Our Take on European Utility M&A Activity

Europe, home to some of the world's largest and most cash-rich utilities, has seen its own wave of merger activity over the past year to parallel the boom in utility M&A in the U.S. The scale of the proposed mergers in many cases dwarfs the size of U.S. deals.

For instance, the acquisition of Spain's  Endesa  by Germany's  E.ON  is the largest utility acquisition ever proposed, with a cash tender offer of $34.7 billion and the assumption of $30 billion in debt. The stock-swap merger of France's  Suez  and Gas de France would create one of world's three largest energy utilities. Both France's EdF and Italy's  Enel (EN) are actively courting takeover targets, and Britain's  Scottish Power  remains on the selling block. However, it's important to note that the reasons behind European mergers and acquisitions are quite different from those driving similar actions in the U.S.

Why All the M&A Activity Now?
Market Liberalization -- The main driver behind the wave of European M&A activity is the liberalization of European Union power markets beginning in 2007. The European Union's  mandate is to integrate fragmented country-centric power markets into a continental grid by July 2007. The goal behind the directive is that of lowering consumer electricity prices by increasing competition. The initial phase of liberalization required former state-run energy providers to divest assets within their home countries to reduce geographic monopolies. As a result of the asset sales, most former national champions are now flush with cash and relatively debt-free. Country-specific laws prevent them from aggregating more market power within their borders, so investing eyes are looking across the EU for new opportunities.

Access to Cheap Capital -- As a result of forced asset sales, formerly state-run companies are now swimming in cash. In addition to internal stockpiles, credit markets offer extremely cheap debt. Borrowing rates for big utilities are as low as 0.5% above government-issued treasuries, and utilities can typically access capital at these prices until their debt loads are roughly equal to shareholders' equity. While companies' surplus cash could be used to pay special dividends, we think this option is less likely because management might prefer to reinvest cash to grow their businesses. Acquisitions, in contrast, have the potential to put cash to work immediately and provide an immediate income stream.

National Champions -- In industrialized nations, energy is viewed as an essential shared service vital to economic growth. Due to their long histories of providing reliable service and thousands of domestic jobs, formerly state-run companies have become icons of national pride. The companies might now be publicly traded, but their governments continue to hold substantial ownership stakes and exert heavy influence on business decisions. As such, the populace remains committed to seeing these companies succeed financially, and patriotic pride grows hand-in-hand with the utilities' ever-increasing scale.

What Makes These Mergers Work?
Scale -- European utilities are avoiding the rhetoric of cost-reduction and best practices touted by their American counterparts simply because those benefits, if they exist at all, pale in comparison to the market power benefits that come with size. Generically speaking, it is only transmission limits and a lack of efficient trading markets that keep electricity from being a fully fungible commodity in Europe. These inefficiencies create exploitable opportunities for those generators that can amass pricing-power scale within geographic concentrations. Sustainable advantages of scale emerge when utilities can successfully walk the line between regional price maker and monopolist. However, companies must be careful as regulators will resist concentration of too much power.

Vertical Integration -- These advantages can compound when power producers vertically integrate their fuel supply chain through ownership of both gas supply networks and generation facilities--which currently exists at E.ON and would result from the GdF/Suez merger. Europe relies heavily on natural-gas-fired turbines, and as gas and power prices continue to converge, those players that control both fuel and power output will hold substantial pricing power.

What Are the Biggest Obstacles?
Abusive Market Power -- Ironically, the main driver behind industry consolidation is the same factor that left companies that were former national champions flush with cash from asset divestitures in the first place. The EU commission had been actively promoting cross-border investments to increase competition. The commission would like to see increased competition spread across several smaller players. However, the current merger proposals arguably run counter to this by increasing the size of European energy companies in aggregate. Ultimately, rather than issuing broad divestiture directives, the EU commission will likely have to specify its market fragmentation targets and define when market power is efficient versus abusive.

Nationalism -- When it comes to enforcement, the EU's bark takes a back seat to the bite of member states. Nations have openly endorsed and legislated rules promoting liberalization, but they have quickly backtracked when their national champions have become targets. Each country wants a nationally based energy champion so badly that they have proclaimed national security is at stake when takeovers are announced. Spanish spokesman Fernando Moraleda has pointed out, for example, that "we will do everything in our power to ensure that Spain's energy companies remain Spanish," and France was willing to merge Suez and GdF simply to cut off Enel's attempts at acquiring a French company.

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