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Deal Talk

Utility Takeover Talk

By Roger S. Conrad, on Sep. 21, 2016

Dominion Resources (NYSE: D) completed its acquisition of Questar Corp in a surprisingly swift fashion. Up until last week, the two utilities had called for the deal to close later in the year. But both management teams had done their homework, enabling the deal to quickly secure approvals from shareholders, federal authorities and state regulators.

This transaction stands in stark contrast to the more than two-year slog that Exelon Corp (NYSE: EXC) endured in its effort to acquire Pepco Holdings, a deal that finally closed in March 2016. Meanwhile, NextEra Energy’s (NYSE: NEE) proposed takeover of Hawaiian Electric Industries (NYSE: HE) ultimately failed after more than two years of political pressure.

Dominion Resources’ third-quarter results will reflect the $4.4 billion in cash that the company paid for Questar as well as $1.22 billion in assumed debt. Earnings accretion will start in the fourth quarter of 2016, a period of seasonal strength for Questar’s utilities in Idaho, Utah and Wyoming.

And Dominion Resources plans to drop down Questar’s natural-gas pipelines to Dominion Midstream Partners LP (NYSE: DM). This transaction will help the master limited partnership (MLP) to delivering annual distribution growth of 22 percent over the next several years.

Here are two key takeaways from Dominion Resources closing its acquisition of Questar ahead of schedule.

Takeaway No. 1: Regulatory Relations Remain Critical

Relationships with state regulators remain the single best predictor of the risk to a proposed acquisition in the utility sector—hardly a surprise when you consider the influence their influence on these companies’ long-run growth prospects and financial health.

Supportive regulators helped Dominion Resources to close its acquisition of Questar quickly. But this swift approval is also the best possible sign that the Virginia-based utility will succeed in its long-term plans to help electric utilities in Utah and Wyoming to transition away from coal. This opportunity will drive cash flow growth for Dominion Resources and Dominion Midstream Partners.

When NextEra Energy walked away from its proposed acquisition of Hawaiian Electric Industries, some state official asserted that another offer would emerge—that hasn’t happened yet. Nor should investors bet on a follow-up bid that involves a decent premium; the state effectively hung out an “Not Welcome” sign for would-be buyers.

Even worse, the failure of NextEra Energy’s takeover bid signals that state regulators may not support the massive capital expenditures that Hawaiian Electric Industries needs to make to accommodate the adoption of solar power and the shuttering of oil-fired power plants.

At this point, half a dozen states have created a similarly hostile regulatory environment for utilities and their shareholders. And with populist sentiment on the rise, we may see more states veer in this direction after the November elections.

The financial infotainment industry will focus exclusively on federal election results; however, the November issue of Conrad’s Utility Investor will examine these outcomes and the gubernatorial races, with a specific focus on their implications for the utility sector.

That month, Conrad’s Utility Investor subscribers will also receive my key takeaways and best investment ideas from the Edison Electric Institute’s annual financial conference, the sector’s premier investor conference.

My five best investment ideas from last year’s conference have generated a total return of about 35 percent, compared with the Dow Jones Utilities Average’s 21 percent return and a 5 percent loss for the five stocks I highlighted as Sells.

Needless to say, I look forward to meeting with management teams once again, talking to other investors and sharing my top picks and takeaways with Conrad’s Utility Investor subscribers. On the fence about subscribing? Click here to download a free sample issue of Conrad’s Utility Investor.

Takeaway No. 2: Takeover Premiums Narrow

At this point, any utility with an investment-grade credit rating can issue bonds at the lowest cost in generations. Even junk-rated names in our Utility Report Card can issue debt at favorable terms, as investor demand for fixed-income securities continues to outstrip supply.

Many utility stocks also trade at their highest price-to-earnings ratios and lowest dividend yields since the 1960s—an advantage when making acquisitions, as issuing equity doesn’t hurt a company’s credit rating.

Companies often avoid equity offerings because many investors sell the stock because of perceived dilution. But as we pointed out in the Aug. 26 installment of Income Insights, several utilities have taken advantage of their elevated valuations to issue equity and use the proceeds to fund growth projects and acquisitions that  lay the groundwork for future prosperity.

Although the run-up in utilities’ share prices facilitates deal-making, potential takeover targets have reached multiples where even the strongest acquirer would struggle to offer a meaningful premium.

Accordingly, Southern Company (NYSE: SO) and other deep-pocketed industry leaders have shifted their focus to acquiring assets, primarily gas pipelines and solar-power capacity that operates under long-term contracts.

Target Practice

The completion (or failure) of several ongoing acquisitions involving utilities, coupled with a potential pullback in the broader market or the sector itself, could create an opportunity for at least one more deal this year.

Two targets on which utilities could turn their sights are midstream operators that own strategically located gas pipelines and regulated utilities that have market capitalizations of less than $2 billion.

Duke Energy Corp’s (NYSE: DUK) management team has expressed an interest in adding exposure to gas pipelines, once the utility digests its acquisition of Piedmont Natural Gas (NYSE: PNY) later this year.

After Williams Partners LP (NYSE: WPZ) divests its Geismar ethane cracker, Williams Companies’ (NYSE: WMB) appeal to utilities as a potential takeover target would increase.

However, the master limited partnership’s (MLP) significant exposure to gathering and processing—business lines that involve more exposure to commodity prices—could prompt utilities to pursue joint ventures with Williams Partners on strategically positioned assets.

Southern Company went this route with its purchase of a 50 percent interest in Kinder Morgan’s (NYSE: KMI) Southern Natural Gas system, while Consolidated Edison (NYSE: ED) did a similar deal with Crestwood Equity Partners LP (NYSE: CEQP) earlier this year.

Smaller gas and electric utilities have also emerged as popular takeover targets among private-equity outfits and Canadian power companies seeking to diversify geographically and boost the proportion of their cash flow that comes from regulated operations.

Emera (TSX: EMA, OTC: EMRAF) and Algonquin Power & Utilities Corp (TSX: AQN, OTC: AQUNF) are two Canada-based names that have made a splash in the US market in recent years.

As a rule of thumb, investors should never buy a stock solely for the company’s appeal as a potential takeover target; the underlying business must be able to create value for shareholders if a deal never emerges.

In my more than three decades of covering utility stocks, this approach has resulted in missing out on some deals that proved quite profitable. But this strategy has also helped me to avoid plenty of floundering companies that would have fetched take-under offers in the best-case scenario.

Here’s an addendum to this rule of thumb that’s tailored specifically for this stage in the cycle: Elevated valuations suggest that investors shouldn’t buy any takeover targets unless these companies can realistically command a premium of at least 10 percent to 15 percent above their stock price.

The September issue of Conrad’s Utility Investor highlighted one rare exception to this rule: A small-cap water utility which trades at an undemanding valuation and recently won a contract that should double its revenue in coming years.

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