Given the importance of scale to the utility sector, the impetus for mergers and acquisitions has always been strong. The past year has brought a number of blockbuster deals involving gas utilities and consolidation in the transmission space; here’s why we expect the merger madness to continue.

However, recent deals in the utility sector have faced significant hurdles, with regulators in the various states playing hardball for concessions and delaying approvals. Exelon Corp’s (NYSE: EXC) acquisition of Pepco Holdings, for example, took almost two years to gain regulatory approval from all the jurisdictions involved.

Even with these uncertainties, the potential rewards of greater scale and efficiency continue to drive electric utilities to the altar.

And many of the more than 50 publicly traded US electric utilities have market capitalizations of less than $10 billion, giving prospective acquirers a smorgasbord of potential takeover targets.

Other motivating factors include a desire to add natural-gas capabilities to profit from growing demand for the inexpensive thermal fuel and to complement electric utilities’ transition away from coal-fired generation capacity.

This rationale underpinned Southern Company’s (NYSE: SO) proposed acquisition of AGL Resources (NYSE: AGL) and Duke Energy Corp’s (NYSE: DUK) pending purchase of Piedmont Natural Gas (NYSE: PNY).

Mergers and acquisitions activity tends to come to the utility sector in waves, usually coinciding with relatively low costs of capital. However, the urge to merge dissipates when debt and equity capital becomes more expensive.

Another Deal for Exelon?

Although Exelon could be forgiven for swearing off future deals after enduring a painfully drawn-out approval process for its acquisition of Pepco, the management team has expressed an appetite for another merger.

In a recent appearance on Bloomberg TV, CEO Chris Crane indicated that the utility sector will continue to consolidate. Three factors suggest that Exelon could announce a follow-up deal sooner than some observers expect.

For one, the uncertainty surrounding whether the District of Columbia Public Service Commission would approve the Pepco deal prompted Exelon’s management team to explore a back-up plan if the transaction were to fall through. The company had already raised the capital needed to fund the acquisition via a bond offering.

Although Exelon’s alternative plan could have involved paying down debt, we wouldn’t be surprised if the company has performed due diligence on a second acquisition.

The company also has an army of lawyers in place from the Pepco deal, which would enable the firm to put them to work on another transaction.

From a strategic standpoint, Exelon would benefit from acquiring regulated assets and further reducing its exposure to whole-sale power prices, which remain under pressure from depressed natural-gas prices.

Adding Pepco’s regulated utility franchise dramatically improved the visibility of Exelon’s revenue and expanded its backlog of potential growth opportunities—encouraging trends for future dividend growth.

Potential Targets

Which publicly traded utilities might be on Exelon’s shopping list?

The company already made one unsuccessful run at New Jersey-based Public Service Enterprise Group (NYSE: PEG), a utility with operations in the Northeast and the Mid-Atlantic region. Exelon has also partnered with the company on nuclear power plants.

Meanwhile, Ameren Corp (NYSE: AEE) would complement Exelon’s Commonwealth Edison franchise in Illinois and give the utility a presence in Missouri. NiSource (NYSE: NI) could be another potential takeover target, thanks to its Northern Indiana Public Service utility.

FirstEnergy Corp’s (NYSE: FE) regulated assets in Pennsylvania, New Jersey and northern Ohio would also be a good fit for Exelon and fit the pattern established with the Pepco deal.

Like Pepco, FirstEnergy’s stock trades at a discount to other electric utilities, fetching 1.2 times book value and 1 times sales. This undemanding valuation reflects the potential that the Federal Energy Regulatory Commission could reject a deal that would effectively re-regulate FirstEnergy’s wholesale-power plants. Becoming a part of Exelon or another large utility would help to mitigate FirstEnergy’s operating risks and financial weakness.

We highlight three of our favorite takeover plays—all of which we wouldn’t mind owning if a deal never materializes—in this exclusive report for Conrad’s Utility Investor subscribers.

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