There's Still Big Money in Utility M&A

...if you know where to look for it

Electricity, heating, water and communications have been essential to modern living for more than 120 years now. And over that time, not one of the literally thousands of mergers between operating utilities has failed to eventually create a financially stronger, more efficient and resilient company.

That includes deals involving bankrupt partners: Public Service of New Hampshire went bust in the 1980s from funding its piece of the Seabrook nuclear plant, but it’s now part of thriving EverSource Energy’s (NYSE: ES). And it includes mergers that literally took decades to complete, such as Kansas City P&L and Westar Energy joining forces in Missouri and Kansas to form Evergy (NYSE: EVRG).

No other industry comes close to that unblemished record of success when it comes to realizing scale advantages by merging. But it’s also fair to say proposed mergers between utilities arouse more suspicion and even outright hostility than those in any other industry.

No one can doubt the Biden Administration wants to promote wind and solar energy. Nonetheless, the Democrat majority at the president’s Federal Energy Regulatory Commission outright rejected Algonquin Power & Utilities’ (TSX: AQN, NYSE: AQN) attempt to buy American Electric Power’s (NYSE: AEP) Kentucky Power unit. That purchase would have dramatically accelerated the Bluegrass state’s transition from coal to wind.

FERC’s objection: Insufficient guarantees customer rates wouldn’t be affected by the sale. That’s a tough bar for any deal to hurdle. But it’s one a growing number of states are likely to apply with inflation squeezing consumers and businesses.

In my Conrad’s Utility Investor coverage universe, there are four mergers in progress. One is a prospective union of electric utilities, with Avangrid Inc (NYSE: AGR) and its 81.64 percent owner Iberdrola SA (Spain: IBE, OTC: IBDRY) pursuing PNM Resources (NYSE: PNM).

Private capital firm Searchlight Capital is attempting to buy the 66.28 percent of weakening telecom Consolidated Communications (NSDQ: CNSL) it doesn’t already own. A Brookfield Renewable Partners (TSX: BEP-U, BEPC, NYSE: BEP, BEPC) led consortium has made an offer for Australian electricity retailer and generator Origin Energy (ASX: ORG, OTC: OGFGY). And Vistra Corp (NYSE: VST) is trying to buy Energy Harbor Corp (OTC: ENGH) to form America’s second largest nuclear power operator.

All of these deals faces meaningful regulatory hurdles. And there’s no guarantee any will eventually close. The history of utility M&A is there’s always something going on, but the volume of activity has been anything but steady.

Activity tends to pick up steam when the cost of debt and equity capital are reasonable, state and federal regulators are no more than mildly ambivalent and companies are more focused on cutting costs than investment. Activity tends to wane or at least take other forms when the opposite is true, as is the case now.

My number one rule shopping for utility takeover targets: Never buy a company you wouldn’t want to own if it never attracted an offer.

It’s more important than ever to heed that advice now. Deal volume is at low ebb. The cost of debt capital is twice what it was 18 months ago. Regulators in a merger-skeptical mood and best in class companies enjoying a wealth of opportunities to invest internally. Moreover, the risk of a recession is elevated and arguably rising. And so is the danger of a steep stock market selloff later this year.

Altice USA (NYSE: ATUS), DISH Network (NSDQ: DISH), Lumen Technologies (NYSE: LUMN) and Uniti Group (NSDQ: UNIT) are battered telecoms with assets no doubt attracting attention. But their stocks are on average down more than -70 percent over the last 12 months because of rising bankruptcy risk. They may ultimately get takeover offers. But they’re being increasingly squeezed by debt at a time of elevated interest rates and declining sales. Takeovers could well come after Chapter 11, with only bondholders receiving anything.

In contrast, strong companies will generate outsized returns while you wait on a deal to appear. And they should weather whatever economic turbulence we see in coming months.

With these broad investment guidelines in mind, there are a number of areas where we’re likely to see more utility M&A activity in the next 12 to 18 months.

One is Australia. The country has historically been welcoming of foreign capital investment in its essential services companies. But its largest electric company as well as its biggest toll roads operators are among candidates for future deals.

US gas distribution utilities have suddenly become controversial in some states, with New York now the first in the nation to actually ban new utility hookups starting later this decade. Other states like Texas, for example, are now defending their franchises with legislation, greatly increasing their appeal as cash cows.

The action so far has been mainly US electric utilities selling some of their gas utility units for cash to fund CAPEX, notably Centerpoint Energy (NYSE: CNP), Dominion Energy (NYSE: D) and NiSource (NYSE: NI). But I expect to see an offer for one of the larger players in the next 12 to 18 months, with even for the biggest names like Atmos Energy (NYSE: ATO) a fraction of the market capitalization of larger electric companies.

It's been several years since renewable energy yieldcos Pattern Energy and TerraForm Power were acquired. But at least one—Atlantica Yield (NSDQ: AY)—may soon be on the block.

Several utilities are now spinning off significant assets to shareholders. Later this month, MDU Resources (NYSE: MDU) will spin off its construction materials unit Knife River (NYSE: KNF) to its shareholders of record May 22, at a ratio of one KNF per 4 MDU. Later this year, Southwest Gas Holdings (NYSE: SWX) will spin off its Centuri construction unit. And I expect to see other utilities with unrelated businesses do the same, with the sum of the parts worth meaningfully more than current share prices.

I also believe we’ll see another merger between investor owned US water utilities. The last was the acquisition of the former Connecticut Water Service by SJW Group (NYSE: SJW), which closed back in October 2019. Since then, there have been dozens of acquisitions of smaller and municipally owned systems by the remaining handful of investor-owned utilities. But with costs of safe water and wastewater rising sharply, advantages of scale are rising. And we may even see what many would consider the sector’s dream deal: Essential Utilities (NYSE: WTRG) and American Water Works (NYSE: AWK), creating the first US water utility with the scale of a blue chip electric.

American and Essential may never merge. But whether they do or don’t, both companies’ Q1 results and guidance updates demonstrate their strengths, and why they should continue to grow investors’ wealth for years to come.