Bigger and Better Utility Companies
Companies / US Utilities Apr 28, 2007 - 11:17 AMBy: Roger_Conrad
Size and scale have long been secrets to success in the business of providing essential services. Since the advent of mass-distributed electricity, natural gas, communications and water more than a century ago, companies have consistently become more profitable by getting bigger.
In the first days of essential services, they were solely the province of the elite, delivered by literally thousands of individual systems. Providers quickly discovered they could do things far more cheaply and profitably by getting larger, chiefly by merging and acquiring neighboring systems. Mass production drove down costs and made it possible to offer utility services at a lower price to all. That, more than anything else, made them completely ubiquitous and more essential than ever to daily life.
Electricity, for example, is now 40 percent of all energy used in the US, according to the US Energy Information Agency. That's up from just 15 percent in 1970, and the trend promises to accelerate with the proliferation of electricity-driven transport. Rapid electrification is even more pronounced overseas, particularly in the developing world.
Scale established itself immediately in the communications industry, as Theodore Vail convinced trust-busting President Theodore Roosevelt to allow his AT&T a national monopoly. The rationale was that only a company with a guaranteed return on investment and no competition could wire the country.
Consolidation happened more slowly in the power sector. Whereas AT&T constructed its own infrastructure, electric plants and wires were built by giant engineering firms like GENERAL ELECTRIC, which for a long time owned and operated the systems as well. As a result, there was no dominant monopoly at the beginning but a series of smaller systems that were combined over time to form larger, more-efficient companies.
In the 1920s and '30s, merger activity in the power and gas industry reached a fever pitch, as giant holding companies gobbled up scores of operating utilities nationwide. By the early '30s, a series of fierce battles bankrupted all but one, the UNITED CORP headed by JP Morgan, which gained a near coast-to-coast monopoly of the country's power and gas grid.
That empire was broken up by the 1935 Public Utility Holding Company Act (PUHCA), which gave the holding companies a literal “death sentence” and left the industry in the hands of regional “operating companies.” Far from ending the march of utility mergers, however, PUHCA merely redirected it to unions between operating companies.
These deals were heavily scrutinized by regulators. But every one created a larger, stronger company more adept at providing essential services to a wider audience at a more economic rate. The proof: No deal between regulated utilities has ever broken apart, no matter how weak the merging companies were beforehand.
In the late '90s, there were more than $1 trillion worth of utility mergers. In my 2001 book “Power Hungry,” I forecast this trend would continue in this decade, not only for electricity but for communications and water as well. Although the bear market of 2001-02 slowed things down a bit, that's definitely been the case.
Moreover, every deal has thus far been wealth creating, leaving a larger, stronger outfit.
The logic of essential service mergers is as simple as it is inescapable. Foremost, these are capital intensive businesses, regularly requiring billions of dollars of investment. Larger, stronger companies enjoy solid access to capital, whereas smaller ones simply can't raise the dough.
Larger utilities can also spread out and better negotiate procurement costs. They can spread out expenses over a wider range of customers, thereby minimizing the burden on individuals. And they have less trouble offering a range of products or changing their existing line of services.
The most-graphic recent example of how scale helps is the nuclear power sector. Nuclear plants were considered dinosaurs as recently as a decade ago. But since the early '90s, capacity rates have risen to more than 90 percent from just 65 percent, while maintenance outage times have fallen by nearly two-thirds. Plants have gone from white elephants to literal cash cows.
The change has come entirely because of plant ownership consolidation. Up until the deregulation in the '90s, nuclear plant ownership was hugely fragmented. Most of the 100-plus reactors in the US were owned by companies that operated no more than one or two nukes. Other plants were held by several owners at once.
The result: There was no scale in the business. Mistakes made at one plant were routinely repeated at others around the country.
Competition for skilled personnel was immense, and near-accidents were all too common.
Deregulation scared many of the smaller owners out of the nuclear business. But a handful of companies began to buy up whatever they were selling. And because regulators allowed sellers to recoup “stranded costs,” selling prices were extremely low.
The consolidators were able to follow the example of the hugely successful French nuclear program, which is operated by single entity that has used the advantages of scale for decades to produce Europe's most-reliable power.
