Two months ago, shares of Potash Corp of Saskatchewan (TSX: POT, NYSE: POT) were hardly considered a hot commodity. Investors fretted about over supply of this key element, which is used in fertilizer, particularly in what appeared to be a weakening economy. The share price languished well under $100.
That, however, was before Australian mining giant BHP Billiton (NYSE: BHP) offered up $130 per share in cash to buy out the company. Suddenly, everyone was concerned they would get too little for their shares. Potash Corp’s board rejected the bid almost immediately, and the rumor mill went into over drive that either BHP or someone else (read: China) would soon be offering up a lot more.
The upshot: Shares of Potash surged toward $150 in a matter of days. And judging by the torrid trading volumes we’ve seen in the stock of late, speculation is raging that it’s going even higher. In fact, I’ll bet my bottom dollar there aren’t a lot of people thinking of selling, despite the staggering profits garnered in such as short period of time.
Potash Corp pays only a very modest dividend. So it’s a safe bet the stock is not in that many income-oriented portfolios. For anyone who does want my opinion, we track the stock in Canadian Edge, and the takeover deal is the subject of this week’s Maple Leaf Memo, penned by CE Associate Editor David Dittman.
The Potash Corp example does, however, illustrate several things that affect income investments of all stripes, particularly as merger activity heats up across corporate America. First, not a lot of investors–including the big institutions that dominate trading–are paying a lot of attention to value.
Up until the BHP offer, for example, there weren’t many investors willing to look beyond economic fears to buy this company, despite its commanding position in the potash market and a share price at barely a third its 2008 high. Those who step up to buy value when it appears, therefore, can not only grab assets cheap but are putting themselves in position for possible windfall capital gains.
That’s basically the rationale for buying the takeover bets featured in the September Utility Forecaster Feature Article. Unless you have a seat on the board and are willing to deal illegally on insider information, the best you can do betting on takeovers is either to bet on the success of deals in progress–very possible with utilities given the lead times needed to win regulatory approval–or else buy great companies trading cheaply and with assets that should be in demand.
Looking ahead, for example, good essential-service assets going cheaply include clean-power generators, smaller regulated utilities that can provide scale to larger companies, energy infrastructure focused on natural gas liquids, rural phone lines and select water distribution systems.
Carbon regulation legislation probably has a worse chance of passing Congress this year than the hometown Washington Nationals do of coming back from last place to win this year’s World Series. Renewable energy assets, however, remain in high demand, thanks largely to state mandates for utilities to switch substantial amounts of generating capacity to them over the next few years.
This week, for example, nuclear power leader Exelon Corp (NYSE: EXC) announced it would buy Deere & Co’s (NYSE: DE) wind power assets in eight US states for $900 million. The purchase includes 735 megawatts (MW) of capacity, as well as 230 MW in advanced development and a total of 1,468 MW in some stage of development. The deal is expected to close by year’s end and will be immediately accretive to Exelon’s earnings, as 75 percent of output is sold under long-term contracts that ensure steady revenue and profitability.
The value of wind power assets has plunged sharply over the past year, thanks to financial weakness among municipally owned utilities. That provided the opening for Exelon for a deal that’s since won kudos even from Wall Street analysts who have recently been critical of the company’s efforts.
Of course, deals like these benefit the acquirer far more than the seller. Moreover, as my colleague Elliott Gue has pointed out in The Energy Strategist, the alternative energy stock universe is notorious for booms and busts. And despite coming well off their highs in the past couple years, most alternative energy plays generate little in the way of real earnings. And what little there is depends highly on government subsidy.
Companies that focus on natural gas generation, however, are also beneficiaries of state drives to clear the air and utilities are rushing to lock up capacity. And with investors focused on the economy and projections extremely gloomy for power prices over the next couple years, they’re cheap and therefore ripe for takeover.
Not every company that owns and operates these assets is a bargain, and not every company will receive a takeover offer. That’s why my No. 1 rule for picking takeovers in any industry, including essential services, is never to buy any company for a takeover that I wouldn’t want to own if no deal appears. That advice holds for other industries as well. It may keep you out of some deals, but you’ll never get stuck with a bad asset whose only appeal is some company may take it off your hands.
The second key point from the Potash Corp example is when a bid is made a lot of investors are going to demand more. BHP’s offer was at least 30 percent above where Potash Corp traded most of the summer. The stock, however, has moved nearly $20 past that point in anticipation of a higher bid coming in.
That’s the kind of action that can induce a would-be buyer to walk away eventually. In fact, it did eventually convince BHP to walk away from an offer for far more valuable Rio Tinto Plc (NYSE: RTP) prior to the 2008 crash. Given the 80 percent plunge in Rio’s share price that followed, I’ll bet more than a few shareholders wish they’d taken the deal. But like the puppy who growled at his reflection and dropped his bone into the water, their greed left them with nothing to show for it.
