Utility Mergers, Groomzillas and Shotgun Weddings
Utility merger mania has been a major theme in the sector over the past year. But the latest deal announced this week–between Great Plains Energy (NYSE: GXP) and Westar Energy (NYSE: WR)–offers a slight variation.
Instead of a utility giant pursuing a smaller company, this tie-up involves two medium-sized utilities in a $12.1 billion cash-and-stock transaction. Consequently, investors should scrutinize this deal closely since it could involve more risk than the typical utility merger.
Indeed, not all utilities mergers are alike. And as we’ve noted in the past, there are times when it’s prudent for shareholders to cash out at a premium—if the transaction is a cash-and-stock or stock-for-stock deal—and leave the combined firm at the altar.
How do you know if it’s time to split the scene? Some common scenarios include when the suitor is overpaying, lacks strategic vision for the new entity, or if the merged firm doesn’t have sufficient synergies.
Over the past 20 years or so, we’ve watched the number of publicly traded electric utilities fall by roughly half. And we’re likely to see further consolidation in the near future.
This time around, utilities are contending with anemic electricity demand, due to sluggish economic growth and rising efficiency. As such, they’re looking to diversify their regulated earnings streams by acquiring other utilities in higher-growth service territories.
Based on the rise in deal volume, more utilities are destined to walk down the aisle this year. Indeed, according to the consultancy PwC, the total value of deals announced during the first quarter jumped to $41.4 billion, compared to just $6.8 billion a year ago. And the average deal size is up 93.4%, to nearly $1.9 billion.
Even with the Federal Reserve’s recent rate hike, we remain in a historically low interest rate environment. And utilities likely feel compelled to pursue mergers and acquisitions while the cost of money is still cheap. The question is whether the rising leverage that results will cause for an unhappy union.
Turning back to the Great Plains-Westar merger, we’re concerned that the smaller, lower-performing Great Plains could turn out to be a “groomzilla,” since it’s willing to almost triple its debt, while risking a lower credit rating to unite with its better-performing and higher-capitalized peer.
It’s too soon to tell how quickly synergies will offset the premium Great Plains is paying, especially since it won’t be eliminating Westar’s headquarters.
Great Plains’ management says the deal will be neutral to earnings per share in the first year, but will provide 6% to 8% earnings per share (EPS) growth in the second year. The dividend is projected to grow 5% to 7% annually, with a payout ratio of 60% to 70% of earnings.
But the credit raters are watching. Fitch placed Westar and its Kansas Gas and Electric Co. subsidiary on a negative rating watch, due to its concern over the consolidated leverage at the combined entity. The deal entails assuming $3.6 billion of debt.
Finally, it’s never a good sign when the betrothed wants to marry for the sake of marrying, rather than true love (or some higher strategic motive).
Westar CEO Mark Ruelle observed, “The transaction fulfills everything that we’ve been saying about the subject of M&A—that is that consolidation will continue, that eventually size matters and in considering whether to be a consolidator or among those consolidated, companies have to pick a line.” Ruelle continued, “Ours, as I said many times, would be more likely to be that of a seller than a buyer.”
For subscribers, we detail a recent merger between two utilities that seems to be a match made in heaven.