schwarz investment banking view (morgan stanley)

L:\UTILITIES_NY\DEPT_ONLY\Personal Folders\BLUX\Tim Schwarz\Utility Industry Presentation.ppt\A2XP\16 SEP 2005\5:55 PM\1

Investment Banking View of the Utility Industry21 September 2005

Table of Contents


Section 1 Utility Sector Update

Section 2 Perspectives on Recent Strategic Activity

Section 3 Energy Policy Act

Section 4 Transmission Environment Update

Appendix A Bio

– Timothy R. Schwarz

Section 1

Utility Sector Update



A Brave New World of Growth is Emerging…


• Growth stocks are starting to make a comeback after 5 consecutive years of trailing value stocks

– Year-to-date performance supports our view, as growth, measured by the Barra indexes, has marginally outperformed value. More telling could be that growth has triumphed over value during each of the last six months

– However, unlike past rebounds in growth stocks, we expect a GARP orientation to dominate during this cycle

– Earnings growth and dividend growth have reconnected after the long absence that defined the 1990s

1

71%

(35)%

43%45%

72%

-60%

-40%

-20%

0%

20%

40%

60%

80%

1960's 1970's 1980's 1990's 2000's

Signs of normalcy?

Correlation Between Dividend Growth and Earnings Growth

Source S&P, Thomson Financial, Morgan Stanley ResearchSource S&P, Thomson Financial, Morgan Stanley Research

Past Two Growth/Value CyclesCycle Start End # of Mths

Growth Jul-89 Dec-91 29

Value Dec-92 Jan-94 13

Flat / Modest Growth Tilt Feb-94 May-98 52

Growth May-98 Feb-00 21

Value Jul-00 Nov-04 53

Source Ibbotson, Morgan Stanley Research

-60%

-40%

-20%

0%

20%

40%

60%

1973 1979 1985 1991 1998 2005

Index of Relative Strength of Growth vs. Value Effectiveness

Source Morgan Stanley Research

Apr 77 Oct 84

Jul 94

NiftyFiftyPeak

EnergySectorPeak

Kuwait/Recession

Tech 2000

Growth

Value

(30)

(20)

(10)

0

10

20

30

1975 1980 1985 1990 1995 2000 2005

Growth vs. Value Flip-Flops Modest growth tilt

Growth cycles get stronger over time

Déjà Vu: We Think Growth Investors Are Looking at Something Akin to the 1994-1997 Period

S&P500 Growth Relative to S&P 500 Value Annual Total Return Growth

Value


Utility Sector Sensitivity to Interest Rates

Notes1. Forecast as of August 8, 2005; all forecast values are for the end of the indicated period


• With the Fed tightening 10 consecutive times, U.S. long-term interest rates have not risen in line with expectations

• U.S. utilities have not been as sensitive to interest rate movements as historically observed

• Morgan Stanley forecasts that the 10 and 30 year US Treasuries will reach 4.75% and 5.0%, respectively, by the end of the year

2

Source FactSet and Morgan Stanley Research

8.0

10.0

12.0

14.0

16.0

18.0

Jul-95 Feb-97 Sep-98 Apr-00 Nov-01 Jun-03 Jul-05

3.0

3.9

4.8

5.7

6.6

7.5

S&P Utilities FY1 P/E

U.S. 30-Yr Treasury

S&P Utility Index FY1 P/E and 30-Year Treasury YieldP/E (x) Yield (%)

Source Bloomberg and Morgan Stanley Research and The Wall Street Journal

4.35

4.855.00

5.30

3.503.75

4.004.25

4.50 4.504.16

4.604.75

5.00 5.10 5.155.355.35

3.00

3.50

4.00

4.50

5.00

5.50

August 29, 2005 05Q3 05Q4 06Q1 06Q2 06Q3

Fed Funds 10Yr UST 30Yr UST

Interest Rate Outlook(1)

%



Utility Sector Valuation Relative to Broader Market

3

• Current valuations are not compelling as the sector is trading close to one standard deviation above its long-term average on most metrics

• Valuations also are unattractive relative to the broader market

• Utility sector trading at 107% of the S&P 500 on a forward P/E basis, above the 5-year historical average of 74%

