Power Plays

Utility mergers are heating up, as companies cope with deregulation's challenges and opportunities.
Andrew OsterlandOctober 12, 2000

Two new powerhouses have emerged in the electric utility industry. On August 7, Akron, Ohio-based FirstEnergy Corp. and Morristown, New Jersey­based GPU Inc. announced they would combine to form a single electric utility, the nation’s sixth largest in terms of customer base. That came on the heels of a $16.4 billion merger between Juno Beach, Florida-based Florida Power & Light (FPL) and New Orleans­ based Entergy Corp., whose combined 6.3 million customers and more than 48,000 megawatts of generating capacity would make it number one. “This is the first real superpower in the industry,” proclaims Entergy CEO Wayne Leonard, who will head the combined entity.

It surely won’t be the last. With more than 100 investor- owned utilities and many more private and cooperative organizations still serving up electricity around the United States, consolidation should continue for at least the next decade. “There were a lot more companies in our 13-state region a few years ago,” says FirstEnergy CFO Richard Marsh, “and there will be fewer down the road.” According to analysts, future candidates for acquisition in eastern regional power pools include Duquesne Light Co., in Pennsylvania, Potomac Electric Power Co., in Washington, D.C., and New York State Electric & Gas Corp.

One reason for the recent surge in deal activity is a sudden recovery in utility stock prices. Last year, utility stocks were Old Economy and out of favor with investors. This year, they have become a high- yielding haven from the stormy technology sector. The Standard & Poor’s utilities index is up an electrifying 48 percent this year– compared with 2 percent for the S&P 500 and ­2 percent for the Nasdaq composite, as of press time. And the pleasant Wall Street trend has had utility executives thinking merger again.

Going Separate Ways

The more fundamental reason for the mergers is, of course, competition. With the industry deregulating at different paces in the various states, many vertically integrated utilities have broken apart and reassembled themselves to focus their business strategies. Some–such as GPU, which has sold off all its power- generation assets–are concentrating on the regulated retail distribution side of the business. They hope to leverage their growing networks by selling new unregulated services such as facilities management and telecommunications. Others emphasize such deregulated lines as power generation and wholesale energy trading. The combined FPL and Entergy entity plans to fire up as many as 65 new General Electric Co. generating turbines during the next several years, growing to as much as 30,000 megawatts of electric capacity in the United States and Western Europe.

“Companies are deciding whether they want to be a wires company or a trading outfit,” says senior analyst Richard Baxter of Boston-based Yankee Group. And investors are trying to figure out how to value the resulting corporate structures. While the unregulated businesses are riskier than simple electricity distribution, they also offer greater opportunities for growth. The stars of this most volatile commodity market–companies such as Enron Corp., Dynegy Inc., and Southern Co.–trade at price-earnings multiples far higher than those of retail-oriented utilities.

In the two recent mergers, shares of both FPL and FirstEnergy fell on the news, although FPL shares have since recovered. The deals were made at small premiums. And in FPL’s case, the investment community was hoping it would be an acquiree, not an acquirer. But beyond that, assessing the outcome of these deals is difficult.

“Utility mergers aren’t usually positive in the short term,” says analyst Paul Patterson of New York­based Credit Suisse First Boston Corp. “The benefits are not completely clear.” Nor is it certain just who will enjoy those benefits: shareholders or ratepayers. Utility mergers can take years to complete as companies negotiate with states’ public service commission regulators about how much of the expected benefits from a merger will go to customers. In several instances, companies have walked away from deals because regulators either demanded too much or dragged out reviews too long. With footprints in five southern states, the FPL/Entergy merger could take up to 18 months to close.

But despite the typically tepid reactions from the stock market, and the prospect of lengthy regulatory review, utility executives say mergers are vital to their future success. FirstEnergy’s Marsh hopes his company’s acquisition of GPU will boost earnings growth from the 5 percent range to between 7 and 8 percent. C. John Wilder, CFO of Entergy, predicts that utilities will require at least 10 million customers to compete as marketers of electricity. And beyond the economies of scale in electricity distribution, many merging utilities hope to bolster their performance in higher-growth, unregulated businesses. “We’ve created a top-performing company poised for accelerated growth,” says Wilder.

When Wholesale Isn’t Cheap

Shareholders aren’t the only ones trying to figure out the corporate combinations. Credit analysts such as Todd Shipman at S&P also have their hands full sorting out the risks and rewards of the regulated and unregulated businesses being blended together. Traditionally, the unregulated businesses, such as power generation and wholesale electricity trading, have been viewed as higher-risk activities by credit analysts. Accordingly, FirstEnergy’s utility subsidiaries are saddled with a BB+ composite rating because of their generation assets and exposure to wholesale market prices for electricity. GPU’s sell-off of virtually all its power- generation assets, on the other hand, has earned it an A rating.

But given the wild and woolly wholesale market in the past three years, analyzing risk has been getting more difficult. While GPU may have abandoned the generation business, for example, it hasn’t escaped the volatility of wholesale markets. And with an obligation to serve its 4.8 million customers in Pennsylvania and New Jersey at regulated prices, it essentially has to manage a massive short position in power.

Long-term contracts supply much of its electricity needs, but during peak demand periods such as last summer, GPU had to make up supply shortfalls by buying power in the wholesale market. That can get expensive: just ask customers of San Diego Gas & Electric Co., a California utility owned by Sempra Energy that generates none of its own power. In California’s sweltering summer, the utility scrambled to buy wholesale power to meet surging demand, and passed the higher costs on to end-users. A customer revolt ensued, and Gov. Gray Davis slapped price caps on the utility. All this from the state that blazed the trail in terms of deregulation of the utility industry.

The bottom line is that with the increased volatility of wholesale prices, management of electricity supply and demand has become far more important for utilities. “There’s nothing wrong per se [with] being long or short” on power, says S&P’s Shipman, who is negative on GPU’s credit rating and positive on FirstEnergy’s. “It’s how you manage your position.”

The margin for error, however, has shrunk. In the uncertain regulatory environment, utilities have had their capital investment budgets on hold for 10 years. At the same time, demand for electricity has grown far faster than expected. The result is smaller-capacity reserve margins–the difference between electricity supply and demand–and extraordinarily volatile wholesale prices in periods of peak demand. Dozens of utilities have suffered huge losses from trading in the wholesale market.

Entergy’s Leonard has essentially decided that managing the wholesale trading side of the business is beyond his company’s expertise. Last April, he entered a joint venture with commodities-trading giant Koch Industries to outsource his risk management. “Utilities underestimate the risks they’re taking,” says Leonard. “We went with Koch because it already has that [trading] mentality.” And with access to the huge generation capacity of Entergy and FPL combined, Koch will give market leader Enron a run for its money in the trading arena.

But whether that translates into long-term success for the new company remains to be seen. It’s clear, however, that more new heavyweights will rise–and perhaps fall–before the dust settles in the deregulating utility industry.