That’s definitely become a threat to the offer by Boralex Inc (TSX: BLX, OTC: BRLXF) for former Utility Forecaster holding Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF). The parent’s offer to swap a convertible bond for every 20 income fund units presented a solid premium to the pre-announcement price. And the offer was further sweetened by raising the interest rate on the convertible to 6.75 percent from 6.25 percent, and by reducing the price for Boralex Inc needed to make the security worth converting.
Those conditions appear to have satisfied roughly 56 percent of Boralex Power Income Fund unitholders, who have seen the value of their investment diminished by the loss of revenue from its biomass plants due to the collapse of the Canadian forestry industry. Completing the transaction, however, requires approval of at least 90 percent of unitholders. And O’Leary Funds Management, owner of almost 10 percent, is now suing in court to block the deal.
Given Boralex Power Income Fund’s weakened position and pending 2011 trust taxation, there would seem to be a lot of reason for shareholders to want a deal rather than see the trust start paying taxes as either a corporation or by remaining in its current form. All of the income fund’s cash flows come from a royalty stream from assets owned and operated by Boralex Inc, which in turn owns 23 percent of income fund units.
Combining ownership presents the opportunity for cost cutting that could be critical to weathering tough times. Until the US homebuilding market gets back on its feet, for example, it’s going to be tough to run the troubled biomass plants profitably. And given the dismal second quarter results, there’s a growing risk of another distribution cut.
The rhetoric, however, is heating up. O’Leary CEO Connor O’Brien, for example, has stated he believes the income fund has a value “well beyond” CAD6 per unit. He also labeled Boralex Inc management actions as “unreasonable, abusive, illegal” that “cannot be forced upon investors.” Maybe not, but neither can reaching investors force a buyer to pay up for what’s basically been a very disappointing asset with increasingly dubious value.
Greedy, greedy makes a hungry puppy.
Question of the Month
- I’ve read on the various blogs that we should be worried about our utility stocks. Specifically, some advisors who are rarely if ever wrong are saying that dividends are at risk because companies have piled on too much debt, are building too many bad assets and are heading for a day of reckoning. Care to comment?
First of all, I’d run away pretty fast from anyone in this business who claims to be “rarely if ever wrong.” Anyone who’s been involved in the markets for any length of time has stumbled and probably fallen. The real test is getting back your feet again and learning from your mistakes.
In that vein, I have a confession to make. I was dead wrong on how bad things would get for electric utilities during the 2001-02 bear market. I didn’t see Enron coming, though Mark Hulbert credited me in Forbes for getting out before the bottom finally dropped out. And I rode down several stocks pretty much all the way, including the former Aquila Corp.
Ever since, my main goal as an advisor has been to spot trouble at underlying businesses before they become acute, and get out. That strategy served me well in 2008-09. Despite the worst economic/credit/market debacle in 80 years, only one of 50-plus Utility Forecaster Portfolio holdings cut its dividend then, ARC Energy Trust (TSX: AET-U, OTC: AETUF), an oil and gas producer Canadian trust that was hit by falling energy prices. ARC today is back on its feet and going strong.
With corporate borrowing rates the lowest in four decades, I think the odds of a 2008 reprise are slim to none. But I’m equally confident that strategy will work again in any future debacle, and if anything Utility Forecaster Portfolio Holdings are on much firmer ground than they were in 2008.
For starters, most have used these low interest rates to refinance billions of dollars of debt, basically eliminating the risk of being forced to borrow in a renewed crunch. But that’s only the tip of the iceberg.
Public Utilities Fortnightly has released its sixth annual Fortnightly 40 Report, ranking performance of 84 industry companies over the past four years. This year’s study focuses on several key factors, including capital spending patterns, free cash flow and regulatory and economic outlook.
Its key conclusion: Utilities are “frugal” as rarely before, but “regulatory and economic uncertainties diminish(ing) during 2010 and 2011.” In fact, reading from the report’s press release, “rebounding electricity sales and a stabilizing economic outlook” are inducing “some companies to expedite projects that previously were deferred” and they “expect to see more announcements as the implications of clean air standards become clearer.”
Utilities have delayed capital expenditures (CAPEX) over the past year, trimming plans by 10 percent in 2009. As a result, fewer are exposed to rate cases that can take down profits, including companies operating in very favorable environments like Virginia. There, Dominion Resources (NYSE: D) expects power demand to grow 30 percent but is still taking a “wait and see approach” toward investments affected by federal policies in the words of CFO Mark McGettrick.
Even that may not be conservative enough for some. But it’s about 180 opposite from the direction many of these companies were leaning in 2000, on the brink of the power sector’s worst bear market since the Great Depression. We’ve got to watch earnings and rate cases for every company we own. That’s the price of operating in an environment where credit risk is paramount and economic growth is uneven.
But more than any sector, power proved itself during the debacle of 2008-09. And after 18 months-plus of balance sheet strengthening and risk cutting since, there’s not a better bet to weather whatever comes next.
Editor’s Note: For additional information on this topic, check out the latest report about Best Alternative Energy Stocks written by Elliott Gue and Roger Conrad.
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