Associate Partner, Accenture
Utilities have long been one of the bedrock industries of the modern western economy. To many, including financial analysts, the very term “utility” conjures up images of long term stability, of an industry that is slow to change and sometimes even seemingly immune from the fundamental forces of globalization that have swept through other sectors.
Figure 1. Few utility M&A deals add value
But in a world where disruptive forces – be they in the form of regulatory reforms, the emergence of new business models or new technology such as distributed power generation – are becoming the norm, that image of stability may soon be swept away. Leading European utility companies, armed with a war chest conservatively estimated to be $175 billion in cash and liquid assets, are embarking on a new acquisition-driven quest for growth through scale and diversification.
Although recent stock market volatility and fears about a recession have dominated the headlines, the longer-term trends affecting the structure of the utility sector continue to play out beneath the surface.
The productivity gains, cost-cutting and deregulation plans that dominated the agenda of chief executives during the last decade are giving way to thoughts about how to achieve the higher returns and share price premiums or “top line growth” that more “dynamic” sectors have attracted.
Paying a premium
A recent Accenture survey of European financial analysts who cover the utility industry highlighted the complex circumstances that face European utilities as they try to re-shape themselves for an uncertain future.
The first wave of expansion through acquisitions more often than not proved to be a double-edged sword. Purchasers often found that their “strategic” acquisitions actually diluted their earnings, with the only “winners” being the shareholders in those companies that were acquired at premium prices.
Figure 2. A few companies are clear winners
The utility industry has performed worse than a cross-industry view, with the combined market capitalization of the acquirer and acquired companies diluted after acquisition.
Many deals of this type had all the hallmarks of being opportunistic and tactical, rather than fitting into a finely thought out and compelling strategy. The “land grab” mentality has dominated the utility mergers and acquisitions (M&A) scene, and portfolios have been hung together with tenuous strands of logic and trade synergies.
In such circumstances the under-performance of many utility stocks is not surprising. The Accenture survey showed that analysts prefer utilities to specialize in their core capabilities. Attempts to diversify into businesses that have little connection with such core competences can act as a drag on the stock of such companies, with typical conglomerate share price discounts in the range of 10 to 15 per cent compared with more focused businesses.
The same survey also showed that analysts believe the best way to achieve growth is through geographic expansion into other European countries.
The evidence this year from Europe suggests companies have taken that advice to heart. M&A activity in the European utility sector this year has been robust, although the prices associated with some recent deals suggest that the lack of attractive targets is forcing acquiring companies to raise their bids, even at the expense of their stock market rating.
That fundamental supply and demand situation will ultimately drive European utilities to look further afield in their quest for scale, with the highly fragmented US utility industry firmly in their sights.
Recent events in California have dramatically underscored that the highly fragmented existing structure of the US electricity industry hides some dangerous fault lines. California’s experience may in fact add greater weight to the case for more consolidation and scale in the US industry.
Figure 3. Xcel and NRG: the key to success is a series of inter-linked acquisitions and spinoffs
Already there is some evidence of European companies taking a greater interest in the US market. NGC, Scottish Power, PowerGen and Centrica are among the European utilities which have made moves recently, and the pace of cross-Atlantic M&A activity is expected to intensify over the next 18 months to two years. Although stock market volatility and the prevailing economic conditions will no doubt affect the timing of some deals, neither would undermine the compelling industrial logic that underlies the trend.
No one can predict the exact shape of things to come. But it is clear that “focus” on a clear and believable strategy will become not only the fashion, but also a necessity for long-term success.
The likely outcome is that utilities that win in the marketplace will increasingly fall within three broad categories of company types: Asset Dominance, Customer-centric and Trading. And winners by pursuing these strategies can already be seen.
First, there will be those that concentrate on assets. Although returns on assets such as power generation have often been relatively low, there is clear evidence that the market rewards those companies that can achieve asset dominance.
The US provides some telling examples. Calpine, which specializes in keeping the lights on in the US, has achieved annual revenue growth of more than 40 per cent, while its shares last year traded on a price/earnings (P/E) ratio of 44, well above the US utility average of 12.
AES, which plays a similar role to Calpine but on the international stage, has also enjoyed strong earnings growth and a high P/E ratio of 55. In both cases the key has been a clearly articulated strategy combined with scale and operational efficiency.
But asset dominance does not mean just piling up different assets. There must be a coherence and clarity that investors can easily see.
The scope for consolidation in the US generating market is substantial, and could lead to dramatic structural changes over the next few years.
Accenture believes that the market could be transformed from one in which no individual generator has more than a three or four per cent national market share to one which is dominated by six or seven “super generators”, which are able to achieve attractive returns through sharing of best practice and standardization of technology on a grand scale.
Consolidation may also occur in the regulated “wires and pipes” business, but the skills needed to play in that market are very different, such as the ability to manage large workforces. Nevertheless, change will come to even the most cosseted parts of the industry.
Centrica, which trades in the UK as British Gas, is often cited as a leading proponent of customer-centric business. It has exploited its utility base to broaden its activities to financial services, telecoms and other services surrounding the home.
