MIZUHO SECURITIES USA INC. | US EQUITY RESEARCH
Summary
We understand the urge to merge, but are confounded by embedded valuation metrics. While we expect consolidation to continue, the clear winners are likely to be those that take advantage of the prevailing theme and sell (for cash, please!) We're not suggesting that buyers can't benefit, but our experience suggests a modicum of care is required. Creating and retaining real tangible value through consolidation is extremely difficult in the regulated utility space; it may be even more difficult at current takeout multiples. Investors should view buyers with caution; own the sellers.
Key Points
Consolidation likely to continue. Low interest rates and a challenging growth environment have been catalysts for consolidation. Financial players have been forced to look beyond their historic comfort zone for long-term, predictable and dependable yield (utility cash flow meets that need). Utilities nervous about tepid demand and changing regulatory structures gain easier access to cheaper capital that's used to finance consolidation (thus delaying the impact of said change). Given that we don't expect either the interest rate environment or motivating factors for either financial or utility participants to change, we believe consolidation will continue, though the pace may slow.
Valuations expected to remain near highs. Competitive auction formats, particularly with foreign financial entities holding unique structural advantages, have driven take-out valuations materially higher. Utilities have been able to stretch to these valuations with the help of rating agencies who have focused primarily on loosely applied earnings accretion metrics versus real tangible value creation. To date, we have seen no lack of competition for deals and no push back from rating agencies, consequently we see no reason for valuations to drop materially.
Caution is warranted. This is not our first rodeo. We recognize that the creation of tangible value through consolidation is not easy. We also know that failure to create value can result in stagnant performance, value destruction and ultimately perhaps a sale at lower valuations. We have seen too many examples of this over the years, stretching from GPU through Conectiv and so on. Our bottom line is that while it's easy for investors to hold those company's that might be coaxed off the fence by high multiples to sell themselves, they should be very cautious holding those companies perceived to be buyers.
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