Deals: what to watch in 2012
After a fast start to 2011 transaction activity, global economic uncertainty took a toll on sector deals in the second half of 2011. What key trends will influence deals in 2012? Joe Fontana reports.
It was a tale of two halves in 2011. The first half got off to a fast start, with a number of major deals announced:
Most active countries and
- January: the Duke-Progress merger (US$25 billion)
- March: PPL's US$6.4 billion acquisition of E.ON's Central Networks business in the UK (following PPL's acquisition of E.ON's Kentucky Utilities in November 2010 for US$7.6 billion)
- April: AES's acquisition of DPL for US$4.6 billion, and shortly after, Exelon's acquisition of Constellation for US$7.9 billion.
sectors in 2011
Most active countries and sectors in 2011
The level of M&A activity declined significantly in the second half of 2011 following global economic uncertainty. The only bright spot was in December with ITC Holdings' announcement of its contemplated acquisition of Entergy's transmission system for nearly US$2 billion.
Lessons to bring forward
Below we identify five key trends in transaction activity in 2011, and the potential winners and losers in each category.
- Uneven valuations. Utilities were one of the strongest-performing sectors in 2011, with underlying market valuations near record levels (price/earnings of ~15.0x vs. 20-year average of ~13.0x for US utilities). Valuations are disjointed across the sector though, with those relying on coal generation affected by asset impairment (see Asset impairment webcast: time to reassess the value of your assets? in the Industry news and events section).
- Utilities with significant regulated operations that are attractive to investors because of strong dividend yields
- Generation businesses in tight power markets.
- Independent power producers (IPPs)
- Utilities with a heavy weighting of unregulated coal-fired generation assets that will be affected by environmental regulation
- Utilities without a strong balance sheet.
- Shale gas is likely to remain a strong source in 2012. Japanese and European prices are significantly higher than US prices, but cheap natural gas is having a global impact.
In the US, where natural gas prices are closely tied to wholesale electricity prices, prices are expected to remain low in the medium term. While merchant generation is feeling the squeeze, hybrids will probably deleverage risk and reduce exposure to generation businesses.
- Consumers, who get cheaper electricity.
- The construction sector as new gas fired plants, pipelines and equipment are needed.
- Utilities with significant unregulated generation operations.
- Capital spending. Capex spend requirements remain at record levels, with the International Energy Agency (IEA) estimating total global investment of US$16.6 trillion will be needed in electricity infrastructure by 2035.
Future capex programs are putting a strain on balance sheets and debt levels, and numerous European power companies (e.g., RWE, EON) have started major disposal programs to better manage future capex programs and debt levels. Some e.g.,RWE have also tried to raise additional equity capital.
- Utilities with strong balance sheets and access to capital that can take advantage of opportunistic acquisitions, as new build costs are now at a significant premium to acquisition multiples.
- Those with already stretched balance sheets and high debt levels or those with limited or expensive access to finance.
- Credit ratings and the Euro crisis. Sovereign downgrades in Italy, Portugal and Spain, and the negative outlook rating for Austria, France and the UK could affect utilities in these countries, raising their borrowing costs. Italian utility Enel's recent downgrade is an example.
It could also trigger disposals of state-owned utilities (e.g., recent Portuguese, and upcoming Irish, privatizations). Access to capital has not been an issue in 2011, but renewed credit-rating pressure and the prospect of higher interest rates in an improving economy could change this.
- Opportunistic investors such as sovereign wealth funds with deep pockets that could take advantage of depressed valuations and forced asset disposals.
- Utilities with high debt levels in countries affected by downgraded credit ratings, especially in the Eurozone.
- Environmental regulation. Significant capex will be needed for US utilities to comply with the Environmental Protection Agency's Mercury and Air Toxics Standards, which will force many coal-fired plants out of operation when it comes into effect in 2015.
Compliance with MATS and the Cross-State Air Pollution Rule could require the retirement of 25GWs to 70GWs of coal-fired generation. Concerns over the environmental impact and safety of shale gas could also increase costs (see Oil & Gas hot topic update: shale gas may face new legislative requirements in the Industry news and event section) for those required to comply.
- Utilities with clean or low-emission generation fleets not affected by environmental regulations.
- Those with the cash or funding to buy or build low-carbon generation.
- Companies with low-cost retrofitting technology.
- Utilities with a high percentage of coal generation with no environmental control equipment.
- Those without access to capital to build or buy low carbon generation or invest in retrofitting.
We expect to see these trends reflected in transactions in 2012 but also in actions outside M&A (e.g., cost reduction programs). These are the industry drivers that will influence strategic decisions about the future of utilities and where they choose to invest.
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| || Joe Fontana |
Joseph has more than 25 years' corporate finance and transaction experience, and 20 years' experience with power generation and utilities. He has led numerous transactions for strategic buyers and private equity investors in this sector, including electric and gas utilities, independent power producers, electric and gas marketing companies, gas pipelines, LNG plant construction projects, gas storage and T&D outsourcing.