The Next Big Takeover Target

Sometimes I look at the stock market and despair that value is based on nothing more than air.

Although owning shares of stock means you have an economic interest in a company, that stake can feel more theoretical than real.

After all, there’s no tangible record of a transaction anymore, like those wonderfully illustrated stock certificates of yore. Instead, a keystroke on a computer triggers a flow of electrons with each order to “Buy” and “Sell.”

As human beings, our brains are still hard-wired to see value in actual things you can see and touch, not virtual records stored on a server farm somewhere in the Midwest.

This feeling is further compounded when share prices race ahead of purported value. When that happens, it all starts to feel like a game to see who will be the greater fool when the market inevitably corrects.

But there is one transaction that makes being a shareholder feel real again: takeovers.

When one company agrees to acquire another company whose stock you own, that transaction finally reveals what your stock is truly worth. And that value is no longer driven by speculation, computerized trading, or other factors that have nothing to do with the stock’s underlying business.

Rather, the acquirer has taken a hard-nosed look at the company whose stock you own and calculated what its business is worth to them, as well as what they think it will take to get shareholders to agree to sell.

As investors, one of the greatest validations is when one of your stocks gets acquired at a significant premium.

While identifying potential takeover targets isn’t at the core of what we do at an income-oriented service like Utility Forecaster, we do perform such an analysis as part of our approach to stock selection.

And it’s quite a rush when the news hits the wire that one of our stocks is being acquired.

Of course, we can’t anticipate every merger. But when a clear theme emerges, it can provide a framework for such analysis.

The Great White North Looks South

One of those themes was underscored by last week’s announcement that the Canadian utility Hydro One Ltd. (TSX: H, OTC: HRNNF) has agreed to acquire the U.S. utility Avista Corp. (NYSE: AVA) in a transaction valued at $5.2 billion.

If you’re keeping score, that’s the fourth major cross-border acquisition by a Canadian utility over the past two years. And this trend has made a lot of money for our subscribers.

What’s driving this action? For one, a lack of opportunity up north. There are really only a handful of Canadian utilities, so companies looking for new growth have to head south.

In addition to being the land of opportunity for Canadian acquirers, the U.S. is also home to utilities with stronger regulated earnings growth.

Following this latest deal, there’s now just one Canadian utility giant that has yet to make a play for a U.S. utility: Canadian Utilities Ltd. (TSX: CU, OTC: CDUAF).

Of course, that doesn’t mean the company has to make such a move. But the family-controlled utility empire—it’s the largest part of a holding company called ATCO Ltd. (TSX: ACO/X, OTC: ACLLF)—is no stranger to buying assets far afield from its home turf in the province of Alberta.

In 2011, Canadian Utilities acquired an Australian gas distributor for $1.1 billion. So it stands to reason that the company has probably also surveyed the landscape closer to home.

While Canadian Utilities currently shoulders a fair amount of debt, it does appear to have just enough balance-sheet capacity to undertake a transformative merger.

With founder Ronald Southern’s death last year, the second generation of the family is now running the whole show. CEO Nancy Southern has been at the helm since 2003, but her father remained on the company’s board until he died.

The younger Southern, who’s now 60, is no stranger to boom-and-bust cycles, as well as what it feels like to enter a downturn saddled with excessive debt. So she may be leery of pursuing another acquisition in this environment.

As she put it in an interview with Canadian Business late last year, “We haven’t been over-leveraged, we’ve managed our cash really well, and I feel pretty confident we’re in good shape.”

But let’s suppose Southern is looking to extend the company’s footprint to the U.S. anyway. Where might she look?

When identifying potential utility pairings, it always makes sense to start with companies that operate in nearby or adjacent service territories. That’s because companies can realize greater economies of scale when their existing networks are complementary.

In addition to location, we also look for companies that are the right size for a potential acquirer to swallow. And, of course, they have to offer the prospect of strong earnings growth while trading at a reasonable value.

In next week’s update for Utility Forecaster subscribers, I’ll reveal the three U.S.-based utilities that could be in Canadian Utilities’ crosshairs.