The Greed Factor
Markets work best, however, when the self-interest driving them is enlightened. In other words, there’s a huge difference between decisions made solely to grab a big payday and those based on sound business principles.
Most corporate and market decisions feature elements of both. The key is whether there’s enough enlightened self-interest involved to make the situation worthwhile for more than just a handful of payoff-focused insiders.
A pretty good example of unenlightened greed is the insider trading case reported in today’s Wall Street Journal, involving takeover information collected from investment banking arms of Morgan Stanley and UBS. The Securities and Exchange Commission (SEC) has filed a complaint against 11 people and three trading companies for using the information about prospective deals to get in ahead of the game.
In this case, the perpetrators have been nailed and more than a few will likely go to jail. But it’s a pretty stark reminder of what some Wall Streeters will do when they see the prospect of easy money–regardless of moral or legal implications–if they think they can get away with it.
The case is another stark reminder that greed and corruption didn’t die with the prosecution of Bernie Ebbers, Jeff Skilling and others in the fallout from the Bear Market of 2000-02. The often onerous Sarbanes-Oxley legislation didn’t cure all the ills of the system. In fact, the evidence is growing that unbridled greed–not enlightened self-interest–is again on the rise. In other words, for us small investors, it’s as much a case of buyer beware as ever.
Last week, I highlighted the growing influence of private capital in the investment markets. Sometimes, its interests are conjoined with those of individual investors, but not always. In fact, I suspect we’re going to see more and more cases where we’re diametrically opposed.
Hours after I wrote that issue, a major private capital deal hit the utility industry, with potential complications for several major players: the proposed buyout of TXU Corp (NYSE: TXU) by a consortium of private capital firms including Kohlberg Kravis Roberts (KKR) and Texas Pacific.
KKR’s motivation isn’t difficult to dissect. The Texas power market is not only the nation’s largest. It’s also extraordinarily isolated from the rest of the country. Unlike most states, little electricity goes in or out of Texas. Instead, the state’s power companies must always produce enough for the state’s growing needs.
TXU is Texas’ largest power producer and thus the biggest beneficiary of the state’s soaring electricity prices. Under the terms of Texas’ deregulation law adopted in 1999, the price of power is set to the price of natural gas. Gas-fired plants account for about half of the state’s total capacity. The idea was to ensure that the deregulated market always got the right price signals, and that this would encourage the building of new plants as well.
As it’s turned out, the price of natural gas has since soared from that point. As a result, Texas’ power rates have risen to among the highest in the nation. And because of the peculiarities of the framework, utilities like TXU have been allowed to keep power prices high, even though natural gas prices have fallen by half from late 2005 levels.
High gas and power prices have encouraged building plants in the state, particularly wind. Texas’ wide open spaces are particularly amenable to wind power, especially the panhandle and the mountainous areas in the west of the state. Even under the most optimistic projections, however, wind power can only provide a fraction of the state’s future needs, let alone displace much existing capacity.
The state has several nuclear power plants and their owners have stated interest in further expanding their capacity. TXU, for example, owns the Comanche Peak plant, the second reactor of which was the last nuclear plant built in the US. NRG Energy (NYSE: NRG), meanwhile, owns the massive South Texas nuclear facility–with a combined two-reactor capacity of 2,600 megawatts–and has led the nation in output for the past three years.
Unfortunately, even in Texas, expanding nuclear power generating capacity is controversial. The “Not in My Backyard” sentiment is strong and the permitting process is long and complex. Consequently, even in a best-case, it would be a while before there’s significant new capacity in Texas.
That brings us back to coal. Before the KKR-led buyout was announced, TXU had introduced plans to build 11 major coal-fired power plants in Texas to meet the state’s projected demand. The plans were immediately denounced by environmental groups, which then took the company to court.
When the buyout was announced, one of the carrots offered by the KKR consortium was a pledge to cancel all but three of TXU’s planned coal plants. That’s induced the group Environmental Defense to drop its lawsuit against the company. The proposed deal has drawn praise from other environmental advocates as well, though others are still fighting to get the company to drop all its planned coal plants.
Skeptics might see another motive. For one thing, cancelling the plants sharply reduces the amount of new supply on the drawing board in Texas. All else equal, reduced future supply means higher electricity prices–and more profits for whoever owns TXU.
Cancelling the plants also ups the ante on anyone else who wants to build coal-fired capacity in Texas. Expect to see increased pressure brought to bear on these companies, as well as owners of existing coal-fired capacity in the state. That, too, has the potential to reduce supply and push up prices over the long haul.
As for regulatory risk, current Texas deregulation law doesn’t give state regulators the right to reject this deal. There are legislators trying to cobble together something to give them that power. Governor Rick Perry, however, has already stated his support of the takeover, so it’s doubtful he’ll sign anything perceived as too restrictive.
KKR has attempted to placate consumers with a promised rate cut of 10 percent. That wouldn’t apply, however, to more than 70 percent of its customer base. Also, it would only be frozen at that level until September 2008.
