Consolidating Utility Industries

Wes is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There are two types of industries: mature and growing. Growing industries require more capital and typically use the cash generated by the business to fund future projects. Mature industries, on the other hand, typically generate more cash than they can use internally, and either pay a dividend, repurchase shares, or even purchase competitors. The utility industry, and its sub industries, is the latter. It is a mature industry that is seeing some major consolidation.

Water, electricity and telecommunication services are three utility industries within the U.S. that are at different stages of consolidation. Investors would be wise to jump in before all of the consolidation is complete.

Water

The water utility is the most fragmented of the three utilities. There are over 10,000 entities in the U.S. that distribute, sanitize and control water. Some major industry players are making compelling arguments to state and local officials to outsource their water services to reduce costs.

Aqua America (NYSE: WTR) is a company that primarily operates in the water utility business in North America. The company is looking to utilize its scale and expertise to become the pre-eminent water and municipal waste company in the U.S. The company has stable revenues, and is looking to create a stable and growing company within a stagnant industry.

Aqua America has completed seven acquisitions so far this year and is on the hunt for more. The company purchases assets from cities, and uses its experience to standardize and optimize local water distribution and municipal waste systems. The company has increased its operating income 10% each year for the past four years, and has a net profit margin of 25.6%. Aqua America pays out 47% of its earnings to support a dividend of 2.4%.

There are many opportunities for Aqua America to increase its footprint in the U.S., as local governments seek to cut costs, and management holds firm on their desire to increase the size and scale of their operations. Aqua America has a market value of $4.5 billion, and can expand a lot more before it will show up on regulators anti-trust radar.

Electricity

Duke Energy (NYSE: DUK) is one of the prime examples of how increasing size can correspond to increasing shareholder value. Duke merged with Progress Energy in a $32 billion deal. Duke moved more towards the regulated business of electricity distribution to customers and away from the increasingly commoditized electricity generation segment. Duke Energy, post merger, now has 85% of its revenue coming from traditionally regulated business, compared to 75% prior to the merger.

Duke can now use its 7 million customers across six states as leverage when negotiating terms for long term energy purchases. One year after the merger, the company committed to saving its customers $70 million in reduced electric costs because of its size advantage. When the numbers came in, Duke actually saved customers $90 million, $27 million more than expected.

For investors, the merger meant a more efficient company. Duke was able to identify 1,860 positions that were mostly redundant within the two companies, and has offered and completed buyouts to 1,051 jobs over the last year. This will translate into lower Sales and General Administration expenses moving forward. 

Duke currently yields 4.6% and has a profit margin that is inline with its peers near 10%. The company’s move into more regulated markets means that Duke will be able to deliver solid results in good times and bad. The dividend has grown by nearly 3.3% over the past 5 years, and investors can continue to expect similar stable growth from this company.

Telecommunications

The telecommunications industry is one crowded space. AT&T (NYSE: T) and Verizon Communications (NYSE: VZ) have been operating in a near duopoly for the better part of a decade in the consumer space, and have raised an eyebrow or two when they want to acquire another domestic competitor. Last year, AT&T tired to purchase Deutche Telecom’s T-Mobile unit, and was ultimately shot down by regulators because of anti-trust concerns.

AT&T and Verizon have both been rumored to be looking at potential takeover targets. In the red corner, Verizon has been eyeing up the 49% of Verizon Wireless that U.K. powerhouse Vodafone controls currently. While in the blue corner, AT&T is rumored to be taking over an international telecommunications company like Spain’s Telefonica.

Both AT&T and Verizon can trace their origins back to the original AT&T Bell System, that was broken up in the 80’s. Both companies grew by taking over other small telecom companies and eventually breaking into the mobile phone market for growth. AT&T purchased Cingular Wireless in 2006 and owns all of its assets, while Verizon shares its wireless division 51%/49% with Vodafone.

Neither AT&T nor Verizon will have much luck in the U.S., but purchasing an over seas competitor looks like the only way to keep growing their customer base. Both companies have comparable dividends with AT&T at 5% and Verizon at 4%. However, Verizon relies heavily on the Verizon Wireless subsidy to continue paying out its dividend.

Both companies have seen record low customer churn the past three years, leading to very predictable revenues and expenses. However, with AT&T owning its assets outright, it is able to return more capital to shareholders than Verizon by partaking in a meaningful share repurchase program. The company repurchased 5% of its shares outstanding last year, and saved over $700 million in dividend payments. That money can now be used to repurchase more shares, increase the dividend, or pay down debt. This makes AT&T a more attractive investment opportunity than Verizon in the telecommunications space.

Foolish bottom line

As industries consolidate, they provide great growth opportunities for the companies that remain. Conservative investors looking for income should turn to AT&T and Duke for leaders in the consolidated mature markets. On the other hand, investors looking for growth should be thirsty for the water industry, and companies like Aqua America, for capital appreciation in a stable industry.


Wes Patoka owns shares of Duke Energy, AT&T and Verizon Communications. The Motley Fool recommends Aqua America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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