A Dealmaking Cure For the Power Industry: Reeling from its years of excess, the utility industry will leverage lots of acquisitions and restructurings to restore vigor and confidence.

Years of expansive moves into newly competitive markets and techniques fostered by deregulation such as trading have left the nation’s largest electric utilities in tatters, beset by a credit crunch, by shock waves in the aftermath of the California wholesale market meltdown, and by the Enron Corp. debacle. But dealmakers looking past the multitude of problems and the massive loss of shareholder value believe that there is opportunity in the industry’s dire state. “The bad news in this industry is absolutely pervasive. It just seems like one piece of bad news after another,” says David Dismukes, head of Louisiana State University’s Center for Energy Studies, in summing up the industry’s shell-shocked condition. California’s deregulation regime resulted in inflated electricity prices, blackouts, and the bankruptcy of one of the state’s two largest public utilities. It could cost taxpayers as much as $40 billion. On top of that, premier energy trader Enron went bankrupt a year ago against a backdrop of accounting misstatements and other kinds of financial reporting irregularities, leading to criminal actions against some officials. But despite this double whammy, an upside for the nation’s electric utilities is that electricity sales are tied to general economic growth so that when the economy improves, experts believe, the country’s electric utility industry will prosper. But until then, a key response to the industry’s recent problems will be to sell assets. “You can expect a long-term reshuffling of assets in the electric utility industry,” says James Hendrickson, a partner in charge of energy m&a at Accenture. One area of dealmaking could be trading, which surged in prominence as deregulation of the industry – traditionally dominated by regulated, geographically focused monopolies – took hold in the 1990s. Hendrickson says that the entire utilities industry is tarred by the collapse of the long-term speculative wholesale markets that stemmed, in large part, from the Enron implosion. The subsequent exit of other major traders in recent months such as Dynegy Inc. and Aquila Inc. is a symptom of the depth of the problems in the trading sector of the industry. “You are likely to see more acquisitions as strategic and private equity buyers break off selected pieces of companies,” he notes, but adds that the problems in the speculative wholesale markets don’t tell the whole story about the $350 billion electricity industry. If potential acquirers are willing to be more conservative and want to play long term in the sector, there are attractive assets to pick up, he says. Dealmakers, however, should proceed cautiously. Power, as the wholesale electricity industry is sometimes referred to by insiders, offers more twists and turns and a richer, if more nefarious, cast of characters than the average capital-intensive, building-block-of-the-economy type of business. Toss in indicted executives, round-trip trades, a quirky regulatory regime, overcharged consumers, and Nigerian barge deals done to shore up quarterly numbers, much of which was featured in the Enron case and other suspect developments, and you have an industry in which even the most swashbuckling dealmakers may fear to tread. Too Late to Stop Now In the mid- to late 1990s, the power industry was reshaped by a wave of mergers that were designed to capitalize on the deregulation of the electricity industry. The landscape had consisted of the regulated electricity providers that had a monopoly relationship with their customers. State public utility commissions told them what they could charge and built in modest profit levels. With the onset of deregulation, some form of which was instituted in about half of the states, a new type of non-regulated company often was created. Sometimes these companies were created via spin-offs from the regulated companies; others were created from scratch. But all of these non-regulated or merchant energy companies were designed to wheel and deal in the new wholesale marketplace. Enron was the largest and most aggressive merchant energy company. The merchants faced greater risks, but had potentially rosier upsides. One of the major drivers for this move to deregulation was the electricity industry’s primary regulator, the Federal Energy Regulatory Commission (FERC). The group of regulators, some pushing for deregulation and some resisting it, also included state bodies like public utility commissions and regional organizations such as the Tennessee Valley Authority (TVA). Referring to the electric industry, populated as it is today by the old-school regulated industries and the merchant players, Prof. Robert Michaels of California State University at Fullerton says, “What we have is a strangled industrial transformation. The underlying need is still there for deregulation; we can’t go back.” One reason for this is that about one-third of all of the power produced in the country comes from merchant generators, i.e., those that don’t have a captive audience of ratepayers to absorb their megawatts. Not surprisingly, post-Enron, post-California blackout, the electricity industry and its investors have stuck to the belief that safer is better. “The search is on for an appropriate business model, and it is taking place against a background of deep skepticism about the unregulated business sector,” says Michelle Michot Foss, director of the Energy Institute at the University of Houston. She expects some asset buyers to come from the regulated