JUICE: Merger Horizons & Utility Futures

By Published On: August 26, 2005

Some good vibes are being generated by Southern California’s troubled power market, and they are resonating with investors across the nation. They have been pushing the price of Sempra Energy and Edison International shares higher while other utility stocks receded from early-August highs. Most utility stock measurements reached their best levels in five years during the first week of the month as investors sniffed the smorgasbord of tax breaks, subsidies, and regulatory changes Congress assembled into an energy bill before its summer break. A featured entr?e was repeal of PUHCA?the Public Utility Holding Company Act of 1935?which some expect to be the centerpiece of a merger feast. Exelon chief executive officer John Rowe told Circuit that he expects “four or five other large [utility mergers] fairly quickly.” Discussing the post-PUHCA possibilities after Public Service Enterprise Group shareholders approved Exelon’s merger offer, he said there’ll be “more and more” of the transactions in the future. He didn’t discuss how quick “quickly” was, but the new energy law says it is at least six months away. That’s when PUHCA actually expires under the new law. Congress gave FERC four months to come up with regulations to implement the new law, which gives the commission enhanced merger oversight. “This is not exactly repeal of Glass-Steagall,” said Merrill Lynch utility analyst Steve Fleishman. He was referring to the change in Depression-era banking laws that spurred consolidation in the financial industry a few years ago. “Remaining FERC and state regulatory obstacles still make utility M&A a difficult process,” the analyst explained. For those wondering how difficult mergers and acquisitions will be in California, state regulators aren’t ready to say. As California Public Utilities Commission counsel Harvey Morris put it, “we aren’t able to share our views yet,” as the 1,700-page energy law is still being studied. As the potential delays offset the initial euphoria, there was a pause in the biggest utility stock price rally since World War II. During the resulting August lull, the S&P Utilities Index slipped 3.5 percent after doubling its October 2002 low. One of the bigger August losers was California’s third publicly traded utility-Pacific Gas & Electric, which has seen its stock price slip 5 percent. Ironically, it is also the California utility that has had the most to say about PUHCA’s repeal. Asked during the second-quarter earnings conference call whether this would result in a change in strategy, PG&E Corp. chief executive officer Peter Darbee responded, “I don?t think so.” Citing the company’s “first and foremost” focus on “delivering better, faster, and more cost-effective service,” he said, “Longer term, we want to be a leader in the industry, and that would suggest we would be a consolidator rather than somebody that’s acquired.” Meanwhile, Sempra and Edison shares traded at 52-week highs this week. One of the better explanations for this came from Barry James at James Equity, who said that despite their gains, the stocks still look cheap compared to the market. He cited “healthy earnings growth” and big dividends, which mean the stocks “should hold up relatively well even if . . . the overall market sells off.” During Edison’s second-quarter conference call, there was one question about the implications of a post-PUHCA industry for the company. Chief executive officer John Bryson responded that there are “none that we see at this time.” It was mid-month before Sempra chief executive officer Stephen Baum spoke up, expressing the belief that utilities “will consolidate at a more rapid rate as a result of the repeal of PUHCA.” “That’s a needed thing,” he continued. “There are so very many utilities that have grown up in a kind of Balkanized landscape in the United States, some of which are really too small to be efficient.” Baum said the consolidation “will help greater efficiency in the lowering of prices.” Beyond utilities acquiring utilities, American Electric Power chief executive officer Mike Morris believes PUHCA’s repeal “will add to the asset acquisition game” by lowering “the barriers to nonutilities or international companies.” In addition to the widely discussed regulatory changes, Merrill Lynch’s Fleishman noted in written comments, the new law “is chock-filled with tax incentives to support new utility infrastructure investment.” Some estimate such needs at $12.7 billion over the next quarter-century. FERC chair Joseph Kelliher agreed that “the electricity business needs a tremendous amount of cash and investment.” He added that he expects to see more coming from the financial industry because PUHCA “was a barrier” to the financial sector. He also sees entry into the power business “by companies that are in the energy business but not the electricity business.” AEP’s Morris believes the tax changes enhance the “dramatic opportunities” for investment being created “as the U.S. economy becomes more and more dependent on more and more reliable electric energy.” He sees this reflected in the profit growth potential for coal and nuclear power plants, explaining that the need for additional generation has been satisfied over the past decade by building natural gas-fueled power plants and pressing aging plants into extended service. While these plants got the industry through the heat waves sweeping across the nation this summer “in real good shape,” delivering record supplies of electricity, the rising cost of gas made this an expensive effort, Morris pointed out. As a result of the new law, he expects that “capital will flow into [the power] business as it needs to.”

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