to comport with higher energy prices. And finally, acquirers will be considering the intrinsic growth rates in the jurisdictions where the utilities reside.
The marriage of two major utilities is not necessarily a given. In the recent past, some have not gotten past the regulatory approval process: Exelon's proposed buyout of PSEG and FPL's foray toward Constellation, both of which were denied in 2006. Concerns over market dominance were a key factor in those cases but the mergers announced this year appear as if they will avoid those same pitfalls.
"Any breakdown in trust can have a very real and detrimental effect on an operator's bottom line and on its future growth aspirations," says David Thomas, KPMG's Global Head of Communications Regulation, referring to relationships between utilities and public utility commissions. "This is often indicative of two groups both needing to learn to understand and trust each other more."
Regulators, of course, must weigh a utility's need to earn adequate returns with those of customers who expect to receive reliable service and pay fair prices. The discussion invariably turns to the approval of rate cases, geographical expansions and building generation. To that end, some of the most attractive assets are those in the nuclear realm that might be better managed by one of the dominate utilities in the field.
Looking out, the U.S. Department of Energy says that electricity growth will occur at 1.5 percent a year for the next two decades. That will come mostly from adding new nuclear units as well as those that run on sustainable fuels. Therefore, companies that have an expertise owning or operating such facilities would have the inside track.
In recent times, the utility market place has seen Electricite de France buy nearly half of Constellation Energy's nuclear assets while E.ON and Spanish-owned Iberdrola are making large investments in wind and solar power here. U.S. green markets, in fact, are seen as lucrative offerings for such experienced European operators.
The recent exchanges among utilities are part of today's market fundamentals. Companies are coping with the aftermath of a harsh recession and preparing now for the next wave economic activity.
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