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The last of the big power deals

M&A activity in the utilities sector has held up in 2009 despite the recession. But a slow-down is on the way, writes Conal Walsh

THE POWER industry is flickering in the gloom of recession. Multibillion-dollar deals are still happening, but there are signs that mergers and acquisitions (M&A) activity is in decline because of falling energy prices and the credit crunch.

In Europe, three big power and gas deals, with a combined value of €29.2bn ($39.9bn), were agreed in the first two months of 2009 alone – equivalent to nearly one-third of the value of all gas and power M&As announced in 2008, according to PricewaterhouseCoopers (PwC). Two of them are among the largest 10 deals to have been announced since the start of 2007 (see Table 1).

German power group RWE announced a €9.3bn deal to acquire the Netherlands' biggest utility, Essent, in January. Holland's second-largest power company, Nuon, met a similar fate in late February, when Swedish utility Vattenfall agreed to pay €10.3bn for its generation and distribution assets. At around the same time, Italian utility Enel paid Spanish construction group Acciona €9.6bn for a further 25% share of Spanish energy group Endesa, raising its stake to 92%.

Digesting recent acquisitions

Those may be the last of the really big deals, however. Companies show signs of needing time to digest their recent acquisitions before spending again. In addition, some industry observers say consolidation among European energy firms, triggered originally by liberalisation and privatisation, is at any rate drawing to a natural close. Already, more than 60% of the continent's total generating capacity is accounted for by just six firms. Apart from Scottish & Southern and Centrica, there are few decent-sized potential targets left.

Looking ahead, it is possible to envisage Europe's largest power firms taking a closer interest in the US, where small, fragmented markets present potential acquisition targets. But the US utilities market is a difficult place to do a deal, as any acquisition that might lead to a rise in electricity prices tends to attract detailed scrutiny from regulators. Another uncertainty, with a direct effect on valuation, is the US' still-evolving environmental stance. With a new president only recently elected, but the Copenhagen summit on climate change just six months away (see p4), nobody knows yet what new requirements will be imposed on utilities.

For the time being, however, power-sector M&A in Europe remains robust. According to Dealogic, there were 201 global M&As in the power sector in the first quarter of 2009, worth $53.3bn in total – compared with $44.5bn spent on 231 deals in the same period a year earlier. But outside Europe, there is significantly less corporate activity than in 2008 and deals of $10bn or more have virtually disappeared.

Valuations are still declining, making buyouts look risky. Asset sales were replacing mergers as the principal form of corporate transaction even as early as mid-2008, according to PwC. In the second half of the year, the flow of deals began to be more strongly driven by companies needing cash. Sellers sought to offload specific assets to repair balance sheets.

Certainly, power companies are not finding it easier to access capital than their counterparts in other industries. E.On, Germany's largest energy company, has suffered multibillion-euro balance sheet write-downs and is planning to cut debt through asset disposals. Under pressure from ratings agencies, Enel has committed to raising €8bn through a rights issue by early July and reducing its debts by €20bn.

And then there is EDF of France, the biggest single spender of 2008, having invested $31bn on seven deals over the year, including the £12.5bn ($18.5bn) purchase of British Energy (BE), the nuclear operator. The pre-crunch spending spree lumbered EDF with almost €25bn of debt, and many of its recently bought assets have fallen in value. Analysts at Citigroup recently described EDF as "our least preferred vertically integrated utility in Europe". However, last month, the French firm took a step towards reducing this debt with an agreement to sell a 20% stake in BE to Centrica for £2.3bn – £1.1bn in cash plus a 51% stake in SPE, Belgium's second-largest energy supplier.

It may be, however, that high levels of gearing would be of greater concern were many of the largest utilities not perceived as national champions with significant levels of state patronage. Enel, for example, is 30% owned by the Italian state; this no doubt helped secure shareholder acceptance of some of its abrupt money-saving measures, including a reduced dividend.

In Europe, national ownership has been at least as decisive a driver of M&A activity as have straightforward commercial considerations. Enel's acquisition of Endesa of Spain succeeded only after a corporate tug-of-war in which Spain's government tried (but failed) to stop the company falling into foreign hands. EDF, 85% owned by the French state, still enjoys a near-monopolistic grip on its home market, despite the EU's attempts to liberalise Europe's energy markets.

Utilities in states that have liberalised in line with EU regulations are increasingly the target of those in states that have not. Enel's take-over of Endesa, and RWE of Germany's purchase of Essent in January, both highlight the vulnerability of smaller firms to those with strong state backing. The third EU Energy Package contains a level-playing-field clause designed to prevent this from happening, but it cannot be applied retrospectively.

Drivers of corporate activity

Other fundamental drivers of corporate activity in the utilities sector are, of course, consumer demand and the energy price – neither of which seems buoyant enough to justify untrammelled spending.

Shares in E.On recently tumbled after it warned that adjusted net income would fall by 10% this year as the recession saps European demand for electricity and gas. The downbeat forecast made it clear that European utilities are not immune from the economic slow-down, because struggling industrial customers are cutting energy consumption and financing costs remain high.

Power demand from some industrial users, including car and steel manufacturers, has tumbled by more than 20%. Nor could E.On rule out customer bad-debt becoming a problem.

The full effect of falling energy prices may not have hit the utilities yet, says Herve Gay, an analyst at SocGen – but, he adds, it is only a matter of time before declining cash flows dampen acquisitive appetites. "Despite the 50% crash in wholesale power prices in the second half of 2008, don't expect to see cash flows hit this year – a large part of 2009 production has been sold forward at high levels," he said. "Only in 2010 could we start to see cash flows hit."

If industry consolidation is coming to an end, there will be relief in some quarters. "These companies generate a lot of cash when energy prices are high and it starts to burn a hole in their pocket," one fund manager complains. But cross-border acquisitions don't really work in the electricity sector, because they don't create any synergies.

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