Mergers and acquisitions in the U.S. electric utilities industry will maintain a steady pace over the next few years. Recent deals have typically been credit neutral because they have been financed with a balanced mix of debt and equity, but how future transactions are structured and executed could change this, according to Moody's Investors Service.
Larger utilities like MidAmerican Energy Holdings Co. (Rated by Moody's as Baa1 stable), Duke Energy Corp. (Baa1 stable) and Exelon Corp. (Baa2 stable) are more likely to meet their expansion and diversification goals through acquisitions, while smaller utilities adopt an “eat or be eaten” strategy.
Examples of small utilities that could be considered consolidation candidates, given their geographic location and service territory, include Vectren Utility Holdings Inc. (A3 stable), Cleco Power LLC (Baa2 positive), Empire District Electric Co. (Baa2 stable) and UNS Energy Corp. (Baa3 stable).
Slower load growth is causing utilities to look beyond their service territories. Load growth has been moderating in recent years primarily because of greater energy conservation and efficiency, increased distributed generation and the 2008 – 2009 economic downturn. These growth trends have pushed some utilities to look beyond their service territories for additional load growth in areas that are growing faster than the national average.
Expanding regulated businesses and diversifying operations reduce risk profiles. Many utilities look to expand their regulated businesses to increase the stability and predictability of cash flows, while also maximizing operational efficiency and spreading operating and maintenance costs over a wider customer base.
Since many utilities are completing or currently at the peak of their capital spending cycle, they will look to diversify their business and attempt to identify new avenues of growth to increase their regulated asset base and earnings. Larger deep-pocketed utilities will also be better positioned to handle future capital expenditure cycles, including increasingly stringent environmental mandates.
Decline in ROEs will spur additional cost reductions, which can be achieved through merger synergies. Falling returns on equity (ROEs) means utilities are looking at consolidation to realize additional cost savings through operational synergies and reduced overheads.
Capital markets support deals. Utilities’ credit quality has strengthened since the financial crisis and capital market access has improved. Both will support more leveraged transactions compared to the several stock-for-stock deals seen just a few years ago which could drive transaction multiples higher.
Potential M&A roadblocks exist but can be overcome. Social concerns, including the selection of the combined company’s chief executive officer (CEO), the make-up of the management team, workforce reductions and location of the headquarters are the biggest hurdles. Other impediments include the sustained level of earnings accretion and regulatory intervention.
All things being equal, however, we expect regulators to remain receptive to consolidation in this fragmented industry. Higher interest rates may slow down the pace of debt-financed acquisitions, but rates should still remain at levels that will not hinder the financing of future deals. In addition, rate rises should help to prevent deal premiums reaching levels that could deter acquisitions.
Utilities that operate in service territories surrounded by "giants" could also be ‘tuck-in’ acquisition targets, but only if the opportunity cost is low given the time and effort to acquire smaller utilities is about the same as larger deals. Vectren Utility Holdings Inc., (VUHI), a unit of Vectren Corp. and the intermediate holding company of its regulated electric and gas units, operates in Indiana and Ohio.
Vectren’s neighboring utilities include larger American Electric Power Inc. (AEP: Baa2 stable) and Duke Energy Corp. (Baa1 stable). Cleco Power is a relatively small vertically-integrated electric utility in Louisiana. Its service territory is almost surrounded by the larger Entergy Corp. (Baa3 stable) and borders other larger concerns including AEP.
Another smaller utility, Empire District Electric Co., whose service territory includes predominantly Missouri and parts of other states, borders larger utilities including Kansas City Power & Light Co. (Baa2 stable) and Union Electric Co. (d/b/a Ameren Missouri: Baa2 stable). SCANA Corp. (Baa3 stable), largely a South Carolina utility, also owns assets in North Carolina, neighbors Duke Energy in the north and Southern Co. (Baa1 stable) in the south. We do acknowledge certain potential acquisitions could raise regulators and customer concerns due to increasing market power. In addition, some smaller utilities could look to merge or acquire another utility as a way to prevent itself from being an acquisition target and as a means for management to reduce the risk of losing their jobs.