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Why Buffett is buying utilities
The industry is consolidating, and a utility with low-cost financing is going to make a lot of money. Here are three stocks that will benefit and four more worth a look.
By Jim Jubak
On May 24, Warren Buffett bought an electric utility. Should you?
Buffett will pay $5.1 billion to buy PacifiCorp from Scottish Power (SPI, news, msgs). That's about an eighth of the more than $40 billion that Berkshire Hathaway (BRK.A, news, msgs) had in cash at the end of March. And the deal to acquire the provider of electricity to 1.6 million customers in the Pacific Northwest is the biggest for Berkshire Hathaway in the last eight years. When the deal was announced, Buffett said Berkshire Hathaway would be looking for more utility acquisitions.
All in all, it adds up to a pretty hefty endorsement of the electric utility industry from a legendary value investor. Which, of course, takes us back to my first question: If Warren Buffett is buying electric utility stocks, shouldn't you?
At first glance, this seems like an odd time for a value investor such as Buffett to invest in utilities. The Dow Jones Utility Index ($UTIL) has returned 11.5% so far in 2005 (as of June 1) after huge total returns of 25.4% in 2004 and 24% in 2003. Stocks such as AES (AES, news, msgs), up 9.15% in 2005 after returning 44.7% in 2004, American Electric Power (AEP, news, msgs), up 7.8% in 2005 after returning 17.4% in 2004, and Duke Energy (DUK, news, msgs) up 12.94% in 2005 after returning 23.8% in 2004, seem closer to the end of their runs than the beginning.
So why does Buffett think utilities are a good buy now? The answer lies in the long- and short-term potential for electric utilities.
The long-term view: Consolidation builds profits
U.S. utilities are in the early stages of a long-term consolidation. Midsized utilities are buying small utilities, and big utilities are buying midsized players.
Right now, there's a mismatch in how the industry is structured. There are thousands of local companies that deliver electricity to their customers. Then, there are regional wholesale electricity markets dominated by a handful of efficient, large-scale electricity producers. The wholesale markets have emerged because local companies can often buy power from others for far less than the cost of generating it themselves. At the same time, some utilities have developed cost advantages that have turned generating and peddling excess electricity to other utilities into very profitable businesses.
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The wholesale markets aren't going away -- in fact, they're gaining in importance. But they are undergoing a subtle transformation. The big low-cost producers aren't content with the profits that come from selling their electricity at wholesale prices. They'd like to capture more of the cash flow by eliminating the local utilities. Why sell bulk power to another utility if you can sell electricity at retail to the company's local customers? Since the electricity business is composed of regulated monopolies, the only way to be able to sell directly to the end users is to buy up the local companies -- lock, stock and customers.
That's exactly what's been going on in recent years. In 2000, American Electric Power bought Central & South West to create the country's biggest utility. Duke Energy plans to merge with Cinergy (CIN, news, msgs), and Exelon (EXC, news, msgs) has proposed the acquisition of Public Service Enterprise Group (PEG, news, msgs).
There's many a slip between projected and real cost savings, as investors know all too well. Even so, when Exelon talks about getting $400 million in cost savings in the first year of the merger by eliminating redundant operations at Public Service Enterprise -- equal to about 4% of PEG's annual revenue -- it's enough to get my attention.
Just one problem, though. There's this inconvenient law left over from the Great Depression when utilities did nasty things like water their stock and play "hide-the-assets" among related shell companies. Called the Public Utility Holding Company Act, the law prohibits nonutility companies, such as Berkshire Hathaway, from directly controlling retail electricity suppliers. The law also requires that utilities (if both are U.S. utilities) must be physically connected in order to merge. It's that latter requirement that led a Securities and Exchange Commission hearing judge to rule in early May that the American Electric Power-Central & South West merger violated the 1935 law. AEP's service area nowhere touched the Texas service area of Central & South West.
For a patient investor like Buffett, though, this is exactly the time to strike. The long-term consolidation trend is gathering speed, and efforts to repeal the 1935 law are making headway in Congress. The energy bill passed by the Senate Energy and Natural Resources Committee on May 26 would allow the large-scale utility mergers now prohibited. Passing a committee, however, isn't the same as getting through the full Senate and the House of Representatives, but the attempts to amend the Public Utility Holding Company Act will bear fruit one of these years.
It's quite possible, however, that Buffett may not have to wait even for that. Technically, Berkshire Hathaway isn't PacifiCorp's buyer. The formal buyer is Berkshire's 80%-owned MidAmerican Energy Holdings.
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