NextEra Energy’s recent pursuit to acquire Duke Energy – a combination that would create the nation’s largest utility company – and Avangrid’s potential purchase of PNM Resources have caused investors to think about whether the utility sector is due for another wave of M&A activity.
While we believe these types of deals create excitement and increase interest in the sector, we don’t view them as a harbinger of more deal activity to come.
Utility M&A History, and Why A Wave of Activity is Unlikely
Merger activity in the utility space is nothing new. There used to be more than one hundred utilities dotting the national landscape, today there are 62 publicly traded utility companies in the U.S. with a market capitalization of at least $1 billion1.
While it should be fairly easy for companies in the sector to merge and create economies of scale, which reduce operating costs and increase earnings, the question remains: why have there been so relatively few utility mergers in recent years?
The lack of activity boils down to one reason: regulators. When companies propose a merger, regulators strive to pass the economic value on to the ratepayers. We’ve even seen potential deals where the state actually tries to capture more than 100% of the economic value that could be achieved from a deal. If ratepayers capture all the value, there is little incentive for the companies and their shareholders to pursue M&A.
Recent Deals Not Likely to Ignite a New Trend
In spite of the foregoing, the potential NextEra/Duke deal makes sense and is a genuine possibility. In this case, NextEra isn’t pursuing the acquisition with an imagination that they will extract economic value from it. Rather, our view is that the deal could lead to an acceleration of Duke’s growth rate.
We believe NextEra’s strategy in pursuing Duke Energy is to obtain development rights. NextEra is in a stronger capital position and can help Duke make a faster transition away from coal-fired plants and increase investment in renewables. This additional investment, coupled with cost cutting which benefits ratepayers, has the potential to generate economic growth for shareholders of the newly merged entity.
In our view, the Avangrid/PNM Resources deal is also a unique situation and not indictive of a M&A trend in utilities. Avangrid’s parent, Iberdrola, has had a long-stated goal of expanding in the U.S. through M&A and views Avangrid as the vehicle to accomplish that. PNM Resources has long been rumored as a potential seller, so the match makes a lot of sense. For many other larger companies, we believe the benefits of buying are not obvious. Balance sheets are stretched, still recovering from purchases made over the past decade.
Many utilities already have as robust a set of organic growth opportunities as they have had in some time coming from energy transition away from fossil fuels, so there is not a tremendous amount of strategic value that can be unlocked through M&A outside of a development opportunity like NextEra has with Duke. Any potential accretion in the deal will likely be made nearly impossible by regulators.
M&A Potential is not an Investment Strategy
While the mergers would be exciting for the industry, it likely doesn’t portend more deals in the future. It’s not a simple economic case for M&A in utilities; many interests must align; sellers have to be willing and regulators open to deals. As such, at Reaves, we do not invest in companies because we believe they might be takeout candidates. Our view is that those companies can deliver subpar performance, and then often fail to get acquired due to the regulatory hurdles that disincentivize many utilities from merging.
Instead, we recommend investing in those utilities that are the best operators, with the best management teams who have the best relationships with local regulators. We believe that combination, with the revenue stability already associated with an essential service industry such as utilities, should provide a recipe for steady earnings and dividend growth over time.
Reaves Asset Management is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration does not imply any skill or training. Reaves is a privately held, independently owned “S” corporation organized under the laws of the State of Delaware.
The information provided in this blog does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. Investors should consider the investment objective, risks, charges and expenses of all investments carefully before investing. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur.
Reaves’ clients hold positions in NextEra Energy Inc. (symbol: NEE) and Duke Energy Corp. (symbol: DUK).
Past performance is no guarantee of future results.
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