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.

What would you do for an extra 3 percent? It depends on what you want, I suppose

Sempra Energy, for example, will apparently do quite a lot, such as inserting itself into a bankruptcy-cum-sale process that's already seen more rejections and plot twists than a season of "The Bachelorette."

This says a lot about the target, Texas utility Oncor Electric Delivery Co. But it also says something about Sempra and the wider utility sector.

Sempra is the fourth public suitor for Oncor, besting a bid by Warren Buffett, which itself came after Texas regulators rejected two earlier bids. Sempra announced its offer on Monday and laid out more details on Friday morning. There are a lot of them.

Sempra plans to acquire Energy Future Holdings Corp., the entity that holds an 80 percent stake in Oncor, for $9.45 billion. Of that, $3 billion will be new debt layered on the reorganized holding company. The rest will consist of new debt and equity raised by Sempra along with an unidentified third-party investor. In the end, Sempra will hold a 60 percent stake in the holding company and, thereby, an indirect stake of 48 percent in Oncor. To assuage regulatory demands, the holding company will have only two representatives on Oncor's board, which will also have seven independent members, all of them based in Texas.

So Sempra is offering the equivalent of about 23 times earnings for a large but minority, indirect stake in a utility that will be run by an independent board (forget about synergies).

In return, it gets ... 3 percent. That's what Sempra can expect in terms of earnings accretion from the deal.

In its presentation on Friday, Sempra laid out some parameters for Oncor, including a starting regulated asset base of $11 billion, an equity ratio of 42.5 percent and an allowed return on equity of 9.8 percent. Sempra has also committed to investment averaging $1.5 billion a year. Assume average annual depreciation of 6 percent of the asset base, and Oncor's projected earnings look like this:

Sounds Like A Plan
Oncor's regulated return and spending plans imply earnings growth of almost 6 percent a year through 2021
Source: Oncor, Bloomberg Gadfly analysis
Note: Assumes starting regulated assets of $11 billion; equity ratio of 42.5 percent; allowed return on equity of 9.8 percent; annual capital expenditure of $1.5 billion; average depreciation per year of 6 percent.

Sempra's stake in the holding company would cost it just shy of $3.9 billion. Assuming it financed that half with new shares and half with debt (with all debt at both levels costing 4 percent), here's how those earnings would be divided up in theory starting in 2018:

Dividing the Pie
The layered structure of Sempra's proposed deal means that, after financing costs, it would have a claim on a little less than one-third of Oncor's allowed earnings
Source: Oncor, Sempra, Bloomberg Gadfly analysis
Note: Oncor earnings assumptions as per article. Split assumes 50/50 equity and debt financing for Sempra's stake in holding company; 4 percent cost of debt, tax-adjusted at 35 percent.

Add it all up and factor in the extra 16.6 million shares Sempra would issue (based on its closing price before it swooped in) and the accretion to earnings through 2021 averages ... 3 percent (2.91 percent to be precise):

Net Net
Buying Oncor could boost Sempra's forecasted earnings by about 3 percent on average
Source: Oncor, Sempra, Bloomberg, Bloomberg Gadfly analysis
Note: Accretion versus consensus forecasts. Assumptions for projected Oncor earnings as per article. Assumes Sempra issues 16.6 million new shares at $116.55 each.

Given all the assumptions involved, those numbers are pretty sensitive. Drop Oncor's allowed return by half a percentage point and nudge interest on debt up by the same amount, and Sempra's accretion drops to 1.5 percent. Separately, if Sempra uses equity to cover 65 percent of its check -- at the top of the range it outlined on Friday -- accretion would also drop below 2 percent.

Why so much trouble for seemingly so little?

U.S. power demand is largely flat; Sempra's retail electricity volume hasn't gone anywhere since 2008. Yet the company targets earnings growth of 10 to 11 percent a year.

Adding Oncor would push that to 11.3 percent. More important, those earnings would be from a regulated U.S. utility, so beloved of both investors and credit-rating firms. As I wrote here, virtually all of Sempra's growth comes from unregulated activities, such as its Cameron liquefied natural gas export project in Louisiana. These assets carry higher risks than domestic utilities, as delays at Cameron have demonstrated. So Oncor's addition helps nudge the profit mix back toward safer territory.

Given the layers involved, though, it's only a nudge: just 2 percent of Sempra's projected earnings in 2018