August 09, 2010

When PPL won the auction to acquire E.ON's Kentucky utilities in April, the stock plunged nearly 10 percent and left many investors scratching their heads. In fact, the stock started its steep downward spiral a few days before the actual sale when the Allentown, Pa.-based company was named by E.ON as one of three potential buyers for the assets.

PPL trumpeted that it would increase its geographical diversification and expand its capital structure, but analysts noted that by adding more regulated electricity to its portfolio, PPL was only further reducing its leverage to profit from any upswing in the economy.

The company itself acknowledged that there would be no cost savings, that the acquisition would be dilutive in the short term and accretive, or add to profits, starting only in 2013. That's their best-case scenario.

Wall Street abhors a vacuum and as weak demand and plunging electricity prices squeeze the already-narrow profit margin at utilities, it is tempting to look for ways to add a few bucks to the bottom line. But even that doesn't explain the PPL acquisition. E.ON's motivation is clear -- the German company wants to reduce debt and had considered this U.S. operation expendable.

The best that PPL chief executive James Miller could offer was that the Kentucky units, which would continue to be operated as a separate company, "will enhance the overall business risk profile of PPL, which we believe will lead to improved access to capital, a stronger credit profile and solid, investment-grade credit ratings in each of our businesses."

Part of the answer might lie in the defections PPL is experiencing in its competitive generation business in Pennsylvania. After its rate cap expired Jan. 1, PPL's rates shot up 30 percent, prompting some 421,000, or 30 percent of its 1.4 million Pennsylvania customers, to switch to lower-priced suppliers. Competition like this may make successful regulated businesses look good.

"I think they may have come under pressure from the credit rating agencies to get some more regulated assets," said Michael Worms at BMO Capital Markets.

But PPL said it expects no cost savings, plans no layoffs and will operate the acquisitions as autonomous units. Analysts originally had expected Duke Energy and American Electric Power to be the logical acquirers, because they, unlike PPL, have abutting properties and could expect to consolidate some operations.

Classically, mergers and acquisitions in the utility sector take place when a healthy company is in a position to take over an ailing company and realize strong profit gains by restoring it to health.

More recently in the electricity sector, analysts say, diversification in the energy generation portfolio can drive M&A activity. This was certainly the case, they say, with FirstEnergy's $8.5 billion acquisition earlier this year of Allegheny Energy. Allegheny generates 98 percent of its power from coal, while FirstEnergy has nuclear, natural gas and coal as well as renewables. The attraction for FirstEnergy was to expand its unregulated generation portfolio to benefit from its expectation that economic recovery will increase demand and prices in the unregulated sector.

Incremental Savings

Moreover, the FirstEnergy-Allegheny linkup did involve adjoining territories. The two companies own nearly 20,000 miles of transmissions that tie their territories together. Synergies between the two companies are expected to save $255 million in the first year alone, and more after that, according to their presentation on the merger.

"You can get more savings on the non-regulated side," said BMO Capital Markets' Worms. "It's a more compelling case for a merger."

Duke Energy CEO Jim Rogers in February said that electrical utilities are facing high capital requirements for environmental regulations, replacing retired plants, and upgrading grid structures. As a result, electricity prices, which have been more or less flat for decades, will start to rise, Rogers said in a meeting with analysts.

"So I believe that in that environment of greater capital requirements and rising prices that regulators will be more receptive," Rogers said. Duke Energy has been able to borrow at low cost because of the strength of its balance sheet, he said. "So that's one of the arguments that can be made in support of consolidation, obviously to the extent that you can reduce costs."

BMO's Worms is skeptical of that argument. "Regulated utilities are pretty adept at getting maximum value," he said. "Putting together one set of regulated utilities with another set is not going to generate incremental savings."

Some of the failed acquisitions proposed in recent years, such as Exelon's proposed takeover of NRG Energy last year, seemed to offer only marginal benefit. That acquisition promised to add 20 to 30 cents a share to Exelon earnings over a period of years. "Why bother?" said Worms. "Exelon can add 4 to 5 cents a share per year just by getting good weather."

Even if CEOs are inclined to engage in a little empire building, though, there are the state regulatory commissions to deal with in any utilities merger. "They're not going to be inclined to help another company on the regulated side three states away," Worms added.

With the uncertainty still surrounding the speed and strength of economic recovery -- especially in light of the euro crisis -- and the whole question about supply, demand and prices for fuels, it's particularly hard to calculate the benefit of acquiring a utility. The acquisition of TXU in 2007, for instance, bet on the constant rise of natural gas prices. That could come back to bite investors and bondholders.

For the moment at least, it seems that big M&A deals in the utility sector will remain opportunistic transactions. It's hard to find the incremental savings in combining big, reasonably efficient companies.

 

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Darrell Delamaide