When Sparks Fly

Utilities across the globe are gearing up for consolidation, with Europe offering U.S. investors the best of the action.

For all their misdeeds, Kenneth Lay and Jeffrey Skilling were onto something. The stodgy electric power industry is in need of a lot of shaking up. No, they didn’t invent the idea of trading power and power-generating assets around like hog bellies, but they certainly increased the visibility of this kind of trading. And now, five years after Enron’s collapse, merger and acquisition activity in the electric power industry is really picking up steam. You can profit from it.

Trimmer and richer, utilities are now “desperately looking to spend,” says Koen Dierckx, financial analyst at KBC Securities, part of the Belgian KBC banking group. In 2005, 527 deals worth $196 billion were announced, including Duke Energy ‘s purchase of Cinergy for $14.3 billion and NRG Energy ‘s purchase of Texas Genco for $8.3 billion. John McConomy, who runs PricewaterhouseCoopers’ U.S. power and utilities practice, sees a likelihood of a lot more deals like these, although he cautions that the volatility of fuel prices and the involvement of newly invigorated regulators will stymie some plans. The proposed $11.2 billion merger between Constellation Energy and FPL announced last year, for example, tripped on red tape.

The hunt for acquisitions is being driven by the huge capital demands facing power companies over the next quarter century. A rule of thumb in the industry, says Duke Energy Chief James E. Rogers, is that for every dollar in operating and maintenance expense that can be reduced in a merger, up to five dollars can be invested in infrastructure upgrades.

Utilities need to upgrade both the quantity and quality of their systems on a large scale. PricewaterhouseCoopers estimates that $12.7 trillion must be spent worldwide by 2030 on power plants and transmission lines. The International Energy Agency forecasts that the world will consume 28 trillion kilowatt-hours of electricity in 2030, nearly twice the current level of consumption. Nor does anyone want a rerun of the overloading in early November of Germany’s grid that left 10 million Europeans in five countries without power over a weekend, or of the collapse of the rickety North American grid in 2003.

Last year’s repeal of the Public Utility Holding Company Act removed restrictions on who could run utilities. That opened the door to investors such as Warren Buffett, who bought PacifiCorp for $5.1 billion in May 2005. There are plenty of other utilities to be picked off. Even after years of deregulation, the U.S. power market remains highly fragmented. Credit researcher CreditSights has a “takeout ten” list of companies it expects will be bought. They include Alliant , Allegheny , Energy East , Empire District , OGE Energy , Pepco , DPL , Great Plains , Westar and Pinnacle West .

Right now the majority of the deals in the power industry are happening in Europe. Western Europeans, jittery about growing dependence on Russia’s Gazprom for natural gas, want to build up power companies of countervailing clout. Meanwhile, the European Commission is trying to create one electricity market across its 25 member countries. It has directed national governments, notably in Spain and France, not to protect former state energy monopolies–now private and meant to stand as “national champions”–when they are the target of foreign bids. Progress is uneven, but regional markets within the EU are forming, deal by deal.

The commission had a big win in getting the Spanish government to drop its opposition to the bid by Germany’s E.ON for Spain’s Endesa . After the initial $34 billion offer in February, the government tried to orchestrate a white-knight bid from Barcelona Gas Natural SDG, encouraged Madrid construction company Acciona to take a minority stake in Endesa and presented a laundry list of conditions for its approval of the deal. But it buckled in the face of the commission’s pressure. e.on’s sweetened bid of $47 billion should be completed soon.

E.ON has also been active in Central Europe and Scandinavia; it bought Powergen in the U.K. for $14 billion in April 2001. The acquisition spree is one reason that Dierckx likes the stock, which trades as an American Depositary Receipt on the New York Stock Exchange. He says that the $67 billion (2005 sales) company, 33rd on our list of the world’s 2,000 largest public companies, is one of the strongest in the sector because of its stability and natural gas business. The shares sell for 17 times trailing earnings.

Dierckx also likes Italy’s Enel , another Forbes 2000 company. A foray to buy France’s Suez was defeated by another local white knight, Gaz de France, but the Italian company succeeded in buying a majority stake in Slovakia’s generating company, the second-largest in Eastern Europe, and is expanding its generating capacity in Brazil by acquiring 11 companies holding concessions for 22 mini-hydro plants. Enel’s first-half sales rose 18% to $24 billion; earnings rose 3% to $2.5 billion. It is trading at a cheapish 15 times trailing earnings.

Even without Enel, Dierckx likes Suez for its exceptional operating performance and the promise in its proposed merger with Gaz de France . French politics delayed the closing of the deal, but Suez Chief Gérard Mestrallet told an investor conference in October that he still expects it to be completed by the end of the year. The merged entity would have $80 billion in annual sales and break new ground in the way it generates power. “If gas prices are high, we’ll turn off the turbine, sell gas and use another source to generate electricity. If gas prices are low, we’ll use the turbine,” says Mestrallet.

More such deals that will let electricity companies become more than passive buyers of gas are expected prior to a July 2007 European Union deadline for all European consumers to be able to select which company will be their preferred gas and electric supplier. The accompanying table contains five of Dierckx’s picks that he believes will benefit from the drive for utility consolidation.