Sempra Energy’s Takeover Offer for Oncor Electric Delivery: Fourth Time’s a Charm?

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“Don’t California my Texas” is more than a T-shirt slogan. In many parts of the Lone Star State, it’s a battle cry against anything related to taxes, regulation and Washington, DC.

Nonetheless, by this time next year, a major California utility likely will own Texas’ largest electricity grid, which includes 3.4 million meters and serves more than 10 million customers.

Sempra Energy’s (NYSE: SRE) $9.45 billion bid for Energy Future Holdings, which owns an 80 percent interest in Oncor Electric Delivery, trumps Berkshire Hathaway’s (NYSE: BRK.A, BRK.B) $9 billion takeover offer; apparently, the Warren Buffett-led organization elected to try to collect its $270 million break-up fee instead of preparing a counterbid.

The California-based utility’s takeover offer follows previously unsuccessful attempts by Florida-based NextEra Energy (NYSE: NEE) and Hunt Consolidated.

These failed bids secured approval from the Federal Energy Regulatory Commission, the US Dept of Justice and the bankruptcy court overseeing Energy Future Holdings’ case. However, neither offer satisfied the Public Utility Commission of Texas.

The rejection of NextEra Energy’s bid prompted the company to allege that state regulators had moved the goalposts for deal approval and refuse the Public Utility Commission’s demands to keep Oncor Electric Delivery’s finances and operations separate.

By agreeing to about 40 concessions that the Public Utility Commission required for the transaction to move forward, Berkshire Hathaway eliminated a lot of heartache and acrimony from the regulatory approval process.

However, the Warren Buffett-led company submitted a lower purchase price to offset these concessions, irking Elliott Management, which owns a significant proportion of the bankrupt Energy Future Holdings’ debt. The activist hedge fund threatened to block Berkshire Hathaway’s deal and propose an alternative takeover offer.

Sempra Energy’s takeover offer involves a higher premium, which should satisfy Elliott Management, and concessions that should placate the Public Utility Commission of Texas.

Low Cost of Capital is Key

Equally important, Wall Street has given the deal its seal of approval.

Sempra Energy’s bond prices haven’t moved perceptibly since the transaction was announced earlier this week, with its 4.45% Notes of 03/15/44 yielding only 3.61 percent to maturity. Fitch Ratings also affirmed the California-based utility’s BBB+ credit rating.

Meanwhile, Sempra Energy’s common stock has avoided the knee-jerk selloff that often occurs after a company announces a major acquisition. The stock still trades at a demanding 22 times trailing earnings, near an all-time high, and yields about 2.8 percent.

Six of the seven Wall Street analysts who rate the stock a Buy reaffirmed their opinions after Sempra Energy announced its proposed acquisition of Oncor Electric Delivery, while the eight Hold ratings appear to be for valuation reasons.

Sempra Energy’s low cost of debt capital and strong equity currency are critical to this deal’s economics, especially when you consider the offer price and the concessions to appease Texas regulators.

The reorganized Energy Future Holdings will issue $3 billion worth of investment-grade debt to fund the transaction, with Sempra Energy on the hook for the other $6.45 billion, 60 percent of which will come from debt and equity issuance. The remainder of which will come from third-party investors.

When all is said and done, Sempra Energy will own a 60 percent interest in Energy Future Holdings and a 40 percent stake in Oncor Energy Delivery. On a conference call to discuss the transaction, Sempra Energy’s management indicated that increasing its ownership to 100 percent would be a longer-term goal.

Sempra Energy expects the acquisition to close in the first half of 2018, with the first bankruptcy court hearings scheduled for Sept. 6. Given the length of the bankruptcy proceedings and the support of major creditors, Sempra Energy’s offer should gain approval. Federal regulators that signed off on NextEra Energy’s failed bid also appear likely to approve the most recent offer.

Texas Hold ‘Em

The Public Utility Commission of Texas remains the wild card. The regulator’s decision to scuttle Hunt Consolidated and NextEra Energy’s bids came as a bit of a surprise because of the state’s pro-business reputation.

Will the Public Utility Commission move the goalposts once again, and how would Sempra Energy react if the regulator opts to play hardball? The $3 billion in debt on Energy Future Holdings’ balance sheet could present a sticking point.

But the deal economics arguably give Sempra Energy more leeway than some might expect. For one, the addition of Oncor Electric Delivery will increase the proportion of the company’s operating income that comes from regulated utilities to more than 81 percent—a major plus at a time when it continue to pursue capital-intensive LNG (liquefied natural gas) export project in Louisiana.

Cameron LNG has encountered construction delays that have pushed the facility’s commercial start date to late 2019, at the earliest. Although contractual agreements for engineering, procurement and construction provide a degree of protection, cost overruns and an oversupplied market could challenge project economics.

Buying Oncor Electric Delivery wouldn’t eliminate these challenges. But just as Southern Company’s (NYSE: SO) purchase of AGL Resources improved its ability to absorb cost overruns at the Vogtle nuclear power plant, adding a major regulated utility would further insulate Sempra Energy’s balance sheet and operating income from an adverse outcome at Cameron LNG.

Moreover, Oncor Electric Delivery’s rate base has grown at a much faster pace than Sempra Energy’s regulated utilities in California.

The Texas transmission and distribution company’s revenue has increased at an average annual rate of 4.7 percent since 2012, while its current budget calls for $7.5 billion worth of capital expenditures on its power lines through 2021.

And although the Public Utility Commission of Texas scrutinizes mergers and acquisitions closely, the regulator has demonstrated a willingness to support capital spending with rate-base increases.

What about the $3 billion in additional debt on Energy Future Holdings’ balance sheet and Sempra Energy’s pledge to pay this down within seven years of the acquisition closing?

Sempra Energy’s low-cost of debt and equity capital should enable the parent to live up to these promises, while Energy Future Holdings’ interest expense and gearing should pale in comparison to the leverage involved when a consortium of KKR & Co LP (NYSE: KKR), TPG Capital and Goldman Sachs Capital Partners took TXU Corp private in 2007.

Where They Stand

Sempra Energy likely has the winning bid for Energy Future Holdings, though the Public Utility Commission of Texas could require some adjustments and concessions. The transaction would give Sempra Energy a new growth platform and create potential synergies with its expanding portfolio of natural-gas pipelines and generation capacity in Mexico.

The California-based utility’s historically elevated valuation keeps us on the sideline, but the best-in-class utility offers exposure to several appealing growth stories and would make an excellent long-term holding at a more reasonable price.

Don’t cry for Berkshire Hathaway or NextEra Energy, either. Even if these former suitors don’t receive the entire break-up fee they claim they’re owed, both companies’ scale and access to low-cost capital make them natural consolidators in the utility sector. They’ll find other deals.

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