A utility shake-up in 2015?

A renewed bid from Pfizer for AstraZenica could excite the stock market and stimulate merger and acquisition activity among utilities. Nigel Hawkins identifies the potential targets.

In the City, there is real interest in whether Pfizer will return with a bid for AstraZeneca: its previous offer of about £70 billion was rejected. Under the rules of the Takeover Panel, Pfizer can re-bid once the six-month cooling-off period has expired – 26 November is the crucial date.

Since Pfizer made its first bid, the US has tightened its rules on tax inversion deals. This policy change collapsed AbbVie’s £31 billion planned acquisition of biopharmaceutical company Shire.

Nonetheless, if there were a renewed Pfizer bid, it would certainly excite the stock market. Currently, Greene King’s £774 million agreed offer for the Spirit Pub Company is the only major ongoing bid situation.

Within a few months, this scenario may change, with UK utilities being in the frame, although next May’s general election does give rise to additional uncertainties, especially in view of Ed Miliband’s pledge to freeze energy prices for 20 months.

Previous evidence in the water sector suggests that, once a five-year periodic review is done and dusted, speculation – if not take-over activity itself – increases.

Early next month, Ofwat will publish its final determinations, most of which will be accepted by individual water companies, although United Utilities and Thames may be the most hard-pressed to do so.

Assuming that Ofwat broadly retains its assumed 3.85 per cent weighted average cost of capital, it should be fairly clear how the cash flows of each water company will pan out until March 2020.

Potential bidders, most likely from private equity, can then assess whether the current premium over the regulatory asset value (Rav) fails to reflect the underlying valuation of each company.

Particular interest will focus on the quoted trio of Severn Trent, United Utilities and the smaller Pennon.

In Severn Trent’s case, it seems probable that it will accept Ofwat’s final  determination.

Last year, its board rejected a final offer of £22 per share from private equity. Such a decision was, in the words of Yes, Minster’s oleaginous Sir Humphrey, “brave”.

Nonetheless, many expect Severn Trent to receive a further bid. The same consortium may return for a second bite of the cherry.

As the owner of a vast sewerage network in industrial Lancashire, United Utilities is hardly a glamorous target, but there has been some bid speculation that has supported its share price.

Nonetheless, the gap between Ofwat’s and United Utilities’ sewerage investment costs until March 2020, although narrowing, still remains a chasm.

As a smaller company, Pennon is perhaps a more obvious target, although any bidder would have to address how it would deal with the struggling Viridor waste business.

Neither should the seven privatised but non-quoted water companies be ignored. Shareholdings could well be exchanged between private equity owners or even sovereign funds.

Furthermore, with recent changes in water legislation, mergers, though unlikely, should not be totally discounted. Both Wessex/South West and Yorkshire/Northumbrian still seem logical combinations.

Similar principles apply to parts of the electricity sector.

Given its many challenges, including ongoing price reviews and fossil fuel generation setbacks, it would be a brave bidder who went for SSE. Nonetheless, with its formidable portfolio of renewable generation assets, it undoubtedly has attractions.

Centrica, which is planning to sell some of its worst performing gas-fired plants, also faces real uncertainty.

Aside from the impact of May’s general election – Centrica’s domestic gas business is particularly vulnerable to the Miliband 20-month price freeze pledge – the company’s long-term strategy may well change given the recent management reshuffle.

A bidder could emerge, although, given current frosty UK-Russian relations, Gazprom is presumably no longer a candidate.

The two German members of the big six, Eon and especially RWE, find themselves at a crossroads. Both are facing massive challenges in their domestic market, with the phase-out of nuclear power by 2022. Their UK returns are poor, which must be testing their long-term commitment to remain here: both may put up core assets for sale.

Drax aside, power station valuations are currently low, although bidders can still be attracted as the Czech-based EPH acquisition of the Eggborough plant has demonstrated. Eon and RWE’s energy supply businesses would attract some interest, albeit at modest prices.

Despite Longannet’s declared non-participation in the capacity auction, Iberdrola looks more settled. Its share price has rallied in recent months, partly on the back of an improved outlook for its formidable renewable generation portfolio.

If either Scottish Power’s or Manweb’s electricity network assets became available, there would be serious interest from potential acquirers.

EDF’s long-term UK commitment is dependent on Hinkley Point C. After all,  EDF has still to take an irrevocable decision to invest and, crucially, to arrange the funding for the project.

Although the size of National Grid, currently capitalised at about £33 billion, probably precludes any takeover initiatives, the outcome of the ongoing RIIO-EDI periodic review will be carefully analysed.

Western Power Distribution has already been fast-tracked, but final determinations are due shortly. Many private equity investors will be doing their long-term cash flow modelling to determine underlying valuations – and may respond accordingly.

For many reasons, 2015 will be a pivotal year for the utilities sector. And, given the herd mentality of the myriad bids for the regional electricity companies back in the mid-1990s, one aggressive bid now could really shake up the utilities sector.