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Mergers & Acquisitions

Utility M&A Update

By Roger S. Conrad on Sep. 7, 2016

We discussed the ins and outs of Enbridge’s (TSX: ENB, NYSE: ENB) proposed acquisition of Spectra Energy Corp (NYSE: SEP) in an Alert emailed to Conrad’s Utility Investor subscribers yesterday. The market’s reaction to this deal catalyzed a sudden selloff in Spectra Energy Partners LP (NYSE: SEP), creating a buying opportunity for savvy investors.

Here we update our takes on the various pending acquisitions in what has proved to be a particularly active year for deals involving the more than 200 essential-services stocks that we cover in our Utility Report Card.

(Click table to enlarge.)Deal Table

A Bite of the Apple is Better than the Whole

Southern Company (NYSE: SO) last week completed its purchase of a 50 percent stake in Kinder Morgan’s (NYSE: KMI) Southern Natural Gas system. This deal should boost the utility’s earnings immediately and increase the firm’s control over its incoming gas supply.

Southern Company also received the Federal Energy Regulatory Commission’s approval to buy a 100-megawatt solar farm in Nevada from cash-strapped SunPower Corp (NSDQ: SPWR).

The speed with which Southern Company closed these purchases contrasts sharply with the months it needed to complete its acquisition of AGL Resources—and that deal that went through relatively quickly by the utility sector’s recent standards. In this instance, friendly relationships with state regulators helped to grease the wheels.

We expect this focus on asset acquisitions to continue in the utility sector, in part because shares of most takeover targets in the space trade near record valuations.

Do Two Rocks Tied Together Sink Faster?

As we explained in Steer Clear of These Kissing Cousins, Tesla Motors’ (NSDQ: TSLA) proposed acquisition of SolarCity Corp (NSDQ: SCTY) looks like a bailout of the ailing solar-power company, not a transaction that will unlock significant synergies.

SolarCity bled about $1.25 billion over the first six months of 2016: $389 million in negative operating cash flow and $857 million worth of purchasing costs for rooftop solar-power systems that the firm will lease to customers. Tesla Motors consumed $610 million in cash over this period.

This incestuous deal has received antitrust clearance and likely will secure shareholder approval later this year. But investors should steer clear of these stocks because both companies lose more money with each incremental sale.

With competition heating up for electric vehicles, residential solar systems and energy storage, SolarCity and Tesla Motors’ reverse economies of scale will only worsen. Both stocks have sold off in the roughly two months that have passed since news of a potential deal hit the tape—and there’s probably more downside to come.

A Winning Deal

NextEra Energy (NYSE: NEE) in late August reached an agreement to acquire Oncor Electric Delivery, which houses the electricity distribution and transmission assets of Energy Future Holdings, formerly TXU Corp.

The deal’s fate rests in the hands of the bankruptcy court and the Public Utility Commission of Texas, both of which must approve the transaction and Energy Future Holdings’ overall reorganization plan. Earlier this year, regulators rejected a takeover bid led by Hunt Consolidated that would have involved significantly more complexity.

Because NextEra Energy owns and operates pipelines and generation capacity in Texas, regulators may require some guarantee of separation. However, the Florida-based utility is also one of the leading renewable-energy producers in the US, an expertise that would dovetail nicely with Texas’ push to develop more wind power.

Management expects the acquisition of Oncor to be accretive to NextEra Energy’s earnings in the near term and over the long term.

With NextEra Energy’s stock sporting a dividend yield of 2.9 percent and a price-to-earnings ratio of more than 21 times trailing earnings, using equity as a currency to fund part of the transaction cost makes eminent sense—though some investors may grouse.

The utility’s October 2044 bonds also yield just 3.25 percent to maturity. And the company could raise capital by dropping down some of its renewable-energy capacity or interests in gas pipelines to NextEra Energy Partners LP (NYSE: NEP).

Selling Targets

With utility stocks trading at frothy valuations and regulatory approvals often dragging on for longer than expected, investors sitting on big gains in most of the target companies in our table should take the money and run.

Only SolarCity trades at a meaningful discount to its offer price—a valuation gap that’s more than justified when you consider the potential downside in Tesla Motors’ stock. If the automaker’s stock were to retreat to its 52-week low of $141, the offer for SolarCity would tumble by 16 percent, to about $15.50 per share.

ITC Holdings Corp (NYSE: ITC) is the lone takeover target in our table worth holding for two reasons:

  • Shareholders will receive a stake in Fortis (TSX: FTS), a Canada-based utility with strong growth prospects over the long run; and
  • If the deal falls through, ITC Holdings has ample opportunity to grow its own through much-needed investments in US electricity transmission.

Duke Energy Corp’s (NYSE: DUK) blockbuster acquisition of Piedmont Natural Gas (NYSE: PNY) appears set to close early in the fourth quarter, at which point CEO Lynn Good has indicated the utility will look to buy midstream gas assets.

Dominion Resources (NYSE: D) could also be on the hunt for gas pipelines after the Virginia-based utility closes its proposed purchase of Questar Corp (NYSE: STR). The odds that this deal will close in the fourth quarter increased sharply when the Utah Public Service Commission signed off on the transaction with few conditions. All that’s required now is for the Wyoming Public Service Commission to approve a settlement agreement already reached between the two utilities and major customers.

Duke Energy and Dominion Resources will be much stronger companies after these acquisitions close. In fact, Dominion Resources increased its guidance for 2017 earnings growth to between 7 and 8 percent from the previous range of 5 percent to 6 percent.

On the other hand, the all-cash takeover offers leave little upside potential for Questar and Piedmont Natural Gas.

The same goes for Talen Energy Corp (NYSE: TLN). Although Riverstone Holdings’ $5 billion cash offer has encountered some opposition from shareholders, the deal likely will close later this year.

Investors should also cash out of Empire District Electric (NYSE: EDE) and Westar Energy (NYSE: WR), as the regulatory approval process could drag on because of resistance from the Missouri Public Service Commission (MPSC).

In fact, the MPSC staff has recommended that Algonquin Power & Utilities Corp’s (TSX: AQN, OTC: AQUNF) acquisition of Empire District Electric be rejected in its current form. With Empire District Electric’s stock trading within pennies of the Canadian power company’s all-cash offer of US$34 per share, investors have little incentive to wait this one out.

Meanwhile, the MPSC has challenged Great Plains Energy (NYSE: GXP) and Westar Energy’s assertion that their proposed combination doesn’t require the state’s utility regulator to approve the deal. The Dept of Justice also opened an investigation of the deal in early August, a process that could result in further delays.

Westar Energy’s stock trades at a sizable discount to the total value of Great Plains Energy’s takeover offer. As we explained in M&A Analysis: Great Plains Energy and Westar Energy, this long overdue tie-up would result in a much stronger company. However, if the deal falls through, Westar Energy’s stock would almost certainly tumble into the mid-$40s.

As for BCE’s (TSX: BCE, NYSE: BCE) takeover offer for Manitoba Telecom Services (TSX: MBT, OTC: MOBAF), shareholders and local regulators support the deal. Unfortunately, tougher reviews from the Competition Bureau and the Canadian Radio-television and Telecommunications Commission remain.

Manitoba Telecom Services rates a Sell because of the uncertainty surrounding the deal and lack of further upside. With or without a deal, BCE will remain a dominant player in Canada’s telecom market.

Essential Reading on Essential Services

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Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b