Utilities: Expect a Jolt of M&A

With long-time ownership limits repealed, industry watchers see a wave of buy-ins and buyouts in the offing. Possibly heading the pack: Warren Buffett

By Aaron Pressman

After overhauling banking and insurance regulations in the 1990s, Congress has finally got around to revamping musty Depression-era rules governing ownership and regulation of electric utilities. The result: A likely wave of mergers and acquisitions in the coming months that could change the face of the industry.

The massive energy bill signed by President Bush on Aug. 8 repeals the 1935 Public Utility Holding Company Act (PUHCA). No longer will the Securities & Exchange Commission have final say over mergers and combos.


  That authority will now fall to the Federal Energy Regulatory Commission (FERC), headed by a former utility-company lobbyist, Joseph Kelliher, who is widely expected to play a hands-off role. At the same time, rules that limited outside companies from 10% ownership of regulated utilities will be lifted.

The new rules won't take effect until six months from enactment (Feb. 8, 2006). But already, big players are signaling they're interested in buying in. Warren Buffett, who acquired PacifiCorp from Britain's Scottish Power (SPI ) for $5.1 billion in May, has declared that Berkshire Hathaway (BRK.A ) is ready to spend an additional $10-15 billion on utility acquisitions. Large insurers such as American International Group (AIG ) and financial companies with big cash piles like General Electric (GE ) might follow Buffett's foray, those who watch the industry say.

"It's a huge deal (for utilities)," says Tim O'Brien, who runs the $365 million Evergreen Utility and Telecommunications Fund (EVUAX ). He predicts a wave of consolidation inside the industry itself, as big players such as Exelon (EXC ), FPL Group (FPL ), and Public Service Enterprise Group (PEG ) buy up smaller fish like NStar (NST ) and Energy East (EAS ).


  Under PUHCA, utilities weren't supposed to merge unless they had contiguous territories. That provision has been lifted, meaning there are more potential buyers for each small fry.

In the world of utilities, where rates are regulated and customer growth is modest, the only real growth strategy available to big companies is to acquire smaller players. Consolidation can generate substantial cost savings, although state regulators have sometimes sopped up the gains in prior deals by demanding rate cuts.

Merrill Lynch (MER ) analyst Steve Fleishman also cites Pennsylvania-based PPL (PPL ) and Ohio operator DPL (DPL ) as strong acquisition candidates. Both companies are financially solid, Fleishman says, and could see share prices jump if a buyer comes knocking.


 . Individual investors may get into the act as well. Fleishman wrote in a recent report that mutual funds and other institutional investors might consider buying a basket of small-cap utility stocks as a play. But choosing the correct stocks and paying trading commissions to assemble such a basket could be a costly and complicated strategy for such an investor to pull off.

Individuals might be better served buying an exchange-traded fund investing in utilities, but currently, none concentrate on the small-cap shares that are likely to be acquired. Among the three diversified exchange-traded funds investing in utilities, Vanguard's Utilities VIPER (VPU ), has the smallest average market cap, according to Morningstar, but 64% of the fund is still concentrated in large-cap utilities.

Cash-rich private-equity firms are also likely to make bids, says Charlie Gaffney, an analyst on the $805 million Eaton Vance Utilities Fund (EVTMX ). Many have already invested in transmission and gas pipelines, making utilities a logical next step. "The repeal of PUHCA clears the way for more of these players to get involved," Gaffney says.


  Why so much interest? Companies like Berkshire Hathaway that have substantial cash on their balance sheets -- $40 billion in Buffet's case -- are earning money-market rates. Investing that dough in a utility instead can earn a stable yield of 10% or more.

"In that situation, there are obviously opportunities," says John Kohli, manager of the $2.6 billion Franklin Utilities Fund (FKUTX ). This is the positive side to the utilities' regulated-rates, slow-growth environment. Returns are steady and predictable, with above-average dividends. Owning utility stock is almost like owning a bond.

Any checks on M&A? There will still be a few. State regulators retain their authority over mergers, which could rein in unbridled dealmaking, says Franklin's Kohli. "You're still talking about a substantial time commitment of 18 months to two years for any kind of merger," he adds.


  The recent spike in long-term interest rates only adds to the buying opportunities for investors, fund managers say. Because most utility shares tend to trade more like bonds, prices tend to rise as rates fall and -- lately -- falling when rates rise. While utility mutual funds have declined by 0.1% over the past month, they're still up more than 12% this year -- the second-best category performance, trailing only energy funds, according to Morningstar.

Barring a spectacular spike in interest rates, most utility companies have the ability to raise their dividends further to keep up with bond yields. As Franklin manager Kohli notes, industry-wide companies are paying out only about 60% of earnings as dividends, well below the 85% to 90% rate seen a decade ago. "Fundamentally, the sector is better off than it's been in a long time," he says.

With the repeal of the post-Depression era's limits on utilities ownership, the M&A urge could be strong, indeed.

Pressman is a correspondent in BusinessWeek's Boston bureau

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