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The Coming Wave of Utility Consolidation

Duke Energy (NYSE: DUK) is still apparently in hot water with North Carolina regulators after firing presumptive CEO Bill Johnson. Johnson previously helmed the former Progress Energy and had been slated to lead Duke following the merger of the two firms, while Duke CEO Jim Rogers would become chairman of the board. However, in a surprise move shortly after the deal’s close, the board voted to oust Johnson as CEO and retain Rogers as top boss.

The controversy makes for fascinating corporate drama, pitting executives and partisans of Raleigh, N.C.–where the former Progress Energy is situated–against those of Duke’s hometown of Charlotte, N.C. And as is predictable for two such powerful entities, it’s drawn in regulators and politicians as well, with some calling for the state’s Utilities Commission to reverse its approval of the deal, and force Duke to split up again.

Others are calling for regulators to impose harsh fines and possibly undo rate increases to punish Duke for allegedly “misleading” them in its merger application. And the typically reactive ratings agency Standard & Poor’s has even cut Duke’s credit rating, largely because of what it calls a deteriorating relationship with North Carolina regulators.

Despite this imbroglio, there’s been relatively little action in Duke Energy’s share price. The stock has backed off from its brief spike over $70 following the close of the merger. But since then, it’s remained fairly stable. Shareholders even reacted positively yesterday to news that Duke had retained financial advisors to assist in the possible sale of its power generation assets in the Midwest.

The main reason for the relative calm among investors: Like every one of the thousands of mergers between power companies since the invention of electricity in the late 19th century, this deal is based on sound economics. By joining forces, utilities gain scale that reduces costs across the board, from financing to procurement and basic operations. This deal promises some $200 million in savings from its operations in the Carolinas alone, and Duke’s moves to sell assets will further that advantage by cutting debt and providing funds to deploy elsewhere.

No other industry can boast the record of successful mergers like the utilities industry. And with capital costs expected to be steep in coming years–for upgrading reliability and complying with tighter environmental standards–we can expect to see many more sector mergers in the coming years. And that’s regardless of whoever occupies the White House and appoints members of the Federal Energy Regulatory Commission (FERC).

Case in point, this week we saw another major deal announced in the power generation space: NRG Energy’s (NYSE: NRG) buyout of Genon (NYSE: GEN). Since the crash of 2008-09, the business of generating and selling power into wholesale markets has been troubled by falling prices, brought on in large part by the collapse in natural gas prices.

Many companies have warded off the worst so far by hedging prices and locking in buyers to long-term contracts. Now that those hedges are coming off, the contracts must be renegotiated at lower prices, even as generating costs for coal have surged for environmental reasons that will only get more severe going forward. As a result, margins have been squeezed, and the damage has been worst at independent producers–like NRG and Genon–that don’t have regulated utility operations to maintain stability.

By combining for scale, NRG and Genon expect to realize $200 million in higher cash flow, as well as $100 million in balance sheet improvements. The combined company will be by far the largest non-utility power producer, with 48,736 megawatts of capacity and a lot of flexibility about what it will keep running going forward.

The new company’s power mix will be approximately half natural gas, 30 percent coal, 17 percent oil, 2 percent nuclear, and the rest a mix of renewables. It will have the advantage of a huge concentration in Texas, a market that’s isolated from the larger regional power grids and where reserve margins are starting to run very low. To encourage new construction, state regulators have doubled the summer cap on wholesale prices, and NRG is in prime position to take advantage once prices rise sufficiently to make it economic.

The merger terms call for each Genon share to be swapped for 0.1216 shares of NRG. The deal needs approval by the FERC, as well as regulators in New York and Texas. Management expects the deal to close in the first quarter of 2013.

There is a potential problem with some dissident shareholders who have sued Genon, claiming it should have negotiated a better price. However, given the fact that Genon looked increasingly likely to follow now-bankrupt sector rival Dynegy into Chapter 11, that may be difficult to argue. For its part, NRG stands to get a breakup fee of $60 million if Genon should walk away, which could well be a blow too great for the latter to bear.

Credit raters Moody’s and Fitch have already given their imprimatur to the deal, as has Wall Street–NRG’s share price has picked up since the announcement. That’s ultimately the most important endorsement of any deal, and provides additional encouragement for more power company mergers down the road.

For shareholders, this is another good reason to keep holding onto your power companies, and buy more of those that are still selling at good prices. Acquired companies always get a near-term pop, for example, even Genon gapped up on its merger news. And when power companies join forces, they typically create a stronger entity that can consistently build wealth through thick and thin.

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