Insull's ghost

Around the start of the 20th century, electricity was generated by independent power generators and distributors that competed for customers and turned the streets of big cities into a jungle of power lines. Samuel Insull, an English immigrant who worked for Thomas Edison for 11 years, realized he could exploit the greater economies of scale afforded by new power distribution technologies and maximize profits by buying up small utility companies. Starting with a single power plant, he built an electricity empire called Commonwealth Edison that at one time served 4 million customers over 32 states and was valued at nearly $3 billion.

Get ready for another wave of consolidation not seen since Insull's day. The U.S. is still the world's most fragmented utility market with 250 utilities and distributors, despite the last wave of consolidation around the turn of this century that saw Peco Energy Co. merge with Unicom Corp. in a $17.8 billion deal that created the country's biggest power company, Exelon Corp. Observers believe these 250 utilities and distributors could operate more efficiently and profitably if they were combined.

The situation has become even more acute now that debt markets have dried up after many years of free-flowing credit, making much-needed capital improvements to the country's power grid (some estimate $800 billion by 2018) amid increasingly stringent environmental mandates (possibly made even stronger by an Obama administration) nearly impossible in the short term. There's even been a drop in electricity consumption in several areas of the country since the crisis began, which only adds to the pressure to do something to grow.

"The U.S. investor-owned electric utility sector is well-insulated from what may be a protracted recessionary environment, but it is not immune from credit market stress and economic weakness," Moody's Investors Service wrote in a report Oct. 14.

These companies' valuations have also fallen to incredibly low levels, creating many bargains in the sector. Shares for power producers like Dynegy Inc. and Reliant Energy Inc. trade for little more than a cup of coffee at Starbucks, and these are companies with mostly hard assets -- not asset-light companies that failed Enron Corp. was trying so famously to become.

Bargain hunters have been on the prowl. Warren Buffett's Berkshire Hathaway Inc. started the trend, with its MidAmerican Energy Holdings Co. unit agreeing in September to buy distressed Baltimore power producer Constellation Energy Group Inc. for a bargain $6.2 billion. Then Chicago utility giant Exelon launched a hostile takeover for NRG Energy Inc. in November for $4.7 billion.

Reliant subsequently announced that it was reviewing strategic alternatives, with Morgan Stanley and Goldman, Sachs & Co. advising it (some think NRG might buy Reliant's retail assets, either as an asset play or to discourage Exelon's advances). Sources say Dynegy has done the same, hiring Goldman Sachs and Greenhill & Co. to advise it.

Karl Miller, a former industry executive raising a $500 million fund to invest in distressed power assets, thinks AES Corp. will be next, especially because of its exposure to emerging markets, where, he quips, "People don't pay their bills when the going gets tough." Mirant Corp., Calpine Corp. and TransAlta Corp. could also be possible targets (some think NRG will rebid for Calpine).

Another handful of companies may buy or be bought to gain greater scale, including American Electric Power Co. of Columbus, Ohio; Dominion Resources Inc. of Richmond, Va.; Progress Energy Inc. of Raleigh, N.C. (which has long been tied to FPL Group Inc. of Juno Beach, Fla.); Allegheny Energy Inc. of Greensburg, Pa.; Public Service Enterprise Group Inc. of Newark, N.J. (whose merger with Exelon failed over objections from state regulators) and Duke Energy Corp. of Charlotte, N.C., (which merged with Cinergy Corp. of Cincinnati a few years ago). As companies cut back their capital expenditures, they'll look for synergies, stronger balance sheets and diversification through deals," says Jeff Holzschuh, vice chairman of investment banking at Morgan Stanley who has worked on some of the biggest deals in the industry. "While it's hard to finance right now, we'll see deals get done. There's a lot of dialogue and generally that will lead to something."

Some utility and power executives admit an M&A wave is coming. At an industry conference in November, Duke CEO Jim Rogers said the case for consolidation in his sector is more compelling today than it's been in his 20-year career as CEO because of what's going on in capital markets, the economy and lack of growth. "I think within 18 months you'll see either consolidation or acquisition of all of them," he said.

Smaller companies will be most at risk, as they need to continue building power plants, nuclear facilities and transmission infrastructure to grow but lack the wherewithal. "The public markets are in such disarray that it is unlikely that many public energy companies will be able to sufficiently access capital on reasonable terms for at least two years, and the market is looking to private capital to fill the void," says Miller.

Who has the deep pockets to acquire? Possible buyers include European utility giants such as Electricité de France SA, E.ON AG, RWE AG and Endesa SA, which have gobbled up utilities across Europe and may be looking to do the same stateside. While some may avoid the U.S. because they think it spread financial contagion to the rest of the world, others will probably come in, buying smaller assets or picking up renewable assets as a platform to expand into more traditional power producers later.

Private equity firms such as Kohlberg Kravis Roberts & Co., Riverstone Holdings LLC, Blackstone Group LP and TPG Capital are also possibilities. They're bleeding red ink on their investments but have multibillion-dollar funds to invest. "These guys want to preserve their capital, and the only place is in solid infrastructure assets," Miller says.

Stronger utilities and power producers, following Exelon's lead, may look to pick up bargains. Entergy Corp. is said to be on the acquisition trail and Sempra Energy, which has been aggressive in the past, may jump in as well.

"In five years, the industry is going to look a lot smaller," Miller says. "You'll see mega-utilities in [the] Northeast and a very select group of independent players of a large size. We'll return to the days of the holding company."

George Bilicic, an investment banker who specializes in utility and power deals at Lazard, disagrees. While he's a believer in slow and steady consolidation over the long term to build companies big enough to absorb body blows from the economy and markets, he thinks deals will be just too hard to finance -- and value -- until credit markets settle down. "With a few notable exceptions, until there's stability in the credit markets, it's going to be hard to consolidate, given that access to reasonable financing is so fundamental to the valuation of companies in the utility sector," he says. "I believe we are not at the beginning of the financial crisis, but we're certainly not at the end, either."

It's worthwhile to consider what happened to Insull, whose vast pyramid-scheme-like empire crashed with the stock market in 1929. Insull ended up dying penniless of a heart attack in a Paris subway station nine years later after being tried and acquitted three times for securities fraud. A cautionary tale if ever there was one.