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posted on 18 February 2016

The Great Gas Grab: Whos Next?

by Ari Charney, Investing Daily

Mergers and acquisitions in the utility space are coming fast and furious these days. In just the past two weeks, $19.6 billion of acquisitions have been announced, an amount that's equivalent to slightly more than half the total value of last year's deals.

The two biggest deals are for stocks we'd only just added to the portfolios in recent months: Questar Corp. (NYSE: STR) and ITC Holdings Corp. (NYSE: ITC).

Questar, the vertically integrated natural gas distributor that we added to the Income Portfolio back in late November, is getting picked up by Dominion Resources Inc. (NYSE: D) at a nearly 32% premium to the price at which we recommended it.

Meanwhile, pure-play electric transmission company ITC is getting taken out by Canadian utility giant Fortis Inc. (TSX: FTS, OTC: FRTSF), at a nearly 27% premium to the price at which it was added to the Growth Portfolio last June.

And the market clearly thinks there's more to come.

Some of the premiums acquirers are willing to pay have been absolutely staggering, creating a happy dilemma for income investors: The joy of booking a huge capital gain versus the need to find another reliable dividend payer to replace a lost income stream.

Meanwhile, some of the biggest acquirers also happen to be among the core holdings of most utility investors' portfolios. This creates a bittersweet scenario, whereby the huge premiums we enjoy on one side of the deal result in higher leverage for the companies we hold on the other side of the deal.

This has not gone unnoticed by credit-rating agencies, which are already growing leery of the huge amounts of debt many utilities have racked up in recent years, though they also concede that so far such spending has been manageable.

As Standard & Poor's put it:

"Recent acquisition activity has been a little troubling, with above-average premiums being paid and, consequently, a more debt-financed profile to the transactions."

Cashing In

Right now, one of the biggest trends in utility M&A is electric utility giants pursuing natural gas distributors.

We've been writing about this trend for some time, but it's really come to fore over the past six months, with Southern Co. (NYSE: SO), Duke Energy Corp. (NYSE: DUK) and Dominion all announcing deals to acquire gas distributors at premium prices.

The strategic rationale for such deals is to diversify into another stable regulated earnings stream with a tailwind from rising gas demand in order to help offset weak or declining electricity demand.

There's also an opportunity for an earnings boost by rate-basing upgrades to aging pipes and expanding infrastructure to meet new demand.

"Gas companies have more growth opportunities," observed Jay Rhame, who manages the Reaves Utilities ETF, in an interview with Bloomberg

. "A lot of the gas systems were built out 50 or 60 years ago. They need replacement work and a lot of state commissions have been positive on safety-like spending."

However, even if such deals prove accretive to earnings, credit raters can't ignore the elevated risk resulting from acquirers' higher leverage.

They also worry that such premiums could set a precedent for future deals. And there certainly is evidence of this in terms of valuations.

With most gas distributors owned by municipalities, the pool of publicly traded pure-play gas distributors is small (and getting smaller with each new deal). Excluding the three gas utilities that are in the process of being acquired, there are now roughly a dozen gas distributors that remain standalone entities, with a total market capitalization of around $30.4 billion.

Income investors love gas distributors since they pay steadily rising dividends, while being among the lowest-risk players in the utility space. And the rising tide of M&A has further lifted share prices in this niche.

Consequently, there's now a lot of money chasing a relatively small corner of the market. Indeed, the average price-to-earnings ratio (P/E) for this tiny cohort is 21.6. That's well above the average utility, at 16.7, and even the broad market, at 16.8.

No GasCo Left Behind

Part of the sudden acceleration in dealmaking is likely due to a desire on the part of acquirers to make transactions while rates remain at historic lows.

Then there's human nature. Potential suitors don't want to miss out on an attractive takeover target. This mindset is best encapsulated by J.P. Morgan's head of power and utilities, who recently quipped,

"If you're not telling the girl next door that you love her, one day you may wake up and see her driving off with another guy to her wedding."

Of course, he's an investment banker, so naturally he wants to encourage as much dealmaking as possible.

But the industry, itself, is similarly enthusiastic about the prospect of consolidation.

At a recent M&A conference, Avangrid CEO Jim Torgerson said:

"I think there's more to do. There are still a lot of midsize utilities that are single-state, and I think the opportunities are tremendous."

Analysts expect the newly formed and under-leveraged Avangrid Inc. (NYSE: AGR), the post-merger entity that combines the former UIL with Spanish utility giant Iberdrola's U.S. assets, to serve as a launchpad for further acquisitions.

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