THE MORE THINGS CHANGE
Even in physical sciences, long-time relationships thought sacrosanct can be broken and disproved. When it comes to the markets, even rules that have seemed immutable for decades can be broken at the drop of a hat. Industries once thought to be permanent have disappeared, replaced by others that have also vanished from everywhere except the dusty shelves of economic history museums.
That's why it's absolutely critical to test any investment theory you have again and again, to ensure things are still in place for it to pan out. Centrally provided electricity, gas, water and communications are now more essential than they've ever been.
But it's entirely possible they'll one day be made obsolete by new technologies. Equally, we may see a time when bigger isn't necessarily better for providing these services, giving smaller--not larger--companies the advantage.
That's what many expected to be the legacy of the '90s in the power sector. Then deregulation created a new class of upstarts, such as CALPINE CORP, that were supposed to eat the lunch of the incumbent utilities with a new fleet of hyperefficient modular power plants.
That theme proved disastrous, after sucking away hundreds of billions of dollars of investors' money. In “Power Hungry,” I also correctly forecast the success of telecom's big boys in recent years and the demise of the small that were so popular on Wall Street at one point.
In my view, here in the late 2000s we're even further from a time when the Davids will be a serious threat to the Goliaths in the essential service industries. But the little guy won a victory in court this week. Voice over Internet protocol (VOIP) service provider VONAGE won a stay of a prior court order awarding cash and a huge chunk of its revenue to VERIZON COMMUNICATIONS for patent infringement. That will allow it to continue providing service, at least until the court rules on its appeal in the case.
Cheating the hangman for now doesn't mean Vonage and other small companies can survive. The trend in the telecom industry is definitely not their friend. The surest evidence is the way the big and rich are still getting richer--even as Vonage has yet to turn a profit--and how utility mergers continue to create more-efficient, profitable companies.
Exhibit A is the more-prolific acquirer of all in the essential service business: AT&T. The new Ma Bell is the creation of a nearly two-decade progression of mergers that have reunited a large chunk of the pre-1984 breakup AT&T, along with a range of extremely profitable new businesses.
The original piece was SOUTHWESTERN BELL, one of seven regional local phone companies, or Baby Bells, to come out the breakup. CEO Ed Whitacre first merged that company with PACTEL, the former Bell for California and Nevada, as SBC COMMUNICATIONS. He then proceeded to snap up SOUTHERN NEW ENGLAND TELECOM and AMERITECH, the Baby Bell for the Midwest, as well as a host of other assets in wireless.
Whitacre's three greatest deals have come this decade. First was the joint acquisition of AT&T WIRELESS with BELLSOUTH, a purchase that overnight made the company the largest wireless company in America with the CINGULAR brand.
Second, the company bought the remains of old Ma Bell itself, engulfing its unmatched corporate customer rolls. Finally, he bought BellSouth, giving the company total control of Cingular and a third former Baby Bell. Along the way, he changed SBC's name to AT&T.
Unlike its predecessor, the new AT&T doesn't hold a virtual monopoly on the country's communications services. But the San Antonio, Texas-based giant does have the leading market share in a wide range of businesses that--unlike the old phone business pre-1984--are growing rapidly and are constantly becoming more essential as well.
AT&T's size and continued aggressive growth make its performance the best test case for how well scale is working in the intensely competitive communications business. How it measures up is a critical question for this sector, which is becoming increasingly competitive as new technology creates convergence between what have traditionally been completely different businesses.
The good news for AT&T owners--as well as shareholders of other Big Tel and Big Cable companies--is the new Ma Bell is prospering.
That's the clear verdict from a scan of its first quarter earnings, announced this week.
Profits per share came in at 65 cents, up from last year's first quarter tally of just 51 cents and well above Wall Street estimates.
There were two key catalysts. First is an 84 percent boost in sales mainly because of the acquisitions, along with continued growth in wireless and broadband services.
Wireless growth came in a bit below expectations, and the company continued to lose local lines. Wire-line margins, however, remained very strong as the company added broadband and launched television service in selected markets nationally. Meanwhile, customer turnover, or churn, fell to 1.7 percent from 1.8 percent a year earlier, and it continued to grab customers from SPRINT NEXTEL.
