Utilities have sprinted ahead of the broad market so far this year, with the Dow Jones Utilities Average generating a total return of 16.4 percent versus about 8 percent for the S&P 500.

As equity valuations have crested new highs, some utilities are turning to mergers and acquisitions to help bridge the divide between current market valuations and future earnings growth. Among their targets are smaller, fast-growing utilities and distribution utilities that offer greater synergies as well as new value from the technological disruption that’s roiling the industry.

In terms of bigger utilities buying smaller ones, the recently announced acquisition by Wisconsin Energy Corp (NYSE: WEC) of Integrys Energy Group Inc (NYSE: TEG) is indicative of this type of deal. Similarly, Texas-based CenterPoint Energy Inc (NYSE: CNP) is contemplating a bid for Louisiana-based Cleco Corp (NYSE: CNL), which is also considering offers from other firms.

Utilities are also looking at companies with robust distribution systems, a development that we detailed extensively in the lead article of the latest Utility Forecaster. Industry insiders believe this part of the utility system will become increasingly valuable as the grid accommodates more distributed technologies and new high-tech systems are adopted to manage these resources.

Recent deals on this front include Exelon Corp’s (NYSE: EXC) pending acquisition of Washington, DC-based Pepco Holdings Inc (NYSE: POM).

And there’s speculation that Dominion Resources (NYSE: D) is conducting “soft” merger talks with NiSource Inc (NYSE: NI). In addition to its electric business, NiSource’s natural gas distribution and storage infrastructure would also be complementary to Dominion’s midstream assets.

Meanwhile, not to be outdone, Warren Buffett’s Berkshire Hathaway Energy in late June announced the purchase of Canada-based electric transmission company AltaLink from parent SNC-Lavalin Group (TSX: SNC).

While these deals are primarily designed to boost earnings growth, they can also help protect utilities against headwinds from service territories with struggling economies, as well as from technological disruption and changing market dynamics.

And as bankers from Morgan Stanley and Wells Fargo observed at the recent Deloitte Energy Conference, these acquisitions can also help firms stave off other challenges, such as declining returns on equity allowed by regulators and an eventual increase in the cost of capital during a rising-rate environment.

These bankers also noted that new financial sector regulations resulting from the 2008 financial crisis have had the effect of increasing the cost of capital, as banks have fewer options to hedge their risks from lending.

Of course, some of these negative trends may work themselves out. For instance, when commenting on the technological threats facing the industry, Eric Fornell, vice chairman of Wells Fargo’s energy and power team, said, “The death spiral of the utilities industry is greatly exaggerated.”

Despite the economy’s slow rebound, as growth picks up, the corresponding growth in the utility sector will help it surmount this problem. The real problem, Fornell argued, is that regulators are not giving full value to the existing grid, so utilities are not being compensated for being a backup to customers who choose to adopt distributed generation technologies such as solar.

Moreover, Jeff Holzschuh, chairman of Morgan Stanley’s Institutional Securities Group, suggested that current equity valuations will not persist for all utilities: “You [couldn’t] dream up a much better scenario of valuation for utility equities than a perceived low volatility in the market, low interest rates, and low commodity prices.”

The problem, as Holzschuh notes, is that many companies are operating in low- or no-growth environments, while price-to-earnings valuations (P/E) imply more than 8 percent earnings growth. “No one is growing at 8 percent. The pressures on prices are … to the downside,” he said.

This growth deficiency can be observed when looking at some of the aforementioned companies on a pre-merger basis. Take, for instance, Exelon’s acquisition of Pepco. Despite trading at a trailing 12-month P/E of 17.4, Exelon was expected to grow earnings at a paltry rate of 0.99 percent annually over the next five years. By contrast, Pepco was forecast to grow earnings by 6.96 percent annually.

Wisconsin Energy offers another case in point. The company is trading at a trailing 12-month P/E of 17.60. But analysts forecast annual earnings growth of 5.5 percent over the next five years. For benchmarking purposes, a firm with a long-term average P/E of around 15 should produce an earnings yield of 6.67 percent.

As a general rule, companies do not return all their earnings in a given year to shareholders. Instead, they pay out a lesser amount. As a result, a stock’s earnings yield usually differs from its dividend yield.

Putting these concepts into practice, Benjamin Graham, the father of value investing, has recommended that investors only buy a stock when its P/E ratio is equal to or lower than the sum of the earnings yield plus the growth rate (See Chart A).

Chart A: Will Mergers Bridge the Market Valuation-Earnings Growth Divide?
Source: YCharts

Note: In most cases, firms with a PEG ratio greater than 1 are considered overvalued, while those with a PEG ratio less than 1 are considered undervalued. 

Clearly, some of the firms being acquired were far from being undervalued. And, in fact, the bankers at the Deloitte Energy Conference noted that many acquisitions have occurred at a premium. The reason is that some of the value in these deals comes from the strategic benefits to the acquirer, such as cost-savings and long-term plays on technology, rather than pricing.

Though we believe these deals will ultimately enhance the value of these utilities, in some cases, acquisitions can be a short-term drag on earnings growth as firms work toward integrating new assets.