Utilities May Ride a Merger Wave

07/31/2007 12:00 am EST

Focus:

Roger Conrad

Founder and Chief Editor, Capitalist Times

Roger Conrad, editor of the Utility Forecaster, says the need for scale may drive consolidation, especially among smaller utilities, and he names two potential targets.

Growing energy demand means increased need for scale and scope. But despite literally thousands of mergers, there are still more than a hundred US-based energy utilities, a couple dozen major communications outfits and a dozen or so water utilities.

The need for scale in this dispersed industry adds up to an inexorable trend of industry mergers. [After the collapse of a big deal late last year], takeover interest shifted to buyouts of small utilities, deals that presented fewer hurdles to completion.

Small utilities today have three possible candidate pools: big US utilities, European giants and private capital. One obstacle to US utility deals is many regulators remain unaccountably suspicious of large utility companies, despite the obvious need for industry scale.

With regulators around the country weighing in against possible private capital buyouts of the magnitude of [the proposed $40-billion buyout of TXU (NYSE: TXU) by a consortium led by Kohlberg Kravis Roberts], acquirers are now likely to focus on lower-profile deals.

[Meanwhile], European giants are expressing interest in acquiring US utilities. They have the added advantage of a sharply appreciated euro, which makes US purchases that much cheaper.

[We have identified some] companies that may get a bid in coming months. [They are also] solid businesses that would make fine holdings even if years pass before a merger is consummated.

Avista Corp (NYSE: AVA), [whose market value is] about $1.1 billion, has undergone a major transformation this year, unloading its volatile and often unprofitable energy trading unit to refocus on core Washington and Idaho utility operations.

The downsized company stands to benefit from the continuing growth of its service territory, as well as a strong position in renewable fuels and conservation. After years of neglect in the name of growing the company, the dividend is low. But the 3.4% increase this spring—despite uncertainty in energy trading—is a sign things should pick up, particularly once Avista regains an investment-grade rating.

This is the kind of cash flow/recovery situation that should attract a high-premium offer.
And if not, Avista is still a great comeback buy up to 24. (The stock closed just below $20 Monday—Editor.)

NiSource (NYSE: NI) elected not to sell its Indiana electric utility unit this spring, presumably because it lacked an attractive offer. But coupled with the Columbia pipeline system and a nine-state, 3.3-million-customer gas- distribution utility, the solid power unit gives the company a triple attraction to would-be suitors.

Debt reduction, construction costs, rate lag, and mild weather’s impact on gas flow have held back profits during the past couple years. But with pipeline expansion and clean energy projects on track, profits should begin to turn up sharply in 2008. In the meantime, the dividend is secure and the stock is cheap. Its total price tag just $5.7 billion, NiSource is a buy up to $25 a share. (The stock closed at around $19.50 Monday—Editor.)

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