NextEra Needs Oncor Or An Encore
To miss one multi-billion dollar utility deal is unfortunate; to miss two is careless, as the old saying goes.
NextEra Energy Inc., a hybrid of Florida's main regulated utility and the country's biggest private portfolio of renewable energy projects, is facing its second failed utility deal in less than a year. The Public Utility Commission of Texas may this week formally block NextEra's $18.4 billion takeover of Oncor Electric Delivery Co., which operates the state's biggest electricity transmission network. Only last July, NextEra's $4.3 billion pursuit of Hawaiian Electric Industries Inc. was also stymied by state regulators.
Utility deals are by nature tricky affairs. If the Oncor deal fails, that will mean $38 billion worth of all U.S. utility M&A deals since the beginning of 2012, about 12 percent of the total announced, have fizzled out, according to data compiled by Bloomberg. People tend not to care too much when one widget-maker buys another, but they take notice when the company keeping their lights on is being pursued.
In NextEra's case, the Hawaiian deal collapsed amid regulatory concerns on several fronts, ranging from the perceived inadequacy of proposed savings for ratepayers to lack of a firm plan to integrate the state's high level of distributed solar-power capacity. With Oncor, the main sticking point is the regulator's desire to keep the business ring-fenced from the rest of NextEra's balance sheet and with a high degree of independence from the parent. Such sensitivities reflect the fact that Oncor is emerging from the wreckage of the TXU Corp. leveraged buyout and subsequent bankruptcy. NextEra, meanwhile, risked damaging its credit rating if it took on billions of dollars of debt for a deal in which it didn't fully control the resulting subsidiary.
Could NextEra have done more to win favor? It's hard to say. Sweetening the deal for Oncor's customers may have helped. Buried towards the end of a submission made to regulators last month by a group called Texas Industrial Energy Consumers was a proposal for "compensation for use of Oncor's credit profile" or, in layman's terms, $840 million worth of payments from NextEra to Oncor's customers spread over four years. Discounted back at 10 percent, that's worth about $645 million today. Back in July, when the deal was announced, ISI Evercore analyst Greg Gordon published a report in which he estimated Oncor might add 25 cents a share to NextEra's earnings in 2018 which, at the current price/earnings multiple, would be worth $2.1 billion. That gap suggests there might have been room for a compromise with an important local constituency. NextEra declined to speak with Gadfly and a legal representative of the TIEC didn't respond to an email for comment.
Assuming the deal is dead, NextEra is, on the face of it, fine -- barring one important caveat. With forecast annual earnings growth averaging 7 percent through 2020, NextEra doesn't appear to need Oncor. On the other hand, no-one attempts an $18.4 billion takeover as a nice-to-have exercise.
NextEra has a compelling reason to buy another regulated utility. Florida offers a solid base for the company, with a favorable regulatory environment and, in contrast to the U.S. overall, modest growth in electricity demand -- emphasis on the "modest," though:
Building its large renewables business is one way NextEra aims to make good on high growth forecasts. Still, while many of the renewables projects are tied to long-term electricity supply contracts, providing a good level of stability, they don't offer the same level of comfort provided by a regulated business -- which presents potential complications for NextEra's credit profile down the road as unregulated profits rise as a proportion of its income.
Oncor offered a neat solution to this. Moody's Investors Service noted in a report published in January that "Oncor will still meaningfully increase the proportion of regulated earnings in [NextEra's] business mix" taking them from 58 percent to 65 percent of overall Ebitda on a pro-forma basis. Unusually, that stability came with good growth prospects, too. While Oncor's customer base has grown by 1.4 percent a year on average since 2010, the regulated value of its distribution business hasn't risen at all, according to Hugh Wynne and Eric Selmon, utilities analysts at SSR LLC. That offers a lot of scope for persuading regulators that expansion is required.
Assuming NextEra's deal is dead, that tension between growth and the earnings mix suggests it will return to the hunt for another large, regulated business (Gadfly assessed a list of potential targets for utility M&A in general here). It remains to be seen, however, whether the record of two failed bids would trouble any future objects of NextEra's affections.
As for Oncor, its growth prospects should attract more suitors. Greg Abel, Chief Executive Officer of Berkshire Hathaway Inc.'s energy business, caused flutters of anticipation during Q&A at a recent analyst day by saying his company had no problem with regulatory ring fences. Warren Buffett's company was said to have submitted a bid for Oncor last year.
It is also possible that Hunt Consolidated Inc. might revisit Oncor. The Hunt-family vehicle tried to buy it last year with a view to putting the assets into a real-estate investment trust. While initially approved by regulators, the unusual structure caused the deal to founder on the question of how the benefits of the REIT's tax savings would be shared with customers. However, this question is now under discussion regarding another Texas utility that is already structured this way under InfraREIT Inc. and is 28 percent-owned by, you guessed it, Hunt Consolidated. A favorable precedent there could yet tempt the Texan family back to the fray.
One thing seems certain, however. With both NextEra and the Hunts having tripped on regulatory issues with this one, and a bidder with Berkshire's value-investing instincts in the wings, whichever offer emerges for Oncor next looks likely to be lower than the last.
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