Utility M&A Deals in Third Quarter

It's become a happy habit of Public Utilities Fortnightly. Another calendar quarter passes by, and before long M&A uber-expert Jeremy Fago from PwC opines for us on the trend of transactions in our industry. For each quarter, he looks back at the run-up to the quarter in question, what deals were done during the quarter, and what we might expect in the quarters ahead.

What deals went down? What's driving deals? And what are the implications going forward? To find out, as usual, PUF turns to Jeremy. 
 

PUF's Steve Mitnick: You've just come out with Q3, the third quarter deals report, in power and utilities. What's the top line here? You're saying this one was distinctive.

Jeremy Fago: Yes, it was a bit slower for sure. We've hit on some of this in the past, but when we think about some of the activity that we've seen over the past handful of years and some of the robustness in the deal activity, it's not surprising to see a bit of a pause, particularly as we're deep into 2019. 

I don't know that we necessarily feel that's going to be the be all end all for the year but it's certainly a bit of a pause compared to some of those mega deals that were announced back in '16 and '17. There were even some in '18 but the fundamentals are still very strong. There's still a lot of necessary investment and capital needed in the power space, and there's a ton of opportunity.

I don't think we're seeing a trend that's going to continue for a long period of time, but we expected this pause just given the limited population of serial mega deal players in the space. As we've talked in some detail in the past, the rationale for some of these deals, particularly those big deals that were announced over the past few years, was really to gain access to platforms that offered synergies and growth opportunities through long term capital deployment.

That's where we're seeing folks focus, on the organic aspect of those deals that they announced, versus continuing to shape big inorganic deals as we sit here today. I don't think that's here to stay. But certainly, that's going to tie up a lot of time, effort, and capital when you think about why those deals were done and the activity necessary to execute and optimize around those deals.

PUF: You're saying there's a natural cycle. Some of the companies that might be doing deals, don't do something every year so it takes them a while to get back to it.

Jeremy Fago: You're right. That's well said. We should keep in mind that things like tax reform shifted focus, particularly in the regulated utility space early last year. They had to digest that, understand what that meant to their business and make sure they had a full appreciation of the impacts from a financial perspective. 

In a lot of cases, that had an immediate cash impact to a lot of these players where you've got to manage the expectation of the customer and the regulator on top of managing the overall financial profile of what tax reform did and how that impacted particularly the regulated utility models.

We've had a lot going on in the industry. To your point about the cycle, that's absolutely true. You can only do so many mega deals year-to-year with balance sheet capacity what it is. It's not surprising to us at all. That said, volume wise, deals are still holding up very well. 

We still continue to see a lot of asset transactions. We still tend to see some portfolio tuck-ins, some smaller acquisitions. We expected and we've seen some portfolio rationalizations. Folks have taken a step back and said, maybe this business or this asset doesn't necessarily fit into our broader strategy of how we think about our business. We've seen some movement there as well and certainly on the renewable asset side and things of that nature, that activity continues to be active.

PUF: A lot of companies want to accelerate how much they have in their portfolio. I suppose that's a major driver.

Jeremy Fago: That's right. In some instances, you're seeing folks looking at freeing up capital through portfolio rationalization to deploy into more focused areas that they consider strategic to their core business. 

As the landscape has shifted, there's a reevaluation of sorts that's happened and again, back to tax reform, we saw that last year where folks took a step back and said, because of the impacts from that, we're going to have to look at other sources of capital. In some cases, they looked at asset rationalization as a source of capital. Certain assets in fact may be more valuable to somebody else than it is us, given our strategic focus.

PUF: When there were a hundred electric and gas companies, there were more possibilities statistically but now that we have a smaller number, probably under fifty, the possibilities are less? Then for some companies, there's more size disparity and some are too small to go through the process?

Jeremy Fago: You hit on it. For the population, it goes back to what I mentioned earlier. It's not a large industry from a number of serial mega deal players and that number is significantly less than it was ten, fifteen, and twenty years ago. Just with that, you're not going to see as much activity because you don't have as many players.

To your point on size, I think of it in another light as well. Utilities have gotten bigger and bigger and not just utilities but overall as we've seen consolidation, you have regulatory pressures and things like market power that you have to deal with. 

As you get bigger, you have size issues to focus on. That starts to impact the number of deals you can do in particular but also how quickly you can get those deals announced and closed because you have to manage the regulatory aspects of doing those deals and the impact it's going to have on the customers.

As you start crossing more state lines, that gets even more complicated with all the different PUC, FERC, and state regulations and processes that you have to manage through.

PUF: Aside from the renewables, what other big drivers might cause there to be some deals coming up?

Jeremy Fago: There are a couple of things. We've been sitting in a low interest rate environment for ten years and in a lot of ways investors in the public arena look at utility stocks almost like a bond. It's a pretty good return, pretty good yield as compared to anything else you can get out there. As folks are looking to do acquisitions, that is an enviable place to be. 

I also highlight that the U.S. has been and still is, ripe with opportunity to invest in what is a fairly welcoming environment from a line of sight on cashflow and earnings, particularly if you start talking about regulated utility type profile.

So, we have undergone and are still undergoing one of the biggest transformations in a capital intensive industry that I've seen in my career with the change over from how we generate electricity and what fuel we use for that generation along with all of the emerging technology discussion.

Then you start talking about all the infrastructure to support that on the transmission and pipeline side. It's just ripe with challenges, but also ripe with investment opportunity. That's in particular why you see things like foreign interest in the U.S. power and utilities space.

With that capital intensity and the changeover in how we not only generate our electricity but where we get our source of fuel for that electricity and how we get it to the customers and changing customer habits, those challenges offer numerous opportunities for investment.

That's why you see a lot of folks looking at deals in this space, in this industry, and in this country. There is still a lot of money out there, particularly when you look at some of the foreign players, some of the infrastructure players looking at the opportunity to deploy capital in what is a pretty nice regulatory aspect here in the U.S. where you're basically deploying capital and getting, for the most part, return of, and on, that capital under a regulated construct.

PUF: Looking forward, when we talk to you about Q4 in 2020, what are you going to say?

Jeremy Fago: We're going to see a few more mega deals come about. We're going to start to see some of the folks free up capital and free up focus. They've focused on those announced deals that we talked about previously and they want to get back into the deal environment and start doing some things.

We're going to see more of that as this ability to, or this desire to really address some of the challenges and some of the investment opportunities that we have in this country, in this sector, continue to put themselves forward. Over the next three to six months, you're going to see some larger announced deals. Folks want to do deals. It's just a matter of when and how and finding the right opportunity.

The fundamentals from what is needed in this industry, it's just too front and center for folks not to try and do more and continue to look at that. I certainly think that's going to continue to happen. We're going to see a pickup in those mega deals as we go forward, we're going to continue to see things like renewable focus and we may even see some more joint ventures and/or partnerships. 

If we look at emerging technologies, I think we'll see some of the traditional players in the industry continuing to focus on the technology aspect, and the customer usability and user interface, and continue to try and stay close to that customer as they offer them a better experience.