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Southern Tries to Buy Its Way Back into Our Hearts

The incredible volatility the market has dished out over the past week may have stopped some investors dead in their tracks, but the wheels of capitalism grind on.

The biggest reminder of that reality came courtesy of Southern Company (NYSE: SO), which announced a nearly $12 billion deal to acquire AGL Resources Inc. (NYSE: GAS) on the very same day that the Dow Jones Industrial Average plunged nearly 1,100 points before recovering roughly half that decline by the market’s close.

Of course, Southern and AGL were working toward this agreement for a number of months beforehand, but it’s still stunning timing for such a momentous announcement.

Under the terms of the deal, AGL’s shareholders will receive $66 per share in cash, which is a 36.3% premium to the average price that prevailed over the month leading up to the grand reveal. The transaction is expected to close during the second half of 2016, at which point AGL will become Southern’s third-largest operating subsidiary.

There are still a number of regulatory hurdles to clear in the interim, including securing approvals from public service commissions in Illinois, Georgia, Virginia, Maryland and New Jersey. Regulatory Research Associates characterizes the regulatory environment as constructive in most of these states, though there’s a possibility that regulators in Maryland and New Jersey could attach more stringent conditions to their approval.

The deal dovetails with a theme that we highlighted in the feature article of our August issue: the ascendance of cheap natural gas as the leading fuel for power generation.

Aside from economics, a big part of the story is the regulatory momentum resulting from the Obama administration’s Clean Power Plan, which aims to reduce carbon emissions from utilities by 32% by 2030.

In fact, analysts with Morgan Stanley see a major opportunity for regulated utilities to boost their bottom lines by spending to decarbonize their operations. Regulated utilities in the Southeast could spend as much as $50 billion toward that end, with much of that cost passed along to ratepayers.

As evidenced by Southern’s deal, regulated natural gas distributors also stand to be major beneficiaries of this trend in the coming years, since rising natural gas use in support of renewables will spur a major infrastructure buildout.

Indeed, as Southern CEO Tom Fanning recently observed, “To the extent you add more renewables, you will require, just rule of thumb, megawatt-for-megawatt base backup generation in order to support the intermittent generation that is largely spoken for with wind and solar resources.” In other words, gas-fired power will provide the reliable backbone for renewable energy.

In looking for ways to play this theme, we closely examined a number of gas distributors, including AGL, but felt that Atmos Energy Corp. (NYSE: ATO) offered superior fundamentals at a more reasonable price. If only we’d been more cavalier!

Still, we fully expect other utilities to borrow from Southern’s playbook by acquiring other regulated gas distributors. And with a market cap of just $5.6 billion, Atmos could very well have a suitor of its own soon enough.

Meanwhile, we’ll be gaining exposure to AGL via Southern, albeit at a huge premium to what we might have paid a month ago.

What is Southern getting in return? AGL is the largest gas distributor in the country, serving about 4.5 million customers in seven states across the South, the Mid-Atlantic and the Midwest. The firm derives about 70% of earnings from regulated operations, and that number is expected to rise to 80% by 2019.

Southern’s management expects the deal will be accretive to earnings per share in the first full year following its close, with long-term growth in earnings per share accelerating to 4% to 5%, up from a previous trajectory of 3% to 4%, along with the possibility of further dividend growth.

The one potential negative from a shareholder standpoint is that Southern will be financing the deal with a combination of debt and equity, with a total of $3 billion in equity issuances—equivalent to about 8% of the firm’s market cap—occurring through 2019. In this way, management hopes to reduce the effect of shareholder dilution, while making the deal ultimately neutral from a credit ratings perspective.

Southern clearly expects this deal to be a game changer, while offsetting some of the disappointments from perennial delays and cost overruns at its clean-coal plant in Mississippi and the expansion of its nuclear power plant in Georgia.

In the wake of the deal’s announcement, most analysts reaffirmed their ratings. The one upgrade came from Edward Jones, which raised its rating to “hold” from “sell.”

We’ve been critical of Southern in recent years, noting that the firm is becoming tougher to love. But the AGL deal has softened our hearts somewhat, even if analyst sentiment on Wall Street remains largely neutral.


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