The urge to merge is in the air and this comes as no surprise. The basic fundamentals for consolidation in the utility industry have been strong for several years as the industry remains highly fragmented, notably in North America, but also in other parts of the world such as Brazil, Australia, and the United Kingdom, to name a few. Over the past twelve months, we've seen the announcement of four major transactions as a sign that further consolidation will occur. It will happen because cost pressures are escalating and utilities are gearing up for major capital expenditures to comply with new environmental rules. Moreover, it will happen because under current market conditions characterized by slowing organic load growth, in-organic growth is the only available path to short-term growth. A clear indication of this is that the sellers have been trading at relative premiums to the buyers. The industry is looking at M&A as the best alternative for top-line growth and, if done correctly, a path to achieve scale and leap-frog operational performance benchmarks.
The issue remains that the value creation from a merger or an acquisition is not guaranteed. The previous wave of mergers, from 1997 to 2004, produced results that were mixed to disappointing. A series of factors can be blamed for this, including a systematic overestimation of strategic and operational synergies as well as difficulties stemming from a resistance to headcount reductions in an industry that is heavily unionized. Factors such as these led to larger premiums and long payback periods.
The current wave of mergers has proven to be quite different from the last. Premiums in recent deals range from zero to low single digits, which is why we are seeing more mergers instead of outright acquisitions. Another interesting fact about the current wave of mergers is that estimated synergies claimed by the merging companies are also quite small. In many cases, merging utilities have either overlapping or adjacent territories which, in both cases, would indicate higher synergy potentials. With lower premiums being paid and smaller synergies being targeted, merging companies might be able to avoid the 'winner's curse'. Nevertheless, significant constraints (e.g., regulation, weak scale, labor, etc.) continue to reduce degrees of freedom for merging utilities in their quest to achieve synergies and create bottom-line value. Our point is that the utility industry is inherently a low growth industry and that after a decade of cost reductions, merging utilities will have to be strategic on how to drive the value to the bottom-line.
The reality of utilities mergers and acquisitions
Most utilities are relatively inexperienced when it comes to mergers and acquisitions. They typically have entered the merger and acquisition arena without differentiated operating capabilities and lack a detailed understanding of how costs and investments behave as you consolidate. This often leads to the erosion of the deal economics. Early benefits almost always prove to be elusive. Costs for organizational transition and integration are commonly under-estimated. Requirements for managing cultural challenges and labor constraints are rarely initiated in a timely fashion and often introduce significant delays to post-merger integration plans (and expected deal economics). Finally, complex requirements for upgrading and consolidating information technology introduce a host of uncertainty in terms of upfront cost as well as expectations for cost reduction in the long-term.
More often than not, the result of forces such as these is a weak integration of the two combining utilities. More aggressive consolidation and operational improvement is deferred to later years, and is rarely achieved. Consequently, the ability to drive value to the bottom-line disappears quickly and produces little change to day to day operations. We believe that this is one of the major reasons that low premiums are currently being observed in the market.
The ability to realize synergies that drive bottom-line results rests on the ability of a high performing utility to either:
- transfer best in class operational and capital efficiencies to another entity, or
- gain scale through M&A thereby driving down fixed and variable costs for non-core processes.
Having an operations driven culture improves one's ability to capture benefits as part of a merger. This is because such a high performing utility will have a clear view of the sources and behaviors of value and how they should be managed. More specifically, these high performing utilities will have a clearer understanding of fixed versus variable cost. They will have the discipline to coordinate a phased approach across multiple organizations to achieve operational scale. They will understand the need to assert the appropriate degree of control and influence to overcome cultural resistance to change in order to improve individual processes and advance competitive advantages across the organization.
Furthermore, this type of utility will likely have established performance management processes (or a well-defined effort aimed at creating them) that will provide flexibility and accountability across all aspects of a large-scale post-merger integration effort. Overall, maximizing value will require driving efficiencies in three different parts of the operating model:
- Core, Less Scalable Processes where operational excellence through continuous process improvement is vital. These are typically mission critical processes that require significant management control and are not highly scalable. Examples include construction management, generation plant operations, asset management and maintenance, etc.
- Non-Core, More Scalable Processes where third party, or other virtual scale, models should be considered. These processes are mission support and can often be managed with well-defined service criteria. They are typically transactional processes with high volume scale and entail repeatable integration issues where virtual scale should be considered. Examples are accounts payable, payroll processing, accounts receivable, procurement, etc.
- Governance & Control Processes which permeate all processes and heavily influence ultimate performance in a number of high value areas. These include planning, performance management and control/accountability processes.
Our view is that significant value waits to be unlocked through the consolidation of the utility industry. However, a study of M&A activity demonstrates that conventional industry approaches to capturing merger and acquisition benefits have been inadequate. In particular, utilities have been slow to move to single operating platforms and, outside of nuclear generation, to proactively establish and target specific performance advantages. Without such transformation we believe that the new combination's will fall short on the promise of delivering growth, achieving scale, and leap frogging their current operation performance benchmarks. In the end, if these operating synergies are not realized and when massive capital expansion is required either due to operational or legislative pressures, Public Utilities Commissions will have little alternative but to drive down rates of return for merged utilities in order to control and minimize potential customer rate increases.
Overall the urge to merge momentum rests on the ability of merging utilities to drive these bottom-line synergies. If that happens, the number of merger announcements will accelerate the consolidation we are now witnessing. We believe there is ample support for industry consolidation given the fragmented nature of the market. Given societal and legislative calls for increased capital expenditures, consolidation with a more aggressive pursuit of operational synergies may be necessary to keep consumer rates low. Presuming successful regulatory approval of the proposed Duke-Progress merger, we foresee more regional consolidation given larger initial opportunities for cost savings and gains due to economies of scale. However, these may prove once again to be elusive if the right steps are not taken. In our view, there is momentum for regional consolidation across the U.S.
In summary, as external pressure mounts for additional capital investment in utility infrastructure and as government grant and loan programs dry out, achieving M&A synergies are one way to help manage impacts to customer rates while still allowing for prudent investments in capital projects needed to modernize the grid. In order to do this, operational excellence -- powered by innovative operating and business models -- will have to become the mantra for successful consolidators if they want to achieve real benefits and deliver real value to customers. Leaders will be characterized by simplified, standardized and extendable operating models and capabilities. They will possess improved operating performance, scale, differentiated leadership, governance, and performance management competencies. They will leverage these capabilities to improve targeting and valuation and, ultimately, reduce the variability of benefit realization. A clear perspective on the value framework and a disciplined approach to M&A is vital. These leaders will drive the urge to merge.