NEW YORK ( TheStreet) -- U.S. utility stocks were a safe way to escape a worsening economy last year with many utility sector funds -- like the Vanguard Utilities ETF (VPU) and the Utilities SPDR (XLU) -- significantly outperformed the major indices in 2011.
The sector was boosted by its stable revenues and high dividends, which attracted safety-minded investors as the yield on U.S. Treasury bonds plunged. In 2011, mega-mergers also led a continued utilities recovery from a 2009 lows as companies looked at consolidation as a way to wrench out cost synergies and lower pressure on operating margins.
While $10 billion deals may not be as common in 2012, Fitch Ratings expects continued utilities M&A and gives 10 companies to watch for as possible acquisition targets.
The keys to the expected utilities M&A wave in 2012 are threefold. Chiefly, regional powerhouses with non-regulated merchant power businesses are going to look at tie-ups as a way to create cost synergies to overcome falling natural gas and electricity prices. Meanwhile, others may look to diversify their unregulated customer bases to those with regulated contracts, less vulnerable to falling energy prices.With an uptick in expected 2012 capital spending throughout the sector, others may target development synergies, while also looking to vertically integrate power generation capabilities with retail distribution businesses, according to Philippe Beard and Glen Grabelsky of Fitch Ratings. "Fitch Ratings expects the industry will continue to consolidate in light of its balkanized structure, and to potentially realize meaningful economies of scale and cost efficiencies," the firm notes in its report on M&A targets in the unregulated utilities sector. Because of diversification and margin needs throughout the utilities sector, Fitch Ratings expects a year of strong M&A, especially among targets with a sub-$5 billion market cap. That would be a slight change from past years, where a $25 billion stock mega-merger between Carolinian powerhouses Duke Energy (DUK) and Progress Energy (PGN), a $10.2 billion tie-up between Mid-Atlantic players Exelon (EXC) and Constellation Energy (CEG) and Northeast Utilities System's (NU) $6.8 billion Oct. 2010 acquisition of NSTAR (NST) drove overall M&A. As result of those deals and others globally, the utilities sector was the fourth leading deals sector, with over $250 billion in M&A globally, according to Dealogic. For more on M&A, see 10 top rated Morningstar M&A picks. "We would have to see when the current deals will close to have a better sense of whether big mergers will happen in 2012. Size is not necessarily the most important element," says Philippe Beard of Fitch Ratings, who cautions that M&A in the sector may not eclipse the 2011 mark of $49 billion. With the bulk of regulated utilities at less than $5 billion in market cap and just a handful over $25 billion in size, Fitch highlights the latter as they become targets in 2012 for larger players like Berkshire Hathaway (BRK.A - Get Report)-owned MidAmerican Energy, Xcel Energy (XEL - Get Report), NextEra Energy (NEE - Get Report) and Wisconsin Energy (WEC - Get Report). "Fitch believes that smaller companies with market capitalization less than $5 billion and book multiples less than 1.3x, represent better financing opportunities for potential purchasers and more likely targets," writes the ratings agency in its M&A report. Still, both Beard and Grabelsky of Fitch Ratings caution investors against expecting high premiums. Companies looking at consolidation as a means of enduring pricing pressure aren't going to pay significant premiums to target price-to-book multiples, according to Grabelsky. Mergers in utilities sector averaged a one month share premium of roughly 20%, the lowest premium of the top 10 M&A sectors globally in 2011, according to Dealogic. A potential headwind are the still pending regulatory approvals of Duke, Exelon and Northeast Utilities Systems' multi-billion dollar takeovers, however Fitch expect that the deals will close. A recent Barclays Capital report shows that even after a utilities merger is announced, investors can find outsized returns by holding the target and acquirers stock through the sometimes multi-year regulatory approval process. If an investor owned the target after the deal announcement through a deals closure, they would earn a 9.1% return, while the acquirer would yield 3.5%. As utilities stocks and indices hit post-crisis highs and dividend yields continue to provide attractive returns, also look at M&A in the utilities sector as driving investor gains - even as the industry faces pricing headwinds. Here's a look at 10 potential regulated utilities M&A targets that Fitch highlights in its deals outlook for the sector.