utilities in states that haven’t embraced deregulation aggressively. Although they were considered stodgy during Enron’s heyday, they may have the last laugh because they have come through the storm relatively unscathed and are the domestic companies that have the cash to make acquisitions. Hendrickson also expects some of the acquirers of the industry’s many distressed assets to come from among the regulated utilities, many of which are vertically integrated and didn’t entirely jump on the deregulated bandwagon without looking. Dismukes, on the other hand, thinks that there will be more joint ventures than outright acquisitions. The whole sector has been so battered, he notes, that the relatively healthy regulated companies will tend to focus on their core competencies rather than buy assets. But Dismukes also suggests that even the regulated companies haven’t escaped the drubbing that stocks have suffered throughout the power industry. That may lead them to forego making acquisitions for now. So who are the other potential buyers on the horizon? Many experts expect a wave of acquisition activity by European utilities that have the cash to pick up North American power assets. Foss says that German utilities RWE AG and E.ON AG, Belgium utility Tractebel SA, Electricite de France, and Spanish power company Iberdrola SA are some of the well-capitalized foreign players that might pounce on American assets. Potential targets for European buyers might be American Electric Power Co., Consolidated Edison Inc., and Exelon Corp., according to Klaus-Dieter Maier, a vice president in the Munich office of Bain & Co. “European utilities are attracted by regulated utilities in the U.S. because they like the risk profile more than that of companies that specialize in trading or generation alone,” he says. The cultural fit between these companies and regulated U.S. utilities is a natural, because the European power companies share this regulated background, he adds. Maier points out, though, that accounting problems in the U.S. electric utility market as well as Sarbanes-Oxley requirements have made potentially acquisitive European utility sector managers cautious about foreign expansion. “The track record of many of these companies in Latin America and Central Europe hasn’t been encouraging. So while they are interested in the U.S., they will move slowly,” he states. Another category of new entrant to the U.S. electricity markets could be a combination of a merchant energy company, such as Alliant Energy Corp., and a company that produces and trades agricultural commodities, such as Cargill Inc., says Michaels. The risk management skills and trading capacities of companies like Cargill are assets that would enable them to trade wholesale electricity effectively, he notes. The other category of players that have begun to buy up electric utility industry assets, especially their trading operations, is banks. Most notably, UBS Warburg took over the trading operations of Enron. Bank of America Corp. has applied for regulatory clearance to trade power. Wall Street firms like the Goldman Sachs Group Inc. and Bear Stearns & Co. have also entered the fray. Experts differ on the likelihood of the banks being able to succeed in wholesale power trading, though. Dismukes says that the financial institutions have the financial resources to be solid counter parties in trades, yet he questions whether they understand the unique constraints and physical limits that characterize the power industry. However, Prof. Ehod Ronn, an energy specialist at the University of Texas at Austin, thinks that financial institutions that enter the market with strong balance sheets will be able to make a go of it in wholesale power trading. “If there is sufficient liquidity, the extension of financial services to energy finance should work,” he asserts. Demise of Speculative Power Trading In the wake of the decisions to close down trading by merchant companies like Dynegy, Aquila, and others that had been standard-bearers for the strategy, the entire spectrum of aggressive, speculative power traders has become suspect. “You do have some companies that embraced the deregulated markets, including wholesale trading, that are doing well, such as Duke and Exelon,” says Julie Simon, vice president for policy at the Electric Power Supply Association (EPSA). She stresses the importance of distinguishing between speculative power trading as practiced by Enron, Dynegy, and others and more conservative, short-term trading, which continues to move power around the country. The banks are requiring companies to show bricks in the ground as a backup to their trading and other merchant activities, says EPSA policy director Mark Stultz. The Enron model of using a financial services template to approach the energy industry while not owning many hard assets will no longer suffice, he says. “You’re really seeing a mixed bag of outcomes. There are a lot of company-specific situations,” Simon says. But she notes that with one-third of all U.S. generation being supplied by merchant providers, it means that one-third of the power in the county, at least, much be moved by wholesale trades. If companies have the vision and the capital resources to plan beyond the next two years, demand will go up and opportunities will present themselves, she says. Another problem for the beleaguered industry that could stimulate asset sales is its weak credit picture. Starting in around 1997, many utilities tried to capitalize on deregulation to buy and build new plants. But as market conditions shifted, prices in some sections dropped, making repayment of these short-term loans difficult. Standard & Poor’s issued a report in October which states that in the first nine months of this year, there were 135 credit downgrades of utility holding companies and their subsidiaries. This was four times the amount from the same period last year. It leaves nearly one-third of the big players in the sector on watch for future downgrades. The Standard & Poor’s report reflects a consensus among the rating agencies. Donna DiDonato, a director in Fitch Ratings’ global power group, says that the companies that have been impacted the most by credit shortfalls have been those that relied on wholesale trading. But while the situation for many companies is dire, bankruptcy is not necessarily the next step. “There is little advantage for banks to pull the plug on these companies. You will see a lot of these covenants being rolled over,” says Ronn. Foss sees potential relief for some debt-heavy energy companies as coming from their states. She cites the example of Long Island Lighting Co., the New York electric utility that was supported by state intervention, as a model that could provide a safety net for some companies. Regardless of whether and how threatened companies might be bailed out, one likely outcome of the credit crisis, according to Accenture’s Hendrickson, will be a decline in the number of pure merchant players. Regulatory Overhang To some observers, a unique obstacle to the straightforward buying and selling of assets in the power industry is the pervasive uncertainty about what the regulatory environment will be, notes Michaels. He adds that FERC is not a stereotypical regulatory agency, and driven by its vision of increased competition, it can be unpredictable at best and motivated by narrow political consideration at the worst. One source of uncertainty is the agency’s push for what it calls “standard market design.” The proposed standard market design (SMD) is calculated to send appropriate price signals, address property rights, develop independent transmission parties or regional transmission organizations, and develop regional planning processes. Its goals are to provide transparency, up-front rules for non-competitive regions, and guidelines for customers and investors. But observers don’t think that the implementation of the SMD is going to be quick or painless. Michaels says the imposition of SMD will lead to years of litigation and strange compromises. As a result, he says that buyers of utility industry assets don’t know what they’ll be getting in a way that is singular to the power industry. Using FERC’s recalculation of payments made to electricity suppliers during the California crisis as an example, he notes that one big drawback to m&a is that the industry lacks the faith in markets and contracts that are taken for granted in other sectors. “You’re exposed to the recalculation of prices and the potential of power providers having to make refunds,” he says. These kind of adjustments tend to give potential buyers second thoughts about investing in assets, he adds. One outcome of this kind of uncertainty, according to Foss, is that companies will tend to move spun-out, merchant operations – whether they are trading, transmission, or generation – back under the umbrella of the regulated entity. Where’s the Bottom? Another question potential acquirers must grapple with is when will the industry’s valuation hit bottom? EPSA’s Stultz says that in light of the uncertainty in the industry, some potential buyers are choosing to wait, in the expectation that prices will drop lower. Hendrickson agrees, saying that he believes there is too much turmoil in the marketplace for many potential acquirers. He expects to see a groundswell of acquisitions in nine to 12 months. He also says that in many cases the industry’s assets are still overvalued. Hendrickson adds that the most crucial concern from a dealmaking standpoint is to develop a bias about what the future market is going to look like. He says that is the only way to find the true value of assets an acquirer might be looking at. “If you believe that the price of power is going to be $30 a megawatt two or three years out, or $50 a megawatt, that will determine what you can pay today.” He goes on to say that some dealmakers may want to wait out one more wave of asset devaluation and then move in strongly with bids. European buyers with cash hoards are operating from some of the same strategic foundations. For example, Maier says that even with their generally depressed stock prices, U.S. utilities are trading at P/E multiples in the teens. This can look pricey to European shoppers, whose own companies have P/E numbers in the single digits. In the meantime, given the depressed state of the industry’s coffers, Hendrickson says he expects to see various private equity players coming into the marketplace. The $22 billion purchase of Dynegy’s Northern Natural Gas pipeline by MidAmerican Energy Holdings Co., controlled by Warren Buffet’s Berkshire Hathaway Inc., while not a pure private equity play, is expected to attract the attention of financial buyers. “Buffet’s purchase is a signal that there will be private equity players coming in. He’s about as astute a market timer as there is, so his move will stimulate interest,” Ronn says. Overall, the U.S. power marketplace will reward shrewd dealmakers who time their moves right and don’t overpay. A long-term take on the marketplace will be needed. Simon says she thinks that intelligent buyers of power industry assets won’t be looking for immediate payouts. A better approach is for them to position themselves for the overall economic rebound and to expect to profit when demand increases, she says.