posted on 31 March 2016
by Richard Stavros
Due to a wave of mergers, utility investors are increasingly in the difficult position of having to evaluate whether the new combined entity will deliver long-term shareholder value.
Happily, most of the recent mergers that have been announced are all-cash deals, meaning that if you're lucky enough to hold the target company, then you can simply take the money and run.
The situation becomes more complicated, however, when a deal entails a combination of cash and stock or is a stock-for-stock transaction. But these types of deals have fallen out of fashion lately.
Then, of course, there's the fact that many of the acquirers are the utility giants that are core holdings in most income investors' portfolios. So even if you own the target company in an all-cash deal, odds are you also own shares of the acquirer.
At Utility Forecaster, we're income investors first and foremost. As such, we generally give our portfolio holdings a wide degree of latitude when it comes to valuation concerns. After all, you don't get paid if you're not invested in a dividend stock.
But we also know that some utility investors trade more frequently than others. And that means they're more attuned to valuation concerns.
Meanwhile, even long-term shareholders must regularly assess whether the fundamentals of their favorite stocks have changed.
While every case is different, mergers and acquisitions (M&A) generally have a poor track record with investors.
In fact, numerous studies confirm this. A Harvard Business Review report showed M&A has a failure rate of anywhere between 50% and 85%. KPMG found that 83% of deals hadn't boosted shareholder returns, while a separate study by A.T. Kearney concluded that total returns on M&A were negative.
More, More, More
When it comes to utilities, it strains credulity to believe that every deal will be able to deliver sufficient value to compensate for their double-digit premiums.
In the Exelon Corp. (NYSE: EXC) merger with Pepco Holdings, which finally (finally!) closed yesterday, the distribution utility's shareholders received a 24.7% premium. In Dominion Resources Inc.'s (NYSE: D) acquisition of Questar Corp. (NYSE: STR), the utility giant agreed to pay a 30% premium. In Southern Company's (NYSE: SO) pending deal to acquire the gas utility AGL Resources Inc. (NYSE: GAS), shareholders will receive a 36% premium.
And Duke Energy Corp.'s (NYSE: DUK) acquisition of Piedmont Natural Gas Co Inc. (NYSE: PNY) involves a whopping 40% premium!
In most cases, the strategic rationale for these mergers is to offset weak electricity demand by diversifying into areas that are expected to deliver a growing stream of regulated earnings.
It still remains to be seen whether that will be the case or if the buying spree will simply be another example of empire-building gone awry.
At the very least, we know that in the near to medium term these deals will stretch most acquirers' credit metrics. Naturally, the rating agencies have taken notice.
In early December, S&P noted:
In other words, the risk from the higher leverage resulting from these deals could offset their purported benefits.
As a result, the three major rating agencies put Southern and Duke on negative outlooks following the announcement of their deals, though both utilities still have investment-grade credit ratings.
Why Utility Mergers Fail
Mergers can fail for any number of reasons, including a clash of business cultures, the difficulty of eliminating redundancies, or a lack of strategic vision or leadership, among others.
These challenges are compounded by the fact that utilities are at the mercy of regulators, and sometimes are forced to make concessions to get the deal done.
Because regulators' constituencies typically include not just ratepayers, but also the politicians who appoint them, they are ultimately political animals.
And that means they're keen on getting utilities to consent to goodies that wouldn't make sense for firms operating in any other sector, such as forcing companies to maintain dual headquarters in order to preserve local jobs; compelling them to offer steep discounts on their product (i.e., rate cuts to ratepayers); or getting them to commit to an investment mandate, like agreeing to spend on renewables or some type of regional economic development.
Once a deal clears all the regulatory hurdles, the costs and benefits of a merger can appear quite different from what they were at the outset.
The Wall Street M&A Problem
Although the number of publicly traded utilities has shrunk over the decades, the number of investment bankers pitching executives to pursue new deals has not. And some C-suites will succumb to such persuasion, even though a banker's merger advice is more often opportunistic than sound.
Cynics likely assume that relationships between executives and investment bankers have always been this way.
Decades ago, however, investment bankers used to act more as a consultant to executives, and investors could count on the fact that the Lazards and Rothschilds of the world were delivering the best strategic advice.
But since the 1970s, most Wall Street investment bankers have essentially become highly paid salesmen, who regularly come calling in the interest of pitching a deal, something that was considered déclassé in the early days of investment banking.
And whatever hope these bankers might have of delivering thoughtful, long-term strategic advice is typically subordinated to the intense competition of a crowded field where getting a deal done at any cost and making the bonus is paramount.
As a result, some utility CEOs that I've known over the years made a practice of banning all investment bankers from the company's premises because of the dubious quality of their strategic advice.
That's why critics have suggested that banking bonuses be staggered over a certain number of years, so that bankers have an incentive to develop deals that have enduring value.
Although some of the mergers that have been announced in recent months do appear to make strategic sense, we'll continue to monitor their developments with the appropriate level of skepticism.
Special message from the author:
Our Super-Secret Stock Pick
In May, we're holding our annual Wealth Summit - this year in Las Vegas. It's a great way for us to meet you, our subscribers, one-on-one, and there are still spaces open if you're interested.
Also this year, we'll be making a special recommendation to those who attend the Summit, and to those who are part of our Wealth Society, whose members receive all the Investing Daily newsletters and other premium services.
It's a fun exercise for us because there are no rules. We don't have to pick a utility stock. In fact, our pick doesn't even need to be a stock: It could be an alternative investment that isn't traded on a public market.
Our publisher says we can't reveal the pick in Utility Forecaster, or even to him before the Summit. But in the weeks ahead, we'll let you in on some of the research we're doing to identify this exclusive pick.
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