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.

Houston, we have a solution.

CenterPoint Energy keeps the lights on and the air-conditioning humming in Texas' oil capital. It has also been one of the worst utility stocks to own this year, down 21 percent. Now, enter the activist: Elliott Management, which sparked a frisson of excitement in CenterPoint's shares earlier this month when it disclosed it had taken a stake in the company. 

Low Center of Gravity
Source: Bloomberg

Elliot's arrival on the shareholder register is often accompanied by a public drubbing of the company's performance and a plan to fix it, but that hasn't happened with CenterPoint. Not to worry: There are several levers for re-energizing the stock. 

CenterPoint's most pressing problem is its roughly 55 percent stake in Enable Midstream Partners. Master Limited Partnerships aren't exactly flavor of the month, what with their exposure to falling oil prices and reliance on public markets to fund growth. Enable, which has a small public float, has fared particularly badly, with its units tumbling two thirds this year against a mere 45 percent for the Alerian MLP index. A big chunk of its business involves pipes and plants to gather and process natural gas and oil from fields, which is more exposed to short-term swings in commodity prices. In the past six months it has changed chief executives and cut its guidance for dividend growth.

Caned Enable
Source: Bloomberg

By and large, investors in utilities do not particularly like owning things where profits rely on what's happening with oil prices. Hence, they have marked down CenterPoint's shares, which now trade at less than 16 times forward earnings, versus roughly 17 to 18 times for other diversified utilities such as Dominion Resources and NextEra Energy.

Jettisoning Enable is, therefore, an obvious step that ought to persuade more traditional utility investors to own CenterPoint's stock. Selling the stake looks problematic, not just because Enable's price has tanked, but also because it could trigger a big tax liability, which stood at $1.8 billion at the end of 2014. That will have shrunk since to perhaps several hundred million dollars. But with CenterPoint's stake only worth around $1.5 billion at the current price, a tax-free spin off to existing shareholders looks like a better option, letting them sell Enable's units to investors expecting a rebound in MLPs.

Freed up, CenterPoint's utilities businesses look attractive -- both in their own right and as acquisition targets.

Supplying electricity to Houston in the middle of an oil price slump may not seem the most winning of propositions. Yet Houston Electric has proved resilient so far, with the company reporting a roughly 2 percent increase in connections in the year through the end of the third quarter. It is hard to believe that won't come under pressure take next year as oil's slump continues, but Houston these days has other industries such as healthcare to help pick up the slack.

Moreover, when it comes to utilities' profits, what really counts is how much money they are investing in their rate base, the infrastructure of wires, transformers and all the rest that gets paid for in your electricity bill. And on that front, Houston Electric's capital expenditure should grow by high single-digit percentages per year through much of the rest of the decade.

The same goes for CenterPoint's natural gas distribution business, which operates several local pipeline networks but centers chiefly on Houston and Minneapolis. Natural gas demand has better growth prospects than for electricity and, again, CenterPoint has a healthy pipeline of upgrade and expansion projects that should expand its rate base at high single-digits.

So what might these be worth alone? CenterPoint is forecast to earn $1.11 a share next year, according to numbers compiled by Bloomberg. Of that, say roughly 50 cents pertains to the electricity business and 33 cents to the gas distribution business. Putting those earnings on a higher multiple of 18 times implies a value of about $15 a share for the utilities businesses. Throw in about $3.70 for the Enable stake - which includes some minimal option value for CenterPoint's stake in the MLP's general partner -- and you end up with roughly $18.70. That is roughly a dollar and change above where the stock trades now.

An extra buck is hardly the stuff of dreams -- likely not Elliott's, anyway.

The most obvious extra step would be to sell the utility businesses, either altogether or as separate electricity and gas units. Around $62 billion worth of acquisitions of U.S. utilities has been announced so far this year, the highest since 2011, according to data compiled by Bloomberg. The average premium has been 32 percent, the highest since 2008. This sleepy sector is hot, largely because organic growth is hard to come by in a country where overall electricity demand hasn't risen for years.

Wired
U.S. utility M&A has risen strongly over the past two years
Source: Bloomberg
Note: 2015 data through Dec. 16th

CenterPoint, with its mix of regulated assets and growth prospects, ought to make a good target. Net off the value of Enable and apply this year's average premium to the adjusted share price, and CenterPoint's implied value climbs to about $22 a share. The price tag for the utility assets would be $7.8 billion plus debt, which looks manageable for larger utilities.

Bidders might yet pay up more, though. Gas networks have been selling at big premiums recently, with both Southern Co. and Duke Energy paying multiples of forward earnings above 20 times for AGL Resources and Piedmont Natural Gas, respectively. If CenterPoint's gas assets were sold separately at a mid-20s multiple, that could add an extra couple of bucks to the valuation, taking the premium to the current price up to more than 35 percent.

One last potential option is converting all or part of the utility business to a real estate investment trust. This was done already by fellow Texan utility InfraREIT and may yet happen for Oncor, which operates the grid in Dallas among other places and is emerging from the bankruptcy of Energy Future Holdings, the old TXU business.

One big wrinkle is that Congress just passed legislation to block tax free spin-offs of assets into REITs as part of the latest spending package.

It may yet be possible, though, for CenterPoint to convert itself into a REIT, perhaps by just taking the tax hit on spinning off Enable. Assume all of CenterPoint's utilities could be put into a REIT structure, with earnings of about 83 cents a share. Adding back corporate income tax -- now no longer owed due to being a REIT -- at a rate of 35 percent and then paying out 90 percent of earnings results in a dividend of $1.16. Put that on InfraREIT's current yield of 4.9 percent and the resulting valuation is $23.60 a share -- or more than $4.2 billion more than the current implied value of CenterPoint's utility businesses after stripping out Enable. In that context, the tax hit on the spinoff could be worth taking.

That's a blue-sky valuation, and the REIT option may be a step too far. Congress' move demonstrates the unease felt about companies using the structure to shield assets. And the scattered nature of CenterPoint's gas assets means they would have to deal with several states in gaining approval, not just Texas.

Leaving the REIT option aside altogether, the bigger point is that there is a decent set of utility businesses lurking within the CenterPoint conglomerate. Properly enabled, they should be valued higher or simply snapped up altogether.

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