In February of 2010, FirstEnergy (FE) reached an agreement to purchase Allegheny Energy (AYE) in a transaction that would combine two utilities that also have a significant ownership of nonregulated generating assets. FirstEnergy would issue 0.667 of a share of its stock for each Allegheny share. This would amount to $26.41an Allegheny share, or a total of $4.48 billion. (We are basing all of our calculations on the closing prices of FirstEnergy and Allegheny Energy on March 18, 2010, which were $39.59 and $23.36, respectively.)
This was the first announcement of a deal involving electric utilities as both buyer and seller since Aquila agreed to be sold in pieces to Black Hills Corp. (BKH) and Great Plains Energy (GXP) three years earlier. At that time, the credit crisis was still more than a year away, so that can’t be blamed entirely for the lack of merger and acquisition activity. In our view, the two key problems are the difficulty in obtaining regulatory approvals and the mediocre track record of utility deals.
Whenever there is a utility merger, at least one state commission, and various federal agencies (most significantly the Federal Energy Regulatory Commission) must approve the combination. This is easier said than done. State regulators normally demand concessions from the companies. This typically means that a portion of the merger-related savings must be passed on to customers. Utilities are willing to do this, as long as the conditions aren’t onerous. Sometimes, a commission’s demands are so high that the buyer decides to terminate the deal. In 2006, Exelon (EXC) decided not to go ahead with its agreement to acquire Public Service Enterprise Group (PEG) for this reason. Other concerns that regulators have are the possibility of a degradation of customer service or a loss of local control of a utility. Furthermore, even when a deal is completed, the process is lengthy—usually more than 12 months. A former utility CEO once lamented that this is the only industry in which the time needed to close a merger is measured in years, not months.
Opposition from outside parties can thwart a transaction, too. In 1995, Baltimore Gas and Electric (now part of Constellation Energy (CEG)) wanted to merge with Potomac Electric Power (now part of Pepco Holdings (POM)). Baltimore G&E is one of the few nonunion utilities. Opposition from Pepco’s unions wasn’t the sole reason why the merger did not go through, but it didn’t help. Already, there has been litigation by some Allegheny shareholders against the deal with FirstEnergy because they believe that the price is too low. FirstEnergy would be paying 11 times earnings for Allegheny. In most utility acquisitions, the multiple is in the low to mid-teens.
Many proposed utility combinations have fallen through. Even when the deals are completed, the results aren’t always favorable. Integrys Energy (TEG) and SCANA (SCG) have had to write off goodwill because they overpaid for other utilities. NiSource (NI), which we now cover among gas utilities, wound up cutting its dividend after it overpaid for a major acquisition.
Considering all of the uncertainty surrounding proposed utility combinations, and the lengthy time to closing, it isn’t surprising that, a month after the deal was announced, Allegheny stock was trading at a discount of more than 10% to the value of FirstEnergy’s offer. This indicates the market’s concern that the deal will fall through. Moreover, this announcement isn’t necessarily going to spur M&A activity among other utilities. It isn’t easy to come up with deals that make sense from a financial, strategic, and operational standpoint. It will be interesting to see the outcome of the FirstEnergy/Allegheny proposal. That likely won’t be known until 2011-- or perhaps 2012.