The second catalyst was massive cost cutting, largely made possible by the mergers. Going forward, the company also plans an additional $22 billion in cost cuts, thanks to its greater scale. The key areas targeted are marketing, network and administrative expenses.
Management has raised its target operating profit margin to the 23 percent to 24 percent range from a prior 21 percent to 23 percent.
The good news for AT&T is it should be able to keep its strong growth going for the rest of 2007 and beyond. For one thing, despite the rapid consolidation of the communications industry in recent years, there are still acquisition opportunities. The company is, for example, rumored to be pursuing a possible takeover of ALLTEL COMMUNICATIONS.
A deal would give the company a dominant presence in rural markets, though it would likely come at a fairly high price and would require substantial capital spending as well the integration of differing networks. Given AT&T's prowess integrating far-flung assets, however, it would be hard to bet against its ultimate success.
Outside AT&T, the two dominant big communications companies are Verizon and COMCAST. Like AT&T, Comcast reported a big headline number in its first quarter, with earnings per share rising 80 percent.
Much of that gain was a one-time item resulting from the dissolution of the company's partnership with TIME WARNER. But it also included rapid growth in the company's product bundles, the focus of its future growth. From all indications, Verizon's growth should also be explosive.
Both companies are maintaining somewhat larger capital budgets than AT&T--Verizon for its fiber-optic service (FiOS) network and Comcast for other upgrades. Consequently, they're not commanding the investor adulation AT&T is at the moment.
Ultimately, however, their investment should pay off even more. And the stock market is already pricing in the spending, so any upside surprise could send their shares decidedly higher.
OTHER SECTOR ACTIVITY
Opportunities to grow scale are even greater in the energy and water utility sectors. There are 10 pending takeovers of US utilities, which I discuss in the May issue of Utility Forecaster, available to subscribers at http://www.utilityforecaster.com beginning Saturday morning. I also look at candidates for future mergers in the sector.
The failure of the FPL GROUP/CONSTELLATION ENERGY merger in the face of opposition in Maryland ended the spate of “dominance mergers” in the sector that took place earlier in the decade. Instead, the prospective deals between utilities now involve smaller companies, which can be completed with fewer regulatory approvals and, therefore, more quickly.
The only large utility currently involved in a deal is TXU CORP, which has reached a $40 billion accord with a private capital consortium led by KKR. Once thought to be a sure thing, this deal has come under increasing scrutiny from all angles. Even the environmental groups that originally went along on the promise of the company's cancellation of seven coal plants have begun to take pot shots.
Thus far, merger proponents have managed to block legislation in the Texas state house that would require a full-scale regulatory review.
And the deal has no shortage of high-profile backers, with Washington power broker James Baker III weighing in. But with customer rates among the highest in the nation, it appears there are still a lot more battles to fight before this emerging war is decided one way or another.
Even if the TXU deal does pass muster, it's unlikely we'll see similar deals for big utilities by private capital. Regulators in several states have already declared their opposition to such deals, as have more than a few utility executives. Moreover, private capital deals are more likely to bring spinoffs and asset sales, rather than profitable consolidation.
As history shows, utility merger activity does have its peaks and valleys. And it's possible last year was the peak of this cycle, given the drop in the dollar value of the average deal in progress.
But as long as scale matters and larger companies get stronger, bigger will be better. We'll continue to see merger activity in essential service businesses, and it will pay to stick with the big and strong and avoid the often overhyped small and weak.
In telecom, the best bets are the giants: AT&T, Comcast and Verizon.
In water, it's AQUA AMERICA, whose path to ultrareliable growth is buying small systems that lack the scale to meet safe drinking water standards on their own.
In energy, it's the larger companies that combine safe infrastructure and good regulation with dominant power production franchises, particularly nuclear companies such as DUKE ENERGY, EXELON CORP and SOUTHERN CO.
Until we see some evidence that bigger utilities are no longer going to be dominant, these companies are their sectors' best bets to keep making shareholders richer long-term. They're solid bedrock for any portfolio.
As I wrote above, for my take on the ongoing merger deals, see the May issue of Utility Forecaster. I also explore my favorite takeover targets. Note the May Canadian Edge will have the latest on the flurry of private capital takeover in the Canadian income trust sector.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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