The potential for companies that come to dominate the retail sector is substantial. In Europe today the retail end of the utilities industry generates about $2.5 billion a year. But if such utilities can take advantage of their well-established market presence and provide additional services, such as telecoms, broadband and other bundled consumer services, then that figure rises to around $500 billion.
But a customer-centric strategy has its complications as well as its potential rewards. Margins tend to be thin, so those who make mistakes or whose performance is poor are quickly penalized.
In addition, cycles mean that margins shift over time between the upstream and downstream. In Europe today there is a surplus of generating capacity which has depressed wholesale margins to the point where companies are, not surprisingly, focusing on the retail segment.
Figure 4. Southern’s spin-off, Mirant: it took only a few months for the market capitalization to double
The opposite situation is occuring in the USA, with capacity constraints leading to high wholesale margins. With large-scale investments in new generating capacity in the pipeline, that situation will change over time. But the key to remember is that cycles still exist, and therefore timing can be a critical issue in planning new investments or acquisitions.
Customer-centric utility companies will need to learn lessons from the best retailers in other sectors and develop new skills that may seem alien to traditional utility professionals. Understanding the needs and expectations of consumers is as much an art as a science, as is matching product to customer.
Segmenting your most profitable customers from others and designing customer-care programmes to treat each segment differently will be integral to success. There is a danger that customer-centric companies will try to be “everything to everyone”, and in doing so, begin to look like a conglomerate, with all the dangers that this label brings to their share price.
High risk strategies
Enron, a company that over the past decade has transformed itself from a natural gas pipeline operator in Texas to a leading market maker both in energy and other commodity trading, provides the classic example of a trading business. In the US it now dominates the on-line trading of gas and electricity as well as other commodity-like products.
Again, trading offers the potential for high growth and high returns. But it also carries with it higher risks than many traditional utility professionals may be comfortable with. Companies that opt for the trading route will find that they need to acquire a much different skill set than the traditional, engineering orientation of the industry. And that means cultural changes on a scale that only a few companies, such as Enron, have so far attempted, yet alone achieved.
The nature of European electricity and gas trading will also be subject to transformation as the market itself develops. As in other markets there will be a shift from the shallow, less than transparent, large margin markets which have emerged so far to the deep, highly transparent, liquid and lower margin markets that characterize the trading of other commodities, like crude oil. In this transitional market there is a great deal of money to be made by companies that have or can obtain the trading skills and the risk appetite to participate. But the window is small.
The European and US utility industries are on the brink of a period of unprecedented change. But the inevitable byproduct of change on such a scale is uncertainty. And such tectonic shifts in the basic structure of the utility industry are unlikely to result in a painless or smooth transition, especially if there is a large-scale expansion of European utilities into the US.
Such an event could lead to some political backlash; some national regulatory hurdles would clearly need to be jumped. And the attitude of individual states could also play a part in the pace at which European companies can expand into the US.
On the corporate level, such a significant structural shift implies a tidal wave of mergers and acquisitions, as companies divest their non-core assets and build up positions in their chosen specialized fields. But given that many recent acquisitions in the industry have actually destroyed rather than created shareholder value, is such a scenario viable?
The short answer is yes. But it will require a change in the way utilities have traditionally viewed M&A activity. The key to success will be a series of inter-linked acquisitions and spin-offs, such as those seen in the evolution in recent years of Public Service Colorado and Southwestern Public Service Company.
Their first step was regional consolidation into New Century Energies and Northern States Power, which provided the base for the creation of Xcel Energy, best described as a “super regional provider”. Xcel in turn spun-off generation assets into a new affiliate, NRG, as part of its strategy of focus and scale.
The evidence that the markets reward such a clear strategy is compelling. In the past year the market capitalization of both Xcel and NRG has quadrupled at a time when the utility industry as a whole has under performed.
The same pattern is evident in the case of the Atlanta-based Southern Company, and its international deregulated power generation affiliate, Mirant. In that case it took only a few months for the market capitalization to double.
The evidence suggests that investors will support those companies that demonstrate that they know how to focus their growth, and can also extract value from that which they spin-off into an affiliate or dispose of altogether.
The Accenture survey of financial analysts suggests that a broad range of factors is required to support such successful growth and spin-off strategies. First, the strategies must be well articulated. Companies that have a strong but simple message are those that tend to be rewarded.
Such strategies must also focus on revenue growth. But they must also show that the company knows which markets are expected to show strong growth in future and that there is a strategy in place to exploit them. There must also be clarity surrounding the product offering and an understanding of issues such as customer retention and branding.
Diversification is fine if it leads to greater revenues or if the company can show that other synergies are possible. But diversification that does not display such characteristics is unlikely to welcomed or rewarded by the market.
A recession or prolonged downturn in equities markets could affect the pace at which many of these expected events take place. But given the significant cash reserves of the European utilities and the depleting number of opportunities to achieve significant scale within Europe, the US is a natural target.
In all likelihood the winners will not be determined by nationality and will come from both sides of the Atlantic. They will, however, share a common corporate characteristic of focus and scale.