A common criticism of private capital buyouts of utilities in the past is that the new owners will be highly incentivized to strip out costs so they can flip the company for a profit down the road. To answer this, the KKR consortium has pledged to hold the utility for at least five years. It’s hard to see, however, how that would be enforceable. Moreover, it doesn’t answer the question of stripping out costs, or the larger question of the new management’s clear incentive to keep the state’s power supplies tight.
There’s also a possibility the Federal Energy Regulatory Commission (FERC) may review the deal. It could also take a pass. And in any case, FERC hasn’t actually rejected a deal in some years, instead leaving that role to the states.
Who Else Benefits
TXU’s top management certainly has much to gain from this deal going through. CEO John Wilder and others have taken pains to appear at least publicly separate from the KKR consortium. In fact, they’ve made no commitment to stay on after the deal. But indications are the payoff is rich.
Stockholders also get a nice gain from this deal, which caps off several years of explosive returns in the stock. The consortium’s current offer is $69.25 per share in cash, a roughly 15 percent premium to last Friday’s close.
The only real losers are TXU’s bondholders. All the major credit raters have downgraded the company’s debt to junk, with Fitch expected to take them down to B in the near future.
It’s not hard to see why. By eliminating publicly traded equity, the post-buyout company’s capitalization would be split between the buyout firms and new debt. And with some $24.6 million in debt financing already raised for the $32 billion deal, the bulk is going to be new debt. In addition, buyout firms like KKR and others tend to be highly leveraged as well.
To be sure, these are good assets. And if the power market in Texas tightens further in response to cancelled coal capacity, there will be abundant cash flow to cover the new debt service obligations. The company’s fourth quarter earnings, for example, were up 33 percent, as high power prices offset the impact of mild weather on demand.
Extremely heavy debt, however, makes the company far more exposed to a setback, particularly on the regulatory front. And it’s quite possible it could wind up a victim of its own success.
Texas’ power rates are extremely high: Residential rates are at 12.15 cents per kilowatt hour compared to a national average of 10.22 cents. And rates are some 50 percent higher than those of other southern utilities, which have also had the benefit of laissez faire regulation.
The fact that TXU’s big profit boost was due to these high rates has triggered a backlash. And it’s doubtful the KKR group’s promised temporary rate cut will cool the situation for long, if at all. A Texas state senate committee has voted 9-0 for legislation that would require a review of the deal, with the Republican chairman the chief sponsor. Whether his bill eventually becomes law or not, it’s a safe bet both parties will eventually pile on as consumer outrage over high rates grows.
In any case, TXU bonds are now deep in the junk category. They may again become interesting once the ownership question is decided, if management elects to begin paying down the new debt. But this is clearly a company that’s not concerned about its debt holders. And unlike recovery play utilities like CMS Energy (NYSE: CMS), there’s no real case for rising bond ratings.
As for TXU common stock, it’s now trading just a few percentage points from the buyout price. The company has until April to solicit counterbids and one is still possible. A consortium led by The Blackstone Group has allegedly bowed out, after interest was rumored. But giant Entergy (NYSE: ETR)–which already has interests in Texas–could be sniffing around.
Should that happen, TXU shares would move even higher, possibly as high as the mid-70s. But the best idea for conservative investors holding TXU is to take the gain. At a price in the 66-to-67 range and consummation some months off in a best-case, the risk is clearly with the holder. And again, the interest of private capital isn’t necessarily aligned with that of the individual here. Should opposition build and KKR and associates actually walk away, the gains we’ve seen this year would rapidly evaporate.
The Big Picture
There are repercussions throughout the affected industry any time there’s a proposed deal of this magnitude. The impact of KKR/TXU on utilities is basically twofold.
First, it again opens up the possibility of a massive private capital buyout of utility assets. Earlier this decade, bids for two utilities–UniSource Energy (NYSE: UNS) and Portland General Electric (NYSE: POR)–foundered in the face of opposition from state regulators. Warren Buffett’s Berkshire Hathaway (NYSE: BRK/B) was successful buying out Midwestern Utilities and several pipelines and then entered the really big leagues by snapping up PacifiCorp.
The appeal of these to Buffett was obvious: lots of reliable cash flow in a business where he has the money to really build scale. As a result, Berkshire is already one of the America’s biggest utility holding companies and is likely to get bigger still the next time utility stocks head lower.
Unlike highly leveraged KKR, Berkshire is a AAA credit. Consequently, bondholders have definitely benefited from his purchases with improved reliability and higher prices, as credit spreads have dramatically tightened.
Stockholders did get some benefit from these deals. PacifiCorp, for example, had been taken over by Scottish Power (NYSE: SPI) several years earlier. Those who stuck with the company through the years under the new arrangement wound up capturing cash when the deal was completed. And their Scottish Power shares have surged thanks to a subsequent takeover offer from Spain’s Iberdrola (OTC: IBDRF).
The upshot is that the benefit of owning these long-term cash earning assets is now outside the purview of individual investors. You can still own them as part of Berkshire. But the cash flow goes to Berkshire, not to individuals.
