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Cashing In on the Next Big Trend

At Utility Forecaster, we don’t buy a stock just because of rumors that it might be a takeover target. After all, if a deal fails to materialize, that might leave us stuck with a real stinker.

Instead, we look for solid companies with strong dividend growth that we’d be happy to hold through thick and thin. If these superior qualities happen to attract a suitor who’s willing to pay a big premium, well then that’s just gravy.

However, the market has a way of making you question even your most fundamental beliefs.

Don’t get us wrong: We intend to maintain a disciplined approach to security selection. But it’s hard to ignore the ever-shrinking number of pure-play regulated gas utilities and not wonder whether we should pile into a space that could prove increasingly crucial as the sector evolves.

As cheap prices and regulatory momentum push power utilities toward natural gas and away from coal, gas distributors stand to benefit from greater demand for the cleaner-burning fuel and the rate-base growth that goes along with building the infrastructure to deliver it.

And with utilities on the look-out for new growth to offset slowing electricity demand, more gas utilities could find themselves in utilities’ crosshairs, particularly those with nearby service territories.

Indeed, we’ve written about this trend a number of times over the past several months. And it looks to be accelerating.

In late August, utility giant Southern Company (NYSE: SO) announced a nearly $12 billion deal to acquire AGL Resources Inc. (NYSE: GAS), the largest natural gas distributor in the U.S.

Admittedly, we were kicking ourselves after news of this deal hit the wires. Okay, we might have muttered a few expletives as well.

That’s because just several weeks prior to the deal’s announcement, we had done a deep dive on AGL as a possible Best Buy for our August issue, but the stock was a bit too expensive at the time relative to its valuation.

We decided to wait for AGL to correct and then add it to the portfolio. Of course, you always think you have all the time in the world, until you don’t.

But we’re finally getting a chance to cash in on this trend.

This week, Southern’s fellow utility behemoth Duke Energy Corp. (NYSE: DUK) announced its plans to acquire Piedmont Natural Gas Co. Inc. (NYSE: PNY), a member of our Income Portfolio Aggressive Holdings, for $4.9 billion in cash plus the assumption of $1.8 billion in debt.

When the deal closes next year, Piedmont shareholders will receive $60 per share in cash, which is a 42.1% premium to its share price prior to the deal’s announcement.

For its part, Duke gets a regulated gas distributor whose service territory largely overlaps with its electric territory. Piedmont distributes natural gas to more than 1 million mostly residential customers in parts of North Carolina, South Carolina and Tennessee.

Some analysts believe the deal is less about Duke’s own need for reliable gas delivery–power generation accounts for just 11% of Piedmont’s margin by customer, but 49% of its volume–than about its desire to expand its portfolio of regulated assets with attractive growth prospects.

Piedmont enjoys strong authorized returns on equity (ROE) of 10.0% to 10.2% on a $2.3 billion rate base across its three main service territories. And Duke says the deal gives it a gas infrastructure platform that could lead to future growth opportunities beyond its existing markets.

To that end, the two firms already have a good working history: Both are key partners in the $5 billion Atlantic Coast Pipeline, a 564-mile interstate transmission pipeline that will move 1.5 billion cubic feet per day of natural gas from the prolific Marcellus Shale formation to high-demand areas in Virginia and the Carolinas.

Duke’s acquisition of Piedmont will boost its stake in the project to 50%–Dominion Resources Inc. (NYSE: D) and AGL Resources are the two other major investors in the pipeline.

Duke’s management projects the deal will be accretive to earnings in the first full year following the transaction’s close. And it sees Piedmont’s strong growth as helping Duke meet its 4% to 6% annual earnings growth target.

The company plans to finance the acquisition with mostly debt, along with the issuance of between $500 million and $750 million of shares, and some cash on hand.

From a Duke shareholder perspective, the deal makes strategic sense, despite the fact that the company will be piling on more debt while also adding incrementally to shareholder dilution.

But the company is paying a pretty hefty premium for Piedmont–the aforementioned 42.1% versus Southern’s 36% premium for AGL. That along with the increase in debt needed to fund the deal prompted bond rater Moody’s Investors Service to put Duke’s long-term ratings under review for possible downgrade.

Management has already said it intends to defend the company’s credit rating and is sanguine about its prospects of doing so. Duke has an investment-grade credit rating of “A3,” and it doesn’t appear that it risks a downgrade of more than one notch.

Overall, we like this deal. And we’ll certainly be happy to collect our 42.1% premium.

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