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posted on 01 June 2016

An Income Dream Deferred

by Ari Charney, Investing Daily

Investing Daily Article of the Week

It was always a bit of a longshot: Buying a bankrupt utility's most prized assets - 119,000 miles of transmission and distribution infrastructure serving 10 million customers - and putting them in a real estate investment trust (REIT) in order to avoid an estimated $250 million in annual taxes. Talk about having your cake and eating it too.

That was the plan hatched by an investor consortium led by oil and gas producer Hunt Consolidated for Texas-based Energy Future Holdings' (NYSE:EFH) subsidiary Oncor's wires.

For a time, the bold move to put utility assets in a REIT structure, a concept that Hunt previously pioneered with InfraREIT Inc. (NYSE: HIFR), inspired other Texas utilities to consider a similar plan for their own wires, namely CenterPoint Energy Inc. (NYSE: CNP).

And that had us salivating at the possibilities. For one, the wires are one of the most valuable assets of the 21st century electric utility. A big part of that is due to the shift from central station power to decentralized generation from renewable sources, such as wind and solar. All those renewable megawatts coming on line need connections to the grid.

To incentivize this buildout, the Federal Energy Regulatory Commission (FERC), which oversees interstate electric transmission infrastructure, has authorized returns on equity (ROE) for wires that are typically a couple of percentage points higher than the ROEs authorized for other types of utility infrastructure.

Take that high-returning infrastructure and put it in a tax-advantaged investment vehicle that's required to pay out at least 90% of its taxable income as distributions to unitholders (i.e., a REIT), and you pretty much have the Holy Grail of income investments.

But the biggest hurdle for a so-called wires REIT was always going to be securing the approval of regulators.

After all, by allowing such a structure, state regulators could end up conceding considerable authority to the feds, especially if a wires REIT starts pursuing interstate empire-building.

At this stage, however, the main sticking point was taxes. Since regulators are there to advocate on behalf of ratepayers, they argued that ratepayers should share in the REIT's tax savings.

But some of the investors in Hunt's consortium balked at those terms, as well as others, and the group decided to abandon its bid, though it's considering filing a new one.

Back on the Auction Block

That means Oncor is up for sale again. And there are a lot of interested suitors.

Kit Konolige, a Bloomberg utilities analyst, observed :

"Pretty much anyone would be looking at Oncor and thinking about it now"

He told Bloomberg's news service:

"We have seen a lot of utilities bought by other utilities or infrastructure funds and certainly from offshore interests as well."

The most frequently tipped bidder is one that had previously been in contention for Oncor's assets: Florida-based NextEra Energy Inc. (NYSE: NEE). The utility holding company, which is among the most forward-thinking operators in the sector, made an unsolicited offer for Oncor last November - its second run at the company in the past two years - but the bankruptcy judge reviewing EFH's restructuring plan blocked NextEra's bid due to timing.

NextEra uses the steady cash flows generated by its regulated Florida Power & Light utility, which accounts for about 65% of operating income, to invest in renewable energy projects across the country, and those generate the balance of operating profits.

NextEra's renewables unit is largely oriented toward wind power, which accounts for about 68% of the megawatts in its portfolio. Indeed, the firm is one of the largest wind-power generators in North America. And a number of its wind farms are concentrated in Texas, while the firm also owns Houston-based retail electricity provider Gexa Energy LP. So NextEra could put Oncor's wires to good use.

Of course, NextEra is currently in the most of a protracted bid for Hawaiian Electric Industries Inc. (NYSE: HE).

The $55 billion utility first announced the $4.3 billion deal nearly 18 months ago. But Hawaii's regulators and politicians have repeatedly opposed the deal. Usually such intransigence is just a negotiating tactic to extract concessions from the acquirer.

If, however, that was the intent, then Hawaii's bureaucrats and politicos may not get any sweeteners. After June 3, NextEra can terminate the deal by paying a $95 million break-up fee.

NextEra is rumored to be interested in making a third run at Oncor, according to two sources who spoke to Bloomberg on condition of anonymity. And analysts are already speculating accordingly.

Guggenheim Securities analysts wrote that Oncor's infrastructure would be "a great strategic fit" for NextEra, which can afford to walk away "from the uphill battle in Hawaii."

That makes us wonder whether NextEra is the unnamed suitor that The Wall Street Journal reported is preparing to file a rival plan for Oncor's business. Although company spokesmen were mum about this development, a comment from NextEra's lawyer suggests that, at the very least, the company is weighing another bid.

It should be noted that, in contrast to Hunt, NextEra would likely not pursue a REIT structure for these assets, since it hasn't in the past.

If NextEra does go for Oncor, it would easily be the biggest deal in the utility space this year. NextEra had previously offered $18.2 billion for the EFH subsidiary, but lost out to Hunt when it dropped its bid by $900 million. Presumably, any new offer would be around $18 billion or so. But it could well be worth it.

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