In addition to the KKR/TXU deal, there are several other ongoing takeovers of utilities by what amounts to private capital. A unit of Australia-based Macquarie Bank (Australia: MBL, OTC: MQBKY) is in the process of buying Pittsburgh-based electric DQE (NYSE: DQE). Meanwhile, a unit of Babcock & Brown (AMEX: BNB) is attempting to win regulatory approval in Montana this month to buy Northwestern Corp (NSDQ: NWEC). Neither of these deals has generated the controversy of KKR/TXU and both appear likely to pass muster.
As for utilities that may become targets, Constellation Energy (NYSE: CEG) has a similar business arrangement to TXU. The ultimate irony would be if Maryland regulators went along with a private capital bid for the company after effectively chasing off another utility last year, FPL Group (NYSE: FPL).
With the $32 billion bid for TXU, literally everyone’s in play. The rules of the game have changed overnight. And with so much private capital floating around, there’s certainly the capacity to do any deal imaginable.
In the short term, private capital buyouts are clearly bullish for shareholders, just as any takeovers are. In contrast, bondholders’ situation is clearly more precarious, and only those in states with generally tight regulation are truly secure.
In the long term, however, stockholders have fewer choices in an industry that’s traditionally been the preserve of individuals. And this is at a time when investors are clamoring for yield.
The second earthquake the KKR/TXU deal brings with it is on the environmental front. Cancelling eight of the 11 coal plants TXU had planned is best viewed as a move to restrict future power supplies in the state to support prices, rather than some kind of altruistic gesture.
It is, however, certain to put additional pressure on the companies behind the 140 or so other coal-fired plants now on the drawing board in the US. In Texas, coal opponents can be expected to push full-bore against the builders of the other seven plants now being contemplated. And it’s likely at least some of them will be cancelled.
For their part, coal-burning utilities are now pressing hard for some kind of federal legislation to set limits on carbon dioxide (CO2) emissions. That’s their best hope for establishing a truly workable system based on achievable, verifiable targets, rather than one constructed emotionally by well-meaning but ultimately unrealistic laymen.
Again, my view remains we’ll see CO2 regulation in the US, based on the same cap-and-trade model that has drastically reduced sulphur and nitrogen oxides emissions that cause acid rain. Cap-and-trade sets a cap on emissions and then allows companies to trade pollution credits to maximize flexibility. It’s the same model adopted in California already, one that Golden State Governor Arnold Schwarzenegger has taken regional via an accord with neighboring states.
Cap-and-trade means utilities will be able to adapt to new regulations without potentially ruinous financial consequences. And it means big money to CO2-free energy providers like wind and nuclear, as well as companies specializing in efficiency.
The KKR/TXU deal greatly ups the odds we’ll see a cap-and-trade regime sooner rather than later. In any case, fewer coal plants means tighter power supplies. That means higher prices for wholesale electricity–and not just in Texas.
I have one additional worry about a private capital takeover boom.
We’ve been here before.
Early in the last century, virtually every utility operating company was scooped up by giant holding companies. Some, such as Samuel Insull’s (formerly Thomas Edison’s business manager), were focused on utilities. Others were owned by entities entirely outside the industry.
The lines between these holding companies and their utility operations were extremely hazy, at best. In the good times, no one cared. But when the Great Depression took root, the bottom dropped out and the financial integrity of what had become absolutely essential companies was suddenly in doubt.
The Public Utility Holding Company Act of 1935 (PUHCA) was in large part set up to eliminate the risk of a utility being dragged down by other businesses. It handed the holding companies a death sentence, forbade outside entities from holding utilities and set strict accounting standards to segregate regulated utilities’ books and financial fortunes from those of their owners.
With the SEC only loosely enforcing it, PUHCA didn’t prevent Enron or the disasters that struck utilities that invested outside the industry in the late 1980s and early ’90s. But it did keep utility ownership basically within the industry.
The repeal of PUHCA means anyone can own a utility, a foreign bank, a billionaire, even one of the original barbarians at the gate like KKR. History never repeats exactly. And a private capital buying spree would doubtless produce profits near-term for utility investors.
I’ll always take whatever profits the market throws at me. But this is a clear-cut case where the interest of private capital is diametrically opposed to individual investors’ long-term interest, taking income producing assets out of our hands.
Since the founding of the power industry at the turn of the last century, there have been hundreds of mergers between utilities. Each one has created scale and long-term value for shareholders. In contrast, private capital ownership of utilities has produced horrendous consequences in the past, for both the sector and the economy in general.
Unfortunately, it’s quite possible state and local officials will let a buying spree happen anyway, and with little real scrutiny. In fact, the “green” marketing carried out by KKR is likely to make many regulators more inclined to approve private capital takeovers, even as they try to put the brakes on mergers between utilities themselves.
Does all this mean the utility industry has become too risky to invest in? Absolutely not. Private capital is still a small part of overall utility ownership. And to the extent there are more KKR/TXUs, our near-term profits will increase.
The bottom line: As long as you own good businesses that are growing in value, you’ll be in good shape in the utility sector. And with most managements still cutting debt and operating risk, there’s a lot more value to come. In the meantime, I’ll keep you posted on this emerging trend–the potential risks as well as rewards.
Note the March issue of Utility Forecaster is now available to subscribers at www.utilityforecaster.com. The focus: utility spinoffs.