Entry and Exit Points Metric Overweight Underweight Relative P/E < 50% to 60% > 75% to 80%

Absolute P/E < 10–11x >14–17x

Yield Spread to S&P 500 > 300 bps < 150 bps

Source FactSet, Bloomberg, Morgan Stanley Research

Source FactSet, Bloomberg, Morgan Stanley Research

Notes1. Morgan Stanley Research data as of September 6, 20052. Market data as of September 6, 2005

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

Apr-95 Mar-96 Feb-97 Jan-98 Dec-98 Nov-99 Oct-00 Sep-01 Aug-02 Jul-03 Jun-04 Aug-05

Rel

ativ

e F

wd

P/E

(%

)

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Yie

ld S

pre

ad (

100b

ps)

Relative FY1 P/E (Utility P/E / S&P 500 P/E) Yield Spread (Utility Yield vs. S&P 500 Yield)

Relative Valuation (S&P Utility Index vs. S&P 500 Index)

Relative Sector Valuation

Fwd P/E (1) LTM P/E (1) Yield (bps) (2)

S&P Utilities Sector 16.3 18.4 331

S&P 500 15.2 17.1 184

% of S&P 500 or Spread to S&P 500 107% 108% 147

3 Yr. Avg. 80% 74% 213

5 Yr. Avg. 74% 70% 206

Premium / (Discount) over 3 / 5 Yr. Averages 28 / 34% 33 / 38% 45 / 41%


Investor Perception of the Utility Sector


• Morgan Stanley recently conducted an informal survey of the top 25 investors in the utility sector asking two fundamental questions on current valuation levels and their sustainability

4

Question #1: “The outperformance of the utility industry relative to other sectors for the past 12-18 months has surprised many in the investment community, what do you think are the principal factors supporting this phenomenon?”

• Macro Factors

– Interest rate environment

– Risk-adjusted growth relative to broader market

– Lack of direction for broader economy

– Tax law changes

• Sector Specific Factors

– Commodity price environment

– Constructive regulatory environment

– PUHCA repeal

Question #2: “Looking out over the next 12-24 months, do you think this outperformance will be sustainable?”

• Macro Factors

– Interest rate environment (Fed actions and shape of the yield curve)

– Growth in other sectors (i.e., alternative investment opportunities)

– Economy (slow-down = sustainability of outperformance / growth = underperformance)

• Sector Specific Factors

– Special situation stories can only turn around once

– M&A / strategic environment

– Regulatory environment / ability to “pass through” costs to customer


Analyzing Utilities Based on Commodity Exposure


• Utilities with commodity growth “kickers” continue to be in favor, however, fully regulated names have also performed well over the past six months

5

NM

15.5

15.3

14.9

16.7

15.1

14.4

0 2 4 6 8 10 12 14 16 18

Fully Regulated

Regulatory Lag

Semi-Regulated - Margin Squeeze Potential

Semi-Regulated - Margin Expansion Potential

Unregulated Mix w/ Regulated Utility Operations

Commodity Focus

Pure Merchant

2006E P/E(x)

Source FactSet

0.1%

7.3%

9.3%

13.9%

15.0%

-2.5%

13.7%

-4% -2% 0% 2% 4% 6% 8% 10% 12% 14% 16%

Fully Regulated

Regulatory Lag

Semi-Regulated - Margin Squeeze Potential

Semi-Regulated - Margin Expansion Potential

Unregulated Mix w/ Regulated Utility Operations

Commodity Focus

Pure Merchant

YTD Share Price Change(%)

Source FactSet

Low

Commodity Exposure

High

Low

Commodity Exposure

High(1)

(6)

(2)

(3)

(4)

(7)

(5)

(8)

(6)

(2)

(3)

(4)

(7)

(5)

