Editor’s Note: Roger Conrad and Elliott Gue will host a free webinar on energy markets and stocks at 1:30 p.m. PST, Sept. 1. Learn more about this online event and reserve your place today. Roger will also give a presentation to the Research Triangle chapter of the American Association of Individual Investors in Cary, North Carolina, on Oct. 8. Learn more about attending this event.
Buying low and selling high is every investor’s objective. However, the same logic doesn’t apply to how the market views secondary equity offerings, even if the stock in question trades at or near a record valuation.
Some investors’ knee-jerk reaction to a follow-on offering is to liquidate their position because of potential dilution or concerns that issuing additional equity may be symptomatic of some underlying weakness.
Consider the recent example of Southern Company (NYSE: SO), which on Aug. 16 announced plans to issue 32.5 million additional shares to fund its $1.47 billion purchase of a 50 percent interest in Kinder Morgan’s (NYSE: KMI) Southern Natural Gas (SNG) pipeline system.
The gas and electric utility’s secondary offering hardly came as a surprise and occurred when the stock traded near a record valuation. And as we explain in Deals, Deals, Deals (and Earnings), management expects the SNG joint venture to be immediately accretive to Southern Company’s earnings. The transaction also makes a great deal of strategic sense for both companies.
Nevertheless, Southern Company’s stock gave up roughly 5 percent of its value on Aug. 7, with trading volume spiking to more than four times the previous day’s session. Sellers probably regret their move already; the shares have recovered from this short-lived swoon. But this seller’s remorse will only worsen.
Not only did Southern Company issue equity at exactly the right time—when the stock traded at a frothy valuation—but the sale also finances an acquisition that creates significant growth opportunities and gives the utility more leverage to growing demand for natural gas within its service territory.
The Dow Jones Utilities Average trades at about 19.5 earnings and yields 3.2 percent—valuations that were last seen when the sector topped out in the early 1960s, late 2000 and early 2008.
In all three instances, utility stocks failed to maintain these lofty multiples for long. Although the primary catalysts for each subsequent selloff vary widely, the end result was the same: The Dow Jones Utilities Average reverted to price-to-earnings ratios in the mid-teens and dividend yields of 4 percent to 5 percent.
More than 70 essential-service companies in our Utility Report Card earned Sell ratings in the August issue of Conrad’s Utility Investor, while only a couple dozen of the more than 200 names that we cover traded below our value-based buy targets.
This environment favors reaping over sowing. Taking at least a partial profit in names that have rallied to unsustainably high valuations can free up some dry powder for future buying opportunities.
At the same time, expensive valuations make it an ideal time for utilities to sell their shares to a dividend-hungry public.
An extremely low cost of debt capital likewise has contributed to the recent upsurge in merger and acquisition activity in the utility sector, while growing demand for natural gas and renewable energy creates ample opportunity for capital expenditures.
Conversely, only foolish management teams would pay top dollar to repurchase shares at these levels.
Over the past several months, we’ve encouraged Conrad’s Utility Investor subscribers to take advantage of utility and telecom stocks’ recent outperformance to rebalance their portfolios and take some profits off the table. We’ve also cashed out of riskier names that we wouldn’t want to hold through a bear market.
As investors with a longer time horizon, we applaud the best-in-class utilities that have taken advantage of yield chasers and momentum-seeking traders to issue equity at lofty valuations.
Not only will raising capital at such low costs further strengthen utilities’ balance sheets today, but the proceeds will also go toward projects and acquisitions that will power shareholders’ returns down the line—making the stocks all the more attractive when the inevitable selloff occurs.
For example, Consolidated Edison (NYSE: ED) in mid-May sold 10.12 million additional shares near the stock’s all-time high to fund the purchase of a 50 percent interest in Crestwood Equity Partners LP’s (NYSE: CEQP) natural-gas pipelines and storage assets in Pennsylvania and southern New York.
Meanwhile, Duke Energy Corp (NYSE: DUK) sold 10.64 million shares in March to fund a portion of its pending acquisition of Piedmont Natural Gas (NYSE: PNY).
NextEra Energy (NYSE: NEE) likely will issue equity and recycle capital by dropping down some of its midstream-gas and renewable-energy assets to its yieldco, NextEra Energy Partners LP (NYSE: NEP), to help pay for its blockbuster purchase of Oncor Energy, which houses the former TXU Corp’s electricity distribution assets.
Dominion Resources (NYSE: D) issued 10.4 million shares in April and plans to recycle capital by dropping down some of Questar Corp’s (NYSE: STR) midstream assets to Dominion Midstream Partners LP (NYSE: DM).
In addition to these follow-on equity offerings, many utilities have at-the-market issuance programs that sell shares on a regular basis. Dividend reinvestment plans also issue equity to shareholders instead of a quarterly cash disbursement.
These efforts can generate significant sums of cash to invest in the business. Exelon Corp (NYSE: EXC), for example, issued equity now worth $2.5 billion over the 12 months ended June 30, 2016, to help pay for the acquisition of Pepco Holdings.
As we explained in Exelon and Pepco Move Closer to Consummating Their Union, this transformational deal tilts the acquirer’s earnings and growth prospects toward its regulated utilities and away from the ongoing challenges in wholesale electricity markets.
Management expects to fund $25 billion worth of investment in its regulated operations, primarily with revenue from its wholesale generation business. But with a low cost of equity and debt capital (Exelon’s 30-year bonds yield 3.46 percent to maturity), the utility can afford to do a lot more.
Utilities’ primary competitors in renewable energy and gas pipelines generally have much higher costs of capital.
Although midstream master limited partnerships’ stocks and bonds have rallied hard from their February lows, even the strongest pipeline companies pay 1 to 2 percentage points more than middle-of-the-road utilities when they issue units or fixed-income securities.
Solar-power companies find themselves at an even bigger disadvantage, as their stocks have plummeted and the yieldcos that they used to recycle capital have been shut out of debt and equity markets.
Even shares of industry leader First Solar (NSDQ: FSLR) have given up 43 percent of their value, while would-be disruptor SolarCity Corp’s (NSDQ: SCTY) stock has plummeted by 55 percent—and the pain would be worse if Tesla Motors (NSDQ: TSLA) didn’t step in with a takeover offer that’s more of a bailout than anything else.
These companies and their peers lack the capital to compete for assets and growth opportunities; in fact, as we explain in The Sun is Setting on SolarCity Corp, But Renewable Energy is for Real, many solar-power outfits’ best hope for survival is to partner with incumbent utilities.
Here’s hoping that the management teams at Exelon and other utilities continue to make hay while the sun shines. The recent spate of equity issuance is yet another sign of frothy valuations in the utility sector, but these moves set the stage for future growth. Investors should bide their time and wait for a pullback to buy our favorite utility stocks.
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