Deals

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

ITC Holdings suddenly fancies itself the blushing bride. Unlike most weddings, though, if this one comes off investors should train their eyes on the groom.

ITC's stock jumped on this week's surprise announcement that it may sell itself. While any deal wouldn't be a shotgun wedding per se, let's just say ITC probably would prefer to dispense with a long engagement. As Bloomberg Gadfly's Gillian Tan wrote earlier this week, ITC's announcement comes amid a boom in utility M&A, with recent deals being done at high premiums.

If giddy valuations provide the pull, ITC's own problems provide the push. Prior to this week, its stock had fallen by 16.5 percent in 2015, lagging behind an already sickly utilities sector. The pure-play electricity transmission company has missed consensus earnings estimates in each of the past four quarters, according to numbers compiled by Bloomberg.

Lost in Transmission
Share price
Source: Bloomberg

Moreover, one of ITC's big selling points -- the promise of double-digit earnings growth -- has come under question. Customer complaints have sparked a review by the Federal Energy Regulatory Commission that could reduce ITC's allowed return on equity, with a final decision not due for about another year. ITC's development pipeline is looking murkier, with the company saying in July that lack of clarity on regulation would likely cause some projects to be "back-end loaded." Analysts are unusually divided in their estimates. The top forecast for 2016 earnings per share is about 25 percent higher than the lowest one, Bloomberg data show. Compare that with, say, Duke Energy, where the gap is about 8 percent. That ITC is now openly contemplating a sale suggests the doubts may have something to them.

Which is why any ITC deal will provide a useful litmus test for the utility sector overall.

Two big recent deals in the sector -- Duke Energy's acquisition of Piedmont Natural Gas and Southern Co.'s purchase of AGL Resources -- are the canaries in this particular coal mine. Both involved largely loading up on cheap debt to pay a big premium for growth. Duke, in particular, paid 29 times estimated 2017 earnings for Piedmont, putting that gas company's multiple on a par with Twitter's.

Why pay social-media multiples for decidedly old-economy pipeline operators? Utilities traditionally make money by persuading regulators to let them invest in new power plants and networks, earning a decent, agreed return on equity on that investment. EPS growth is thus largely a function of how high your capital expenditure is. The problem is that U.S. electricity sales have stalled out since 2007 because of the recession, measures to enhance energy efficiency and, at the margin, the growing popularity of distributed power like residential solar panels.

Flatlining
U.S. electricity consumption isn't growing
Source: Energy Information Administration

"If your growth depends on spending on plants, that's not happening anymore," says Greg Gordon, chief utilities analyst at Evercore ISI. Hence the push by the likes of Duke and Southern to take advantage of cheap debt to buy into a faster-growing business like gas distribution to boost earnings.

On that basis, it is possible that a big utility could be tempted to pay up for ITC. Assuming a 40 percent premium to the company's 90-day volume-weighted average price of $33.12 prior to its announcement, ITC's price tag would be roughly $11.5 billion, including the assumption of its existing net debt. Using the consensus estimate of $766 million of Ebit in 2017, and assuming a 4 percent rate on the acquisition debt and a tax rate of 35 percent, incremental net income for an acquirer would come to roughly $200 million.

Imagine Duke was the buyer (there is no indication it is, so this is for illustrative purposes only). Adjusted for the impact of the Piedmont deal (my colleague Brooke Sutherland and I laid out the math on that one here), Duke's implied EPS in 2017 is $5.18 with ITC under its belt, 4 percent above the current consensus forecast.

Ah, the joys of cheap debt and earnings accretion -- analysts up and down Wall Street are running screens as to which small-ish utility will get taken out next. The thing is, though, cheap debt is still debt. Buying Piedmont already would push Duke's pro-forma net debt to estimated 2017 Ebitda from less than 4 times to about 4.3 times. Buying ITC at a 40 percent premium would raise that above 5 times, which would likely pique the interest of credit-rating firms. And every 0.5 percent addition to the cost of acquisition debt would knock almost a fifth off the extra net income coming in the door -- which is uncertain anyway, given ITC's challenges.

Besides the math, the bigger problem with a utility paying up for ITC is the signal it would send. Duke has underperformed the sector and lost $5.3 billion in value since it announced its deal to buy Piedmont -- for $4.8 billion. 

Duke Rebuke
Duke Energy's value has fallen by 10 percent since the Piedmont deal was announced
Source: Bloomberg

The market doesn't seem to necessarily relish earnings growth at any price. Indeed, it has to be asked why traditional utilities promise earnings growth rates in the mid-single digits -- roughly twice the growth rate of the economy -- when demand for grid-delivered electricity seems to have topped out. One somewhat analogous situation concerns the master limited partnerships sector, which has long promised very high dividend growth rates. Those stocks have been hammered in recent months as investors have questioned whether the underlying businesses support such promises with oil at $40 a barrel, and companies have begun showing the strain by cutting guidance or resorting to creative finance to cover their cash obligations.

The utilities aren't in such straits. But the point is whether it really makes sense to maintain such growth targets if it requires leveraging up the balance sheet to reward the shareholders of target companies with tech-like takeout premiums. Regulators, too, ought to be questioning the wisdom of this when they are considering utilities' investment plans.

ITC may yet get a big premium, especially if it ends up being bought by, say, an infrastructure fund. If a traditional utility buys it instead, it will offer a further reason as to why the pursuit of growth should be turning investors off, not onto, the sector.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net