Notes

1. Includes RRI, NRG, DYN and CPN

2. Includes D, TXU, WMB, EP

3. Includes DUK, FPL, CEG, SRE, DTE, TE

4. Includes EXC, ETR, EIX, AEE, PNM

5. Includes FE, AEP, PPL, CIN, DPL

6. Includes PNW, PSD, IDA, AVA

7. Includes SO, PCG, ED, PGN, XEL, POM, NU

8. Includes RRI, NRG and DYN. CPN was excluded because its YTD share price change was -25.4%

EIX

PSDNU

TXU

TE

PCG

XEL

SO

SCG

PGN

POM

GXP

EAS

DTE

ED

CIN

AEE

LNT

SRE

PPLPNW

FPL

FE

EXC

ETR

DUK

DPL

D

CEG

AEP

11

12

13

14

15

16

17

0.4 0.5 0.6 0.7 0.8 0.9 1.0

Projected Beta vs. Forward P/E0.4 = Low Risk/1.0 = High Risk

AEP

CEG

D

DPL

DUK

ETR

EXC

FE

FPL

PNW

PPL

PEG

SRE

LNT

AEE

CIN

ED

DTE

EAS

GXP

POM

PGN

SCG

SO

XEL

PCG

TE

TXU

NUPSD

EIX

11

12

13

14

15

16

17

18

2 3 4 5 6 7 8

Business Profile vs. Forward P/E2 = Low Risk/7 = High Risk


Does EPS Growth Matter?


• Given the spotted track record of the utility sector over the past three years, investors are largely discounting EPS growth rates greater than 5%

• Taking on greater business risk, in the search for incremental EPS growth, is not necessarily being rewarded appropriately by the investment community for the commensurate risk

– The market does not see significant value in distinguishing between 4-6% growth for a couple of year period vs. 2-3% long-term growth when visibility is limited to the regulatory treatment of rate base and timing of rate increases

6

15.7x

14.3x

15.5x

14.2x

13.0

13.5

14.0

14.5

15.0

15.5

16.0

Greater than 5.0% 5.0% 4.0%–5.0% Less than 4.0%

2006

E P

/E

Estimated Growth Rates vs. 2006E P/E

Source FactSet, IBES

Projected Beta

IBE

S 2

006E

P/E

Sources FactSet, IBES and S&P Credit Reports

IBE

S 2

006E

P/E

S&P Business Profile Rating

Sources FactSet, IBES and Barra


What is the Market Rewarding?


• There continues to be a negative relationship between growth and P/E multiples

– Market is skeptical of Utilities achieving stated growth objectives above 5%

– Premium is being placed on lower risk, low growth strategies (i.e., stick to core competencies)

• The market is also placing premium valuations on companies that are returning cash to shareholders if they don’t have a use for it in their core business

– High dividend paying stocks are being rewarded by the market

• Conclusion: Any “growth” investments face a high hurdle rate for investors

7

Source FactSet and IBESSource FactSet and IBES

IBE

S 2

006E

P/E

Payout Ratio (%)IB

ES

200

6E P

/EIBES LT Growth Rate (%)

PEG

SRE

CIN

PGN

AEP

CEG

D

DPL

DUK

ETR

EXC

FE

FPL

PNW

PPL

LNT

AEE

ED

EAS

GXP

POM

SCG

SO

XEL

PCG

TE

TXU

NU

PSD

EIX

11

12

13

14

15

16

17

18

2 3 4 5 6 7 8 9 10

…Estimated Growth Rates Are Not Necessarily Rewarded

PEG

SRE

LNT

AEE

GXP

AEPCEG D

DPLDUK

ETR

EXC

FE

FPL

PNW

PPLCIN

ED

EAS

POMSCG

SO

XEL

PCG

TE

12

13

14

15

16

17

18

19

20

0 20 40 60 80 100

Higher Dividend Payouts Are Still Being Rewarded…

Section 2

Perspectives on Recent Strategic Activity




Key Observations

Notes1. Includes global announced transactions of $100MM or more; excludes terminated transactions2. Annual amounts based on mean of percentage premiums paid over unaffected stock price which is defined as stock price 4 weeks prior to the earliest of the

deal announcement; announcement of a competing bid; and market rumors before 31 March 20053. Includes all announced bids irrespective of consideration offered (i.e., includes all cash, all stock and hybrid bids). Excludes outliers

• M&A activity in 2005 continues to be robust

– YTD announced global volume up 35% over same period in 2004

8

Source Thomson Financial as of 9 Sept 2005

38 37 3942 43

3733 32

2824

373939

485043

0

10

20

30

40

50

60

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Avg. Premiums Paid

Premiums Paid Have Come Down SignificantlyM&A Premiums Paid for Global Public Targets (1990–YTD) (%) (2) (3)

