Controlling the urge to merge



  BY Allen Greenberg
  Editor-in-chief of EnergyBiz

Moody's Investors Service doesn't like it much, and neither do I.

 

I'm talking about all of the M&A activity of late in the electric and water utility industry, of which there has been a bunch. According to E&Y's latest report, the third quarter saw a record $57 billion in such deals in just North and South America. That figure is almost 10 times the value of M&A activity recorded in the second quarter. 

  
    

Investment bankers and CEOs can make plenty of money off M&A deals, but the cons can outweigh the pros in any merger, especially if there's a lot of new debt involved.

That appears to be what's happening now.

"We are finding that utility holding companies are increasingly using parent debt to finance M&A deals. Several recent acquisitions include the use of significant leverage at the parent as part of the acquisition financing," Moody's VP and Senior Analyst Jeffrey Cassella said in a recently issued forecast for 2016. "As a result, we have taken negative rating actions on the parent's rating or outlook."

The pursuit of stable cash flow amid the drop in demand for electricity in North America is driving most of these deals. Because that trend is unlikely to be reversed, we could be seeing the beginnings of a vicious circle.

Among the transactions it reviewed, Moody's clearly isn't a big fan of Southern Co.'s plans to purchase Atlanta-based AGL Resources Inc. That deal, it said, will mean up to $8 billion in new debt at the holding company. 

Moody's isn't alone in its concern. Earlier this year, Standard & Poor's Ratings Services and Fitch Ratings joined Moody's in revising downward their outlooks for Southern in light of the AGL deal. Moody's said its rating of Southern is likely to be lowered one notch "at or before" the closing date of the AGL purchase, which is expected sometime in mid-2016.

Rising debt isn't the only item that's problematic about these mergers. Corporate unions can lead to diseconomies of scale just as easily as they might yield economies. A monolith, after all, could easily have a tough time matching the level of control that a smaller company can exert.

Also of concern is the distance between corporate parents and the communities they serve. Despite offering a raft of generous concessions and pledges, Florida-based NextEra is certainly hearing plenty of complaints along those lines in its bid to acquire Hawaiian Electric Industries.

Also, I'm sorry to say it, but mergers often fail to bring about the gains that management teams trumpet at the time of the deal.

Having said all that, the urge to merge is understandable. Utilities have found themselves operating in a whole new, growth-challenged world nowadays. Their stocks are under all kinds of pressure, the reflection of a sluggish economy, vast supplies of natural gas and a gaggle of rooftop-solar hawkers. Consolidation just seems like the way to go when you need to boost the balance sheet, right?

Well, perhaps not. Instead, how about a strategy that is more about paring down vs. fattening up?

The utility experts at Strategy& put out a paper last year noting that some utilities are considering a new path to better shareholder returns: growth via carve-out transactions. 

"Separating business lines that no longer complement each other creates a strategically coherent business portfolio with clear competitive differentiators, stronger growth prospects, and a more attractive investment profile," the authors of the paper wrote.

This approach is rare in the utilities industry but certainly not unheard of. As examples, Strategy& pointed to Dominion Resources' decision to exit retail power marketing and Ameren's move to shed generating assets. More recently, NRG Energy announced it planned to spin off its renewable energy business as soon as it can.

With a gazillion variables in motion, there's no guarantee that a carve-out will burnish your stock price any better than going the acquisition route. But many buying binges are invariably followed by regrets and questions about whether management paid too much, missed critical blemishes and failed to stop share price declines.

Life for utilities is getting more complicated every day. Some executive teams might be able to pull off multibillion-dollar acquisitions without breaking a sweat. But even the best of them could just as easily become overwhelmed by the many hurdles of digesting a newly acquired company.

Look at it this way: how likely is a credit-rating agency to issue a note of concern or, worse yet, a downgrade on a company shedding assets for the sake of strategic clarity? 

Acquiring your way to better financial health shouldn't be off the table. But it shouldn't be the default, either.

By the way, on an unrelated noted, Moody's in its forecast had something really interesting to say about the Obama administration's Clean Power Plan: 

"The final regulatory rules on carbon emissions issued by the EPA in August are likely beneficial to regulated utilities, even if they have significant exposure to coal. Additional investments required by the rule will result in greater regulated earnings opportunities, a credit positive for the industry overall. Although the rule could push up consumer electricity bills, a credit negative, we believe that regulated utilities will still benefit on balance," it said.

You might not want to let the EPA's Gina McCarthy see that. She'll just want to spit out more "credit positive" rules and regulations. 

EnergyBiz