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How to Handle Rejection

By Ari Charney on May 12, 2017

The utility sector’s M&A spree has given subscribers to Utility Forecaster a number of nice windfalls over the past two years.

Indeed, on two separate occasions deals emerged for stocks that we’d only recently added to one of our portfolios.

In late-November 2015, we added Questar Corp., a natural gas distributor, to the Income Portfolio. Barely two months later, utility giant Dominion Resources Inc. (NYSE: D) swooped in with a bid at a nearly 32% premium to the price at which we recommended it.

Last October, we added the Washington, D.C.-based gas distributor WGL Holdings Inc. (NYSE: WGL) to the Income Portfolio. Not even a month later, rumors started swirling that the Spanish utility Iberdrola SA (OTC: IBDRY) was preparing to make an offer for the firm.

Iberdrola ended up walking away. But with WGL now firmly in play, another foreign utility began circling the company and reached an agreement with it toward the end of January.

As value-oriented investors, we recommended WGL during a period when the stock had sold off, so our potential upside from a takeover premium is substantial. The Canadian utility AltaGas Ltd. (TSX: ALA, OTC: ATGFF) plans to acquire WGL in a $4.5 billion all-cash deal, or $88.25 per share, which is a 44.2% premium to the price at which we recommended it.

Under normal circumstances, we would be content to hold WGL until the acquisition is consummated. After all, it’s still paying a dividend, which was boosted by 4.6% during the first quarter, so it still offers an attractive yield based on the price at which we established the position.

There’s nothing more satisfying than knowing that a huge capital gain awaits while still collecting a nice stream of income.

Take the Money and Run

This time around, however, we may end up cashing in early and redeploying our capital elsewhere, even though it means leaving some money on the table. That’s because this deal faces substantial risks.

Indeed, the stock currently trades at a sizable discount to the deal price, recently at around 6.2%, suggesting the market sees some pretty big hurdles ahead.

For one, WGL operates in service territories with notoriously prickly regulators. Maryland and D.C. commissioners really put Exelon Corp. (NYSE: EXC) through the ringer during its acquisition of Pepco and extracted significant concessions.

There’s no reason to expect this situation will be any different. And AltaGas may not have the financial strength to accommodate regulators’ demands.

That’s because AltaGas already carries significant debt and will be taking on more leverage to get the deal done.

Thus far, the C$7.7 billion Canadian utility has raised C$2.6 billion via two secondary equity issuances and has lined up a C$3.0 billion bridge loan to help fund the deal. For the balance, it’s looking to divest non-core assets and issue debt and preferred shares.

Although the capital markets have proved very accommodating toward AltaGas’ efforts to finance the acquisition, regulators may not smile upon the leverage profile of the combined entity.

After all, regulators are ultimately political animals, and while many have cozy relationships with the companies they oversee, ratepayers (and the politicians they elect) are their real constituency.

Since regulators are mindful of network reliability, they worry that utilities shouldering a lot of debt won’t be able to invest in properly maintaining and upgrading crucial infrastructure.

In fact, we’ve recently watched two utility mergers get rejected by regulators, in part, due to such concerns.

While Texas regulators cited Florida-based NextEra Energy Inc.’s (NYSE: NEE) refusal to adopt ring-fencing provisions as the reason for spurning its acquisition of Oncor, the deal’s leverage underpinned that rationale.

And Kansas regulators quashed Great Plains Energy Inc.’s (NYSE: GXP) bid for Westar Energy Inc. (NYSE: WR) because of the debt required to close the deal.

Given the potential risk to the AltaGas/WGL tie-up, we are unlikely to hold WGL until the transaction closes.

Originally, we told subscribers that we would wait to sell WGL until the discount to its deal value narrows to just 2% to 3%. The upper bound of that range would mean a share price of around $85.60.

But WGL hasn’t traded anywhere near that level since the deal was announced, so we may end up relaxing that threshold.

The difficulty in closing these deals is one of the reasons why potential acquirers look for utilities that operate in single-state service territories and trade at reasonable valuations.

Right now, of course, there aren’t very many utilities that offer either attribute. But share prices fluctuate, and eventually the utilities that do possess these characteristics could get picked up at a premium.

To that end, we recently updated a special report that lists nine potential utility takeover targets.

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