Source Thomson Financial

• Valuation levels provide support to the current M&A environment

– Acquisition premiums are down as buyers demonstrate increased discipline

957

3,053 3,191

2,285

1,5311,451

1,747

1,2151,057806

431344266249348

2,297

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

0

200

400

600

800

1,000

1,200

1,400

M&A Volume Avg. Transaction SizeAnnualized 2005 Volume

Volume and Average Deal Size up Significantly (1)

Volume ($Bn) Avg. Transaction Size ($MM)



The Market Is More Receptive to M&A

Note1. Aftermarket performance compared to acquiror’s unaffected stock price (1-day prior to announcement) 9

(0.5)

(6.4)(5.8)

(2.3)

(1.1)

(3.4)

(2.2)

(7.0)

(6.0)

(5.0)

(4.0)

(3.0)

(2.0)

(1.0)

0.0

1999 2000 2001 2002 2003 2004 2005

1 Day After Announcement

Median Aftermarket Performance of the Acquiror’s Stock Price Following Announcement (1)

Largest 20 Announced Deals in the U.S. per Year (1999–YTD)—Change (%)


• Improved market receptivity to announced transactions

(0.9)

(6.8)

(3.9)

(1.2)

(4.1)

(2.5)

(4.2)

(7.0)

(6.0)

(5.0)

(4.0)

(3.0)

(2.0)

(1.0)

0.0

1999 2000 2001 2002 2003 2004 2005

1 Week After Announcement

Median Aftermarket Performance of the Acquiror’s Stock Price Following Announcement (1)

Largest 20 Announced Deals in the U.S. per Year (1999–YTD)—Change (%)


Transaction Terms & Valuation

Exelon / PSEG Duke/ CinergyMidAmerican/ PacifiCorp

Target Market Capitalization (Date of Announcement) 10.6Bn 8.0Bn NA

Acquiror Market Capitalization (Date of Announcement) 28.7Bn 27.2Bn NA

Equity Purchase Price 13.5Bn 9.1Bn 5.1Bn

Target Aggregate Value 27.1Bn 14.4Bn 9.4Bn

Exchange Ratio 1.225 1.56 NA

Target Pro Forma Ownership 32% 24% NA

Premium to Target Trading Levels

Based on Date of Announcement Unaffected Price 19.2% 13.4% NA

Based on Avg 5-Day Unaffected Price 19.0% 14.2% NA

Based on Avg 1-Month Unaffected Price 18.8% 14.9% NA

Multiples Paid (IBES)

2005E P/E 15.9x 16.2x 15.0-16.0x

2006E P/E 15.1x 14.8x NA

EV/2005E EBITDA 10.0x 9.8x 7.0x

Multiples Paid Relative to Acquiror's Valuation

Acquiror 2005E P/E vs 2005E P/E Paid 91.2% 117.0% NA

Acquiror 2006E P/E vs 2006E P/E Paid 89.8% 116.9% NA

Acquiror 2005 EV/EBITDA vs 2005E EV/EBITDA Paid 75.0% 84.8% NA


Notes1. Based on unaffected prices as of 5/6/2005, 12/15/2004, and 5/23/2005, for Duke/Cinergy, Exelon/PSEG, and Scottish Power, respectively2. Aggregate Value without securitized debt is $25Bn; EV/2005E EBITDA without securitized debt is 10.4x3. Based on equity research estimates4. LTM P/E (March ’05) is 20.5x5. LTM EV/EBITDA (March ’05) is 8.6x


10

(1)

(1)

(1)

(1)

(1)

(3)

(3)

• Price performance since announcement

(4)

(5)(2)

(2)

Comparison of Recent M&A TransactionsKey Merger Statistics

Indexed Performance (%) (1)

EXC DUK SP

1- Day (0.8) (1.8) 6.3

1-Week 1.8 (6.1) 4.9

Current 28.3 (1.3) 26.2



Emergence of Alternative Sources of Capital

Note1. Transactions greater than $400MM. Includes transactions with U.S. based seller or buyer

• Financial sponsors and hedge funds have emerged as an increasingly important pool of capital

