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Downed Wires

You probably don’t think about them all that much unless a heavy storm sweeps through your area: the wires that transmit and distribute electricity to your home.

But for the 21st century electric utility, the wires are big business. That’s not just because building out transmission and distribution is costly—an average of around $1 million per mile.

Wires that cross state lines are overseen by the Federal Energy Regulatory Commission (FERC), which generally allows higher returns on equity (ROE) for these assets than state regulators. The feds are willing to give utilities a boost in order to encourage a buildout of transmission infrastructure.

The policies underpinning higher ROEs for transmission have varied over the years. In the late 1990s and early 2000s, for instance, the feds incentivized investment in the wires in order to facilitate the creation of wholesale power markets.

More recently, higher ROEs were deemed necessary to incentivize investment in infrastructure that would connect distributed renewable energy resources to the grid.

While it remains to be seen what policies will drive ROEs for interstate transmission during the Trump era, the president is a big fan of infrastructure projects, so presumably his administration will do what it takes to spur further investment in this area.

Wired for Growth

Unfortunately for utility investors, the only pure-play on U.S. transmission, ITC Holdings Corp., was acquired by Canadian utility giant Fortis Inc. (NYSE: FTS, TSX: FTS) last year.

Investing Daily’s Utility Forecaster first added shares of ITC to the Growth Portfolio back in June 2015, so the acquisition by Fortis ended up being a well-timed windfall. ITC gave Utility Forecaster subscribers a total return of nearly 32% over that 16-month period, well ahead of the market’s 4% return and almost double that of the major utility benchmarks. Not bad!

Even without a transmission pure-play, there are other utilities that have significant exposure to the wires. The future of California utility giant Edison International (NYSE: EIX), for instance, is essentially as a wires company. Edison boasts one of the strongest earnings and dividend growth trajectories in the sector.

Meanwhile, another utility giant has made a big play for transmission: Florida-based NextEra Energy Inc. (NYSE: NEE). The utility holding company uses the steady earnings from its regulated Florida power utility (about 70% of operating income) as a stable base while it pushes into competitive renewables.

This forward-thinking approach has given NextEra sector-leading earnings and dividend growth, making it the new king of the utility giants in terms of market cap. Consequently, the hybrid business model that it’s pioneered is being rapidly adopted by peers ranging from the recently formed Avangrid Inc. (NYSE: AGR) to Xcel Energy Inc. (NYSE: XCEL).

But NextEra’s investment story could soon get even better … if it can clear the latest hurdle (more on that below).

While the company’s competitive renewables business has given it a major growth kicker, it also makes NextEra a riskier play than a fully regulated utility. As such, the credit-rating analysts at Moody’s and S&P that we interviewed last year clearly see NextEra in a different category compared to other utilities such as Duke Energy Corp. (NYSE: DUK).

However, NextEra’s business mix could soon shift back significantly toward regulated utilities: The company is in the midst of acquired the Texas transmission giant Oncor.

True, the pending $18.4 billion deal will temporarily boost NextEra’s debt to somewhat uncomfortable levels. But credit raters expect the company’s leverage metrics to return to normal by the end of 2018, as cash flows ramp up from Oncor’s integration and the company recycles assets.

Texas Toast?

But NextEra’s deal could still get derailed by Texas regulators. On Thursday, the Public Utility Commission of Texas said it doesn’t believe the acquisition is in the public interest.

While the commissioners have multiple concerns about the deal, the sticking point is an Oncor board comprised of a majority of independent directors.

In testimony before regulators earlier this year, NextEra CEO Jim Robo described that condition and other proposed ring-fencing provisions as “burdensome and a deal-killer.” In fact, he used the term “deal killer” about a dozen times during his appearance before the commission.

That, in turn, prompted the chair of the commission to comment, “The question still remains whether your deal-killers and our deal-killers match.” We think there’s a match!

For regulators, an independent board isn’t just some theoretical good. Oncor’s independence from its holding company is credited with keeping operations running efficiently even as its parent entered bankruptcy.

For NextEra, board control would be a big positive from both an operational and a credit-rating standpoint, a key consideration since its balance sheet will be stretched in the near term.

The good news is that regulators’ current sentiments aren’t final. The commission will probably vote on the transaction on April 13.

That gives NextEra time to negotiate and presumably offer various concessions that meet regulators’ demands halfway. Nevertheless, one analyst declared that the “writing on the wall is pretty ominous for this deal.”

This isn’t the first time that Texas regulators have scotched a deal for Oncor. Early last year, the commission spurned a consortium led by Hunt Consolidated to acquire the transmission company and turn it into a real estate investment trust (REIT).

And this isn’t the first time that NextEra has faced regulatory intransigence over a major deal. The utility giant abandoned its $4.3 billion acquisition of Hawaiian Electric Industries Inc. (NYSE: HE) last year.

Both of these actions teed up Oncor for NextEra. And both actions also show each party that they’re dealing with entities that know how to walk away. Let’s hope that this time around they find a way to come together.


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