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I am pleased to be on this panel as a representative of the financial community. Thanks to all the panelists for taking time out of their busy schedules to participate in this unique discussion. Also, Bob Gee deserves special acknowledgement for arranging all of this today. In this short presentation I wanted to briefly discuss two strategic dynamics affecting the Power and Utility Industry. Since our firm has helped restructure or is restructuring many of the troubled companies in the Industry, I will say a word or two about the restructuring/credit environment for those companies. Second, since our firm is ultimately and strictly an advisory firm principally focused on mergers and acquisitions, I will also communicate a few thoughts on mergers and acquisitions. As we have believed for some time, it remains our view that the Industry is a fundamentally consolidating one, with some of the best constituency value opportunities residing in logical, well-executed mergers.
The box on this slide, with its inputs, represents our views of the material factors affecting the Industry today and strategies that may allow participants to meet the challenges and opportunities suggested by the inputs. While I suspect all of these, and other factors, will be considered during the course of our discussions, I want to focus on a dynamic that leads us to the conclusion that appropriately structured Industry consolidation is consistent with the interests of relevant constituencies and may even be a useful public policy tool.
Utilities continue to trade at a significant premium to historical P/E multiples, though there has been some recent compression as interest rates have begun to rise in reaction to strengthening economic indicators. Despite the recent material correction in the market’s long-term earnings growth expectations, trading multiples until recently reacted inversely, underscoring the market’s recent (though abating) emphasis on yield. As the Industry continues to re-base its valuations along fundamental principles and macro-economic and Industry factors continue to normalize, the Industry, generally, and particularly those utilities that recently enjoyed significant premiums, will likely trend toward more historical levels, although President Bush’s tax cut should offset this downward pressure to some extent.
As the hoped-for growth prospects of previous strategies have largely failed to materialize, companies are investigating several strategies intended to restore moderate earnings growth, all with a view to the income focus of the investor community. The predominant strategy over the past 12-18 months has been a “Back-to Basics” approach. Some companies which have largely completed their “Back-to-Basics” efforts are now investigating strategies designed to produce long-term growth at rates higher than those available solely through cost-cutting, etc. The Regulated Growth Strategy incorporates an increased focus on the core regulated business; maximizing the value of existing assets and investigating ways to grow the regulated asset base. This strategy has become one that more and more Industry observers are discussing as an attractive source of growth. And it is – if regulators allow a reasonable rate of return. However, there are two aspects of this strategy worth mentioning. First, this strategy may require rate increases which are difficult as we all know. Second, robust rate base investment cannot continue perpetually as prudent investment opportunities are limited. Others are pursuing strategies which we refer to as Specialized Growth Strategies. These Strategies range from conservative generation or merchant strategies, including wind, to LNG and, increasingly, consolidation. Each of the companies pursuing these strategies appears to be doing so in a way that is measured.
While some companies may be able to cobble together a growth-enhancing strategy based on “Back-to-Basics” and selected forays in the non-regulated and regulated area, we believe that consolidation in the Industry, while fraught with execution risk, should continue to provide the best long-term value proposition for companies and, as a result of reasonably attainable synergy levels, very attractive relative earnings growth opportunities. Today, as evidenced by the various colors on the map, the Power and Utility Industry remains markedly unconsolidated, suggesting the opportunity. Importantly, as one reviews this multi-colored map, it is reasonable to ask the question as to whether the various companies that are present in the map, taken together with municipal-owned entities and cooperatives and others, somehow increases the complexity of this country’s utility and power system and thus puts pressure on the ability to deliver reliable electricity service.
In the wake of last summer’s blackout, the topic of system reliability has demanded the attention of policymakers, advocacy groups and Industry executives. In addition to considering whether the fragmented nature of the Industry itself may contribute to reliability questions, we have been considering whether consolidation itself could be a source of capital for the apparent significant investment needs to ensure infrastructure reliability. In our view, the available synergies associated with mergers in the Industry could be utilized, in part, to support investment in the system which, as noted on this slide, could be a win-win result for all constituencies. In particular, assuming a reasonable regulatory construct, some portion of synergies associated with a merger could be allocated to shareholders with the balance allocated to system investment, as apposed to being allocated to rate decreases, thereby locking-in enhanced future earnings growth for the relevant utility and greater system reliability as a result of enhanced investment. In your copies you will find an article we recently published in Public Utilities Fortnightly on this topic.