A New Trend in Utility M&A?

After Eversource Energy (NYSE: ES) agreed to pony up $880 million in cash and assume $795 million in debt to buy privately held Aquarion Water, industry scuttlebutt has explored whether this deal marks a new trend in utility mergers and acquisitions.

Once America’s third-largest investor-owned water utility, Aquarion Water gave up its independence for $37.50 per share when UK-based Kelda Group acquired the water utility. A Citigroup (NYSE: C)-led consortium, in turn, bought Kelda in February 2008. Around that time, Aquarion Water passed to its current owner, a group led by Macquarie Infrastructure Partners.

Aquarion Water’s system investment has grown modestly over the years, with the utility adding and replacing infrastructure serving its roughly 226,000 customers in Connecticut, Massachusetts, and New Hampshire.

Based on Aquarion Water’s 2016 results, Eversource Energy’s winning bid came in at 2.3 times book value and 4.2 times revenue. In comparison, Connecticut Water Service (NSDQ: CWTS), a publicly traded water utility with a market capitalization of $705 million, goes for about 2.77 times book value and 6.8 times sales.

The acquisition will give Eversource Energy water customers in areas where the utility already has monopolies on electricity and gas distribution. Accordingly, buying Aquarion Water creates an opportunity to reduce general and administrative costs. And with Eversource Energy’s bonds maturing in June 2045 yielding 3.65 percent, the utility likely has opportunities to cut interest expense by refinancing.

For Eversource Energy, the main attraction of acquiring Aquarion Water is most likely the company’s steady growth. The gas and electric utility’s ability to achieve its targeted earnings growth hinges on completing large projects that face regulatory delays, including the $1.6 billion Northern Pass transmission line that’s under review in New Hampshire.

Buying Aquarion Water won’t eliminate the sting of failing to complete these projects in a timely manner. But water utilities can expand their rate base reliably by replacing pipelines and mains and building modern infrastructure to reduce costs.

Per capita water consumption may have leveled off in the US, but publicly traded utilities continue to grow their customer base by acquiring and integrating adjacent systems from municipalities that can’t afford the necessary upgrades and expansions.

A complementary geographic footprint and sub-$1 billion market capitalization could make Connecticut Water Service a potential takeover target if Eversource Energy opts to build scale in its water business.

Deals of this nature invariably prompt speculation about potential copycat transactions. We’ll play matchmaker to the utility sector and make the case for a marriage between Exelon Corp (NYSE: EXC) and Aqua America (NYSE: WTR).

Although Exelon’s headquarters is in Chicago, the acquisition of Pepco Holdings shifted the company’s center of gravity toward its old stomping grounds of Philadelphia—a short train ride from Aqua America’s long-standing base in Bryn Mawr, Pennsylvania.

Pennsylvania remains Aqua America’s largest market by far, contributing more than half of the company’s revenue last year. And like Exelon, Aqua America has operations in Illinois and New Jersey. The water utility’s systems in Indiana, North Carolina, Ohio, Texas, and Virginia match the footprint of Exelon’s merchant power business.

With a market capitalization of $6.1 billion, Aqua America is a much bigger company than Aquarion Water. The stock also trades at 3.26 times book value and 7.5 times sales—loftier valuations than what Eversource Energy paid for Aquarion Water.

On the other hand, Aqua America’s superior scale has enabled the company to grow its revenue at a faster pace than Aquarion Water and Connecticut Water Service. The Pennsylvania-based water utility has increased its customer rolls by 1.5 to 2 percent annually, fueled by favorable demographics, acquisitions, and system expansions. These trends have expanded its rate base at an annual rate of about 6 to 7 percent, supporting earnings and dividend growth in the upper single digits.

Aqua America’s annual revenue of about $850 million would be a drop in the bucket relative to the $33 billion that Exelon rakes in each year. But being part of a bigger company could help the water utility to land some of the larger municipal deals in its pipeline, accelerating earnings and dividend growth.

In recent years, the Q-and-A portion of Exelon’s earnings calls and conference presentations have tended to focus on conditions in the wholesale-power market and their implications for the company’s fleet of nuclear power plants.

This focus makes sense when you consider the persistent weakness in electricity prices and the reality that Exelon’s unregulated operations are expected to contribute 42 percent of earnings per share this year.

Buying Pepco Holdings bolstered Exelon’s exposure to regulated markets, improving the visibility of future earnings and dividend growth. But Exelon has also played made the most of a challenging market, securing zero-emission credits that allow its nuclear power plants to run profitably in Illinois and New York. The company also continues to lobby for similar dispensations in New Jersey and Pennsylvania.

Exelon also maintains a robust hedge book to limit volatility in this segment. The power producer has hedged 97 to 100 percent of its expected output for 2017; 60 to 63 percent for 2018; and 30 to 33 percent for 2019.

The company also continues to high-grade its generation portfolio. Earlier this year, for example, Exelon reached an agreement to sell ExGen Texas Power, a subsidiary that operates fossil fuel-burning generation capacity.

Meanwhile, Exelon continues to plow free cash flow from its power-generation business into investments that grow its regulated rate base, further tilting its revenue mix away from unregulated operations.

Will Eversource Energy’s acquisition of Aquarion Water mark the start of a new fad in the utility sector?

Management teams and boards of directors will decide whether such a course makes sense. But diversifying into the water business adds regulated revenue and creates a new growth platform for bolt-on transactions and system investment.

Investors looking to profit from potential takeovers should only buy targets that they wouldn’t mind holding if the company remained independent.

This stipulation narrows the range of options considerably; investors have already bid up many water utilities’ shares to record valuations, even for names that must contend with unfriendly regulatory environments.

But for disciplined investors who buy selectively and at the right price, an increase in merger and acquisition activity provides another reason to own best-in-class water utilities.

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