Five top-tier utilities are truly in a league of their own. They occupy a space no other utility can reach. This is the "40-plus" club -- $40 billion, that is -- and two mergers in the works would make this club even more exclusive than it already is.
Only five utilities have enterprise values of $40 billion or more:
* Southern Company (SO), $54 billion
* Dominion Resources (D), $46 billion
* NextEra Energy (NEE), $43 billion
* Duke Energy (DUK), $41 billion
* Exelon (EXC), $40 billion
Utilities seeking admission into this club are billions behind. The two closest are American Electric Power (AEP) at $34.5 billion, and PG&E Corporation (PCG) at $29 billion.
The 40-plus club utilities not only enjoy economies of scale, they also participate in more elements of the utility value chain. For example, all five members of this club own generating assets, transmission lines and distribution systems. Their smaller cousins are limited and may own few generating or transmission line assets -- if any. Further, because they participate in more elements, the 40-plus club players are likely to become the early adopters in smart grid technologies, which will lower their costs and provide them with a competitive advantage.
It's going to be hard for others to catch up with the 40-plus club. Two of the club's smaller members are in the process of acquiring large competitors. Exelon is acquiring Constellation Energy Group (CEG) and Duke is acquiring Progress Energy (PGN).
These acquisitions are large. Constellation has a market capitalization $7.3 billion and an enterprise value of $11 billion. Progress Energy has a market capitalization of $13.4 billion and an enterprise value of $25.8 billion.
But before any merger can take place, each state that regulates the utilities must agree with the terms of the merger. If a single state fails to approve a merger, that merger is shelved.
To appreciate current and future valuations of the acquired companies, it is important to appreciate the merger rules imposed by individual states. Under normal circumstances, when a merger is announced, market capitalizations of the individual parties involved are adjusted.
Utility mergers are not a normal circumstance. The market capitalizations of the individual companies have not been fully digested because there remains significant uncertainty. It is not clear whether all utilities can obtain all approvals. It is also unclear what costs will be imposed for those approvals. Regulators' decisions could impact individual balance sheets and market capitalizations.
The primary uncertainty and risk is with the individual states. State regulators do not want to lose influence, and they typically want to extract value out of the merger. Typically, the value is in the form of savings for local consumers, maintaining employment levels and maybe additional investments within the state. Right now Exelon is assuring the state of Maryland that most of Constellation's employment levels will be maintained and they are investing in plush new offices.
As the deals approach the finish lines and the regulatory risks diminish, the market capitalizations of the acquired companies should adjust. In Constellation's case, if Maryland approves the merger, Constellation's market capitalization should improve.
But it will not be a zero-sum game. Constellation is unhealthy, needs a new management team, and needs a realignment of assets. Investors cannot simply add Constellation's enterprise value to Exelon's and believe that will be the ultimate outcome. It will not.
This is also the case with Duke and Progress. Progress has some challenges, particularly with its Crystal River Nuclear Power Plant. Combined, their market capitalizations and enterprise values will be less than the sum of their parts.
Nevertheless, Exelon and Duke currently hold the bottom rungs in the 40-plus club and the lowest price-to-earnings ratios of the group. If their respective mergers are successful, they will move up to the top rungs, making it more difficult for other utilities to join this club. If the P/E ratios also improve, the 40-plus club may have to be renamed the 50-plus club.