Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Utilities are dealing with an unfamiliar threat -- namely, losing customers. That, by way of a case-study in Vegas, was the theme of my column Monday. This one is about how they're reacting to it.

Besides lobbying for regulatory relief from the threat posed by distributed generation, North American utilities have made a surge of acquisitions. These are running at almost $38 billion so far this year, according to data compiled by Bloomberg. That's almost as much as for the whole of last year and, annualized, would set up 2016 to be the biggest year for utility deals in at least a dozen years.

Wired
North American utilities M&A is running hot
Source: Bloomberg
Note: 2016 data as of June 10.

What utilities are buying is just as important as how much they're spending. Of 37 deals listed so far this year by Bloomberg, 11 involved buying renewable power generation outright. Another six were for companies specializing in demand management or efficiency services. And three were for natural-gas pipelines and distribution utilities.

Buying solar and wind assets, as well as services aimed at actually helping customers manage demand, rather than just pushing kilowatt hours to them, is clearly about co-opting the growth of those businesses -- turning a threat into a growth opportunity. Southern Co., the epitome of a big, traditional utility, has been active on both fronts, most notably by paying $431 million for PowerSecure International. And while natural gas might seem more old-school, it differs from electricity in one key respect: It is a growth market (in part because gas is now so cheap).

Burning Up
Growth in U.S. gas and power sales, indexed to 1997
Source: Energy Information Administration

While flat electricity sales have weighed on growth, that has been offset by big investment in grids. Utilities make their money mainly by spending money, earning an agreed return on investments in new infrastructure and upgrades that gets charged to bill-payers. What with America's perennial problems of aging infrastructure, the need to prepare for the next Hurricane Sandy and -- yes -- the need to integrate renewable energy sources with the grid, utility budgets have risen far faster than underlying demand.

But, as a survey published on Monday by Greg Gordon of Evercore ISI shows, while spending remains high, this tailwind may also be slowing.

Piling On the Pylons
Annual spending on wires almost doubled between 2010 and 2015 but now looks set to slow
Source: Evercore ISI
Note: Data for 2016 through 2018 are forecasts.

Little wonder, therefore, that utilities haven't been shy about paying up for deals. Multiples on gas acquisitions, such as those by Duke Energy and Southern last year, haven't quite been in LinkedIn territory, but are still much higher than you'd normally expect.

Besides necessity, such exuberance also flows from the stock market, where utilities are leading the field so far in 2016.

Winning
Price performance by S&P 500 sector, year to date
Source: Bloomberg

Just as important here is why utilities shares are doing so well. It isn't growth, that much is clear.

Trailing Wires
S&P 500 earnings increased by 11.1% a year, compounded, between 2009 and 2015, versus just 6.2% for utilities. Estimated growth for 2016 and 2017 is 10.4% for the S&P 500; 6.8% for utilities
Source: Bloomberg, Bloomberg Intelligence
Note: Performance indexed to 2009. Data for 2016 and 2017 reflect estimates. Regulated utilities data as per the Bloomberg Intelligence North America Regulated Utilities index.

Over the same period covered in the chart above, shares of the regulated utilities have more than kept pace with the broader stock market. Right now, they're leading the S&P 500 by about 15 percentage points since the end of 2009. Here's why:

Multiplier Effect
Utility valuations have risen strongly as investors award them higher multiples for their expected earnings
Source: Bloomberg, Bloomberg Intelligence
Note: Data are 1-year forward P/E multiples. Utilities data as per the Bloomberg Intelligence North America Regulated Integrated Utilities index.

A big reason for this has nothing to do with electricity and everything to do with anxiety, about the economy and potential shocks to it -- like, for example, the U.K. leaving the EU. These push out expectations of the Federal Reserve raising interest rates further (great for dividend stocks, like utilities) and draw U.S. investors back to the comforts of home (great for domestic-facing businesses, like utilities).

Lower bond yields also make M&A shopping that much easier. For example, with Southern's 10-year bonds issued last month yielding just 3.03 percent, pretty much any target with a pulse would boost earnings. Hence, it isn't just gas and renewables that have commanded high prices. Fortis paid a premium of one-third over the price that ITC Holdings, the transmission company, traded at before it effectively put itself up for sale in November. Just a couple of weeks ago, Great Plains Energy offered 24 times 2017 earnings for Westar Energy, a relatively low-growth electric utility in Kansas.

Amid the push of cheap finance and the pull of dealing with the threat of the Vegas scenario of fleeing customers, utilities should remain a reliable source of M&A fees. That's great for bankers and targets alike. Investors providing the wherewithal, and more than usually beholden to the Fed's thinking, might pause to consider if they're taking too much of a gamble themselves.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net