– Proliferation of $1Bn+ funds

• Convergence of hedge funds and private equity

• Growth in number and size of alternative investment funds driven by search for outperformance in low-return environment

– Traditional strategies generating lower-return prospects

11

17.319.6

22.8

7.76.34.35.3

7.710.1

0.0

7.0

14.0

21.0

28.0

35.0

1996 1997 1998 1999 2000 2001 2002 2003 2004

0

7

14

21

28

35

Sponsor Share of U.S. M&A

Financial Sponsor Activity as % of Total U.S. M&A Volume (1)

% # of deals

Source 1996–2004 Thomson Financial

0

200

400

600

800

1,000

1996 1997 1998 1999 2000 2001 2002 2003 2004

0

1,500

3,000

4,500

6,000

7,500

Net Asset Flow Estimated Assets Number of Funds

Growth in Global Hedge Funds, 1996–2004Asset ($Bn) Number of Funds

Source HFR report


Financial Player Activity in the Power SectorNew Financial Players Enter the Project Finance Merchant Energy Sector. . .


• Not all financial players are the same. Those actively involved in the power sector include:

– A mix of private equity partnerships and funds

– Commercial banks that have reluctantly become owners through foreclosures

– Hedge funds that have entered the sector by trading distressed debt and equity

– Financial institutions seeking long-term, stable annuity-like returns, such as pension funds or newly formed infrastructure funds

– Investment banks looking to expand their commodity positions

12

Issuer Financial Player Asset

Generating Capacity

MW Issuer/Issue Rating Cogentrix Energy Inc. Goldman Sachs Power developer 987 ICR B-/Stable; $50MM revolv credit fac bank,

BB+/Stable; $700MM term B bank ln,

BB+; $355MM 8.75% sr nts, A+/Stable

East Coast Power LLC GS Linden Power Holdings LLC, a Goldman Sachs subsidiary

Two combined-cycle gas fired cogeneration plants in New Jersey

940 US$193.5MM 6.737% sr secd nts, BBB-/Stable;

US$248MM 7.536% sr secd nts, BBB-/Stable

US$184MM 7.066% sr secd, BBB-/Stable

Green Country Energy LLC 90% owned by subsidiaries of General Electric Structured Finance (GESF) and 10% by a Cogentrix subsidiary

Single combined-cycle power generation plant in Oklahoma

810 $319MM 7.21% sr secd nts, BBB-/Stable

ITC Holdings Corp. Kohlberg Kravis Roberts/Trimarin Capital

Electric transmission system in Michigan

N/A $267MM 5.25% sr unsecd nts, BBB/Stable

KGen LLC Mattlin Patterson Fund Merchant power generation assets in southeast U.S.

5,325 $325MM first lien term A bank ln, B/Stable;

$150MM second lien term B bank ln, B-/Stable

La Paloma Generating Co. LLC Indirectly owned by lenders to U.S. Gen Energy Group

Merchant power generation assets in California

1,022 (net)

Senior secured (4 issues) BB-/Stable; $155MM second lien term C bank ln due 2013, B/Stable

LS Power Funding Corp. Indirectly owned by ArcLight Capital Partners LLC

Two cogeneration plants in upper Midwest

490 $105.6MM sr secd bnds and $226.4MM sr secd bonds, BBB/Stable

MSW Energy Holdings LLC and MSW Energy Holdings II LLC

AIG High Star/CSFB private equity

Portfolio of waste-to-energy plants. American Ref-Fuel

N/A $200MM sr secd notes, BB-/Stable; $225MM sr secd Notes, BB-/Stable

NRG Energy Inc. Mattlin Patterson Fund Power developer 15,481 ICR B+/Stable/--; $800MM term loan B bank ln, BB; $150MM revolving credit fac bank in, BB; $697MM 1st prior term B bank, BB-; $250MM 1st prior revolv cred fac bank ln due 2006, BB-; $400MM convertible perpetual pfd stk, CCC+; $1.725Bn 8% 2nd priority bond, B

NSG Holdings II LLC AIG High Star/Ontario Teachers Pension Fund

Portfolio of power generation assets

1,042 $160MM sr secd bank fac, B+/Stable

Primary Energy Finance LLC American Securities Capital Partners

Portfolio of mostly contracted power generation assets

N/A $150MM sr secd term bank ln, BB-/Stable

Texas Genco LLC Private equity: The Blackstone Group, Hellman & Friedman, Kohlberg Kravis Roberts & Co., and The Texas Pacific Group

Merchant power generation assets in Texas

14,386; 5,222

base load

BB/Stable (ICR); $1.625Bn first lien term B bank ln, BB; $325MM first lien revolv cred fac bank ln, BB; US$1.125Bn 6.875% sr nts, B


CalBear Energy Marketing and Trading Venture


• On September 8th, Bear Stearns and Calpine announced the formation of a new energy marketing and trading venture focused on physical natural gas and power trading

13

Overview

• CalBear Energy LP (“CalBear”)

– 100% owned by Bear Stearns

– Bear Stearns will guarantee approved CalBear transactions

– Actively managed risk and trading limits

• Calpine Merchant Services Company (“CMSC”)

– 100% owned by Calpine

– Calpine, through CMSC will retain CES employees and infrastructure

– CMSC will act as agent for CalBear and CES

• Calpine will retain all economics from its generation assets

• CalBear will provide CES with a $350MM credit intermediation agreement

– Reduces cash collateral position

– Nets gas purchases and power sales

– Limited to transactions less than 61 days out

• CalBear third-party energy services profits split 50/50

– 50% to CMSC as a service fee

Transaction Structure

Business Opportunity

• Fragmented industry with thousands of asset owners– Load-serving entities– Non-utility generators– Retail aggregators– Industrials– Natural gas producers– Pipelines

• CalBear to provide the expertise to optimize assets• Energy market price volatility creates interest from

professional investors and end users• Market inefficiencies and arbitrage opportunities

Calpine

Corporation

Transactions

RELATED to

Calpine Assets

Distribution

of Profits

Services

Fees

$350MM Credit Intermediation

Agreement for Power & Gas Trades

Around Calpine Assets

Services

Service Fee

Equal to 50%

of CalBear

Profits

100%

Ownership

Calpine Energy

Services, L.P. (CES)

Bear Stearns

Companies Inc.

Transactions NOT

RELATED to

Calpine Assets

CalBear Energy LP

(CalBear)

Calpine Merchant

Services Company

(CMSC)

2.50

3.00

3.50

4.00

CPN Stock Price($/share)

Source Factset

Sept. 8th Announcement

1-Aug 10-Aug 19-Aug 30-Aug 12-Sept

Section 3

Energy Policy Act


Energy Policy Act

The Energy Policy ActOverview of PUHCA Repeal


14

• The repeal of PUHCA in the Energy Act will facilitate M&A activity in the utility industry

• The SEC’s traditional role in reviewing M&A proposals has been removed, as has the requirement for utility combinations to be contiguous or interconnected

• However, an increase in M&A activity is not assured, as state approval for M&A will still be required and both FERC and the states have been granted additional authority

– How that authority is implemented will be critical to future consolidation in the industry

• It is our view that PUHCA repeal will increase strategic activity in the sector over time, however, regulatory hurdles in the utility industry will continue to represent obstacles to mergers and acquisitions

– State commissions have, and will continue to represent hurdles, particularly to acquisitions by entities not already in the utility business (e.g. rejection of the TPG / Portland General and KKR / Unisource transactions)

– FERC can be expected to apply its merger guidelines rigorously to protect consumers from the anticompetitive effects of utility mergers and acquisitions that would permit the exercise of horizontal or vertical market power

– In addition, holding companies will be subject to enhanced information reporting to both FERC and state utility regulators to facilitate rate regulation and protection of ratepayers from abusive company transactions

• Despite its enhanced regulatory role, FERC’s oversight should not be nearly as intrusive as was the SEC’s under PUHCA

– The new legislation, which will be implemented through FERC rulemaking, appears to limit the scope of FERC’s review to anti-trust related and cross subsidization issues rather than the wide-ranging review required by the SEC under PUHCA

– Moreover, congress has limited FERC’s merger review process to 180 days (absent a showing of good cause) in striking contrast to the open-ended SEC process in which some utility mergers simply died from SEC inaction

• As a consequence, electric and gas utilities may be newly vulnerable to strategic approaches and may have increased pressure to perform financially and therefore may increasingly look to acquisitions as a means to grow and improve financial performance through the potential synergies derived from consolidation

Energy Policy Act

The Energy Policy ActPotential Implications of PUHCA Repeal


• The market is still the driving factor behind transactions, but the Energy Act removes some obstacles that have historically stood in the way of economically sound M&A transactions

15

• New entrants

– Financial players, foreign entities and non-utility energy companies that have historically balked at subjecting themselves to regulation under PUHCA

– Construction or technology companies (not merely Bechtel or GE, but purveyors of clean coal technology, transmission or even new nuclear facilities) can now take an equity interest in projects they build or design

• New acquirers

– Utilities in strong financial positions that are not contiguous to many other utilities (e.g. those in Florida), as well as those in highly integrated pools or RTOs (e.g., PJM), may be particularly well placed for increased M&A activity

• New targets

– Small and medium sized utilities will likely enjoy a broader range of potential acquirers

• Transmission consolidation

– A utility which knows how to operate a complex electric transmission network can now own electric transmission across the country, without regard to integration of those systems, or in distant states where they cannot be accused of manipulating transmission to benefit their own native generation

• Restructuring Opportunities

– “Flat utilities” that have operations in several states and non-utility subsidiaries will be able to restructure as holding companies with separate state utilities and non-utility businesses held apart from the utility ownership chain without having to register under PUHCA (such a structure may simplify state regulatory issues)

Section 4

Transmission Environment Update



The Energy Policy ActTransmission Implications


• The Energy Act advances the objective of integrating regional markets for wholesale power by ensuring generator access to increased investment in and streamlined operations of the national transmission grid

16

Key Provisions

• Carries forward the integration of the national transmission grid initiated by Energy Policy Act of 1992, removing the remaining constraints on industry integration imposed by the Public Utility Holding Company Act of 1935 (PUHCA) and giving FERC authority it lacked under the 1992 Act to integrate federal and state utilities into an open-access national transmission system

• Designed to foment investment in transmission infrastructure. Grants FERC the right to issue construction permits and coordinate environmental approvals for transmission projects deemed by the Secretary of Energy to be in the national interest

• The 2005 Act also grants tax and tariff incentives for investment in transmission infrastructure, and seeks to improve the functioning of the national transmission grid by requiring that its owners, operators and users adhere to federal reliability standards

Implications for the Utility Sector

• As regional power markets become increasingly integrated, prices should trend upward in lower-cost regions where nuclear and coal-fired generators predominate, such as the Midwest, while coming under downward pressure in regions such as the Mid-Atlantic, where higher-cost gas-fired generation sets the price

– Off-peak power prices, which are set by coal in the Midwest but increasingly by gas-fired generators in the Mid-Atlantic, should be particularly affected

• As in other commodity markets, the beneficiaries of these trends will be the lowest-cost suppliers

– In particular, as market integration causes off-peak prices in Midwestern power prices to rise, base-load generators in these markets should enjoy a marked improvement in generation gross margin

• Among the primary beneficiaries of the regional integration of power markets, therefore, will be utilities with large, unregulated nuclear generation fleets: companies like Exelon, Dominion, FirstEnergy, Entergy and Constellation


Strategic Trends in TransmissionFERC Gives Utilities Incentives to Sell Transmission…


• Given the signing of the Energy Policy Act and recent developments with respect to transmission assets, we believe strategic activity in the transmission sector will accelerate over the next 6-12 months

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• Federal regulators, namely FERC and the Department of Energy, have noted a decline in transmission investment, and recognize that a reversal of this pattern is needed to improve reliability, reduce blackouts and lower the cost of electricity

– The DOE estimates that $50-100 billion of investment is required to modernize the transmission grid

– FERC has been supportive of the creation of independent transmission companies such as ITC, and has awarded a 100 bps bonus ROE to encourage them

– In approving ITC’s IPO, FERC has shown its support for independent transmission businesses, as they fall only under FERC’s jurisdiction, and do not have to seek cost recovery from state regulators who may have different agendas

• FERC recently proposed policy changes to further encourage electric utilities to sell transmission assets, stating that the current policy has led to too few divestitures

– Policy set in January 2003 allows transmission companies independent of utilities to charge higher rates for the use of their transmission systems

– Proposed change would allow the higher rates even when a utility retains a stake in the transmission company (utility ownership limited to 5% of voting control and 49% of economic interest)

• Combined with other incentives, an independent company may qualify for a return as high as 15% on new transmission lines, compared with about 12% for a typical utility

– In addition, recent tax bill allows utilities to defer taxes on profits from the sale of transmission systems for eight years


Strategic Trends in TransmissionCase Study: ITC Holdings Corp. $331MM IPO (1)

• On July 25, 2005, Morgan Stanley, with Lehman and CSFB, priced the $330.6MM IPO of ITC Holdings at $23/share

– $57.5MM primary shares

– $273.1MM secondary shares

• IPO priced above the filing range of $19-21

• Book was over 17x oversubscribed

• Implied 2005E P/E of 25.5x on a fully distributed basis

• Dividend yield of 4.6% at pricing and 4.0% on a fully distributed basis

Source DealAxis; Morgan Stanley

Notes1. Total IPO proceeds include overallotment2. Overallotment option of 1.875MM shares consists of 100% secondary shares

International9%

U.S.91%

Allocation Summary

Retail20%

Institutional80%

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Overview of Common Stock IPO

Initial S-1 Filing Date March 29, 2005

Launch July 11, 2005

Pricing Date July 25, 2005

Original Filing Range $19.00 - 21.00

Offer Price $23.00

Total Amount Offered(1) $330.6MM

Total Shares Offered(1) 14.375MM

Primary/Secondary 2.5MM / 11.875MM

Overallotment Option(2) 1.875MM

% of Shares Outstanding 43.3%

Common Stock Outstanding Post Offering 33.216MM

Use of ProceedsDebt pay-down and return of capital to

the existing shareholders

Joint Bookrunners Morgan Stanley / CSFB / Lehman

Ticker / Listing ITC / NYSE

Transaction Overview

• ITC priced at $23.00 per share--$2.00 above the original filing range of $19-21• Investors were primarily attracted to ITC's unique business model, combination

of high growth potential and dividend yield, earnings visibility (automatic rate recovery through Attachment O mechanism), attractive rate of return and experienced management team

• An extensive 10-day marketing program was undertaken by management, including 39 one-on-ones, 12 two-on-ones, 2 three-on-ones, 6 conference calls, and 6 group meetings in 17 cities

• Management achieved a one-on-one hit ratio of over 90%• The offering was over 17x oversubscribed (pre-greenshoe) with minimal price

sensitivity, with almost 400 institutional investors in the order book, and 79 investors placing orders for 10% of the transaction

• Retail interest in the offering was almost 16MM shares• ITC’s stock began trading on July 26, 2005 and opened at approximately $27.

ITC closed the day at $26.40


8.7 13.3 16.3 15.0

202.7

22.5

46.9

149.4

92.1

0

50

100

150

200

7/12 7/13 7/14 7/15 7/18 7/19 7/20 7/21 7/22 7/25

Institutional Demand Build-up(MM Shares)

Source DealAxis

210.4


Appendix A

Bio

Bio

Timothy R. Schwarz

Timothy R. SchwarzExecutive Director

Global Energy and Utilities GroupTel: (212) 761-6514E-mail: [email protected]

• Timothy is an Executive Director in the Firm’s Global Energy and Utitilies Group. He joined Morgan Stanley in 1989 as a Generalist in the Mergers & Acquisitions Department.

• Timothy joined the Global Energy and Utilities Group in 1994. Since then he has worked extensively on mergers, restructurings and capital formation strategies for a wide variety of clients both domestically and internationally. He has worked with electric, gas and water utilities. Timothy has spent significant time working with integrated utilities as they develop and execute strategies to address the changing regulatory environment, with particular focus on the generation and transmission segments of the industry

• Timothy received a B.A. in Economics from Wesleyan University in 1983 and an MBA from Harvard University in 1989.

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schwarz investment banking view (morgan stanley)

Documents

utility sector update

utility industry relative

dividend growth

growth investors

morgan stanley forecasts

pm8 morgan stanley

commodity growth kickers

yield curve growth