Size Matters: Consider the Alternatives
May 15, 2003
By Lyle D. Miller
For small to midsize utilities, the costs and burdens of being a stand-alone investor-owned utility merit considering the alternatives.
A pressing question for many utilities-particularly small to midsize utilities-is whether to remain a standalone publicly owned company at their current form and size. Do the benefits outweigh the costs?
Being a public company is, despite its many benefits, costly in several respects. The most obvious benefit is the (usually) ready access to equity funds for growth. A traded equity currency for use in strategic transactions also is important. The lowest cost of equity is obtained from the public markets. Nevertheless, the costs and burdens of public ownership and the accompanying regulation continue to rise.
Consider the actual costs of being a public company: preparation of periodic regulatory filings and reporting; financial and legal staff to prepare these filings and monitor compliance; filing fees; an investor relations department; annual meetings and reports; and related costs, such as director and officer (D&O) insurance.
With the enactment of the Sarbanes-Oxley Act and recent increased scrutiny, these costs-particularly D&O insurance-have only escalated (see Figure 1).
More to the point, the personal exposure, financial or otherwise, of the CEO, CFO, and other officers has increased significantly. Any member of a public company board of directors has to have the same concerns. Increased regulatory and public scrutiny will help curb many of the abuses seen in the go-go years, but unfortunately, everyone gets caught in this dragnet and pays the costs just the same.
A publicly owned company faces the difficulty of striking a balance between what a CEO believes to be the right strategic course and what the investing public believes is best. The public capital market serves a major role in instilling strategic discipline and keeping management focused on maintaining and building shareholder value. However, recent history would suggest that the investing public, including major institutional investors, is not always more astute than managers.
Management of a public company cannot ignore the equity research community. Analysts are now playing to a highly skeptical audience, and they will have to err on the side of criticality and more in-depth analysis. As a result, it will become harder to attract and retain equity research coverage for companies with smaller public equity floats and investor interest, leading to more and more research orphans.
Lastly, but no less importantly, actions of the major credit rating agencies have a much more significant impact on a utility's public share price. As a result, price/earnings ratios are highly correlated positively to credit ratings. Larger, more diverse utilities will have an implied safety and stability premium over smaller utilities.
Merge, Sell, or Go Private?
Does it make sense to be a public company today? The question specifically applies to the more than 50 small and midize utilities (market capitalization of $200 million to $2 billion), with limited future investment needs and an appropriate, stable capital structure. For these utilities, the benefits of being a standalone public company may not measure up to the increasing costs and burdens.
In these cases, the most likely alternative for smaller utilities would be the sale of the company to a larger utility. Shareholders could receive stock from the acquiror, which would allow them to continue enjoying the benefits of owning equity in a utility. They also should receive a strategic price premium in the sale process.
Another possibility is to seek a similar-sized merger partner. The combined company might be more able to justify the costs of being public, or result in a company that attracts more strategic interest and, therefore, a higher premium.
For midsize utilities, the scenarios are similar. However, it is more important for these companies to focus on finding a similar merger partner to achieve the scale benefits of being a larger public company.
Alternatively, a "going private" transaction may merit consideration. Morgan Stanley estimates that about $150 billion of private equity funds is currently available for investment. With typical leverage levels, that translates to about $500 billion of potential acquisitions. More importantly, the returns required by many private equity investors have come down significantly, with risk-adjusted returns for regulated utilities currently as low as the mid-teens.
For small to midsize utilities, the current conditions in the private equity market are favorable. Although going private will not make sense if a strategic buyer would pay more for the company, in today's displaced market, there are fewer strategic acquirors, and those that exist may not be willing to pay large strategic premiums.
A larger company will require substantially more private equity and have more complicated regulatory issues, all of which make a going-private transaction less likely. In 2000, TNP Enterprises, the holding company for Texas-New Mexico Power Co. went private. Its shareholders received a 33 percent premium to their pre-announcement share price. More recently, Citizens Communications sold its Hawaiian gas division to K-1 USA Ventures for $115 million in cash.
Is There a Role for Public Sector Ownership?
Though anathema to many industry participants, there may be a role for public sector ownership (municipal, public authority, etc.) of purely regulated, monopoly utility businesses. If one looks primarily at cost of capital and capital structure, the lower-cost financing and 100 percent debt structure available to a public sector owner can lead to much lower rates for consumers. However, the overall level of difficulty of selling, on a commercial basis, to a public sector owner is high, and the process is always subject to political currents and public sentiment.
Nonetheless, successful examples exist. The Long Island Power Authority (LIPA), a municipal entity formed in New York, acquired the transmission and distribution assets of the Long Island Lighting Co., which suffered significant financial difficulties, for $2.5 billion in cash and $3.6 billion of assumed liabilities. The transaction was funded by municipal bonds, and LIPA began operation with an immediate 20 percent reduction in rates to its 1 million customers.
The water utility sector has an effective model for contracted operation, resulting in the best of both worlds-efficient financial ownership and professional management. Operational contracts let private sector companies earn greater returns by allowing them to focus solely on applying their operational expertise rather than on asset ownership. Such a model could work more broadly in the utility industry to the benefit of shareholders and ratepayers.
Lyle Miller is a managing director in Morgan Stanley's Global Energy and Utility Group.
Articles found on this page are available to Internet subscribers only. For more information about obtaining a username and password, please call our Customer Service Department at 1-800-368-5001.
Public
Utilities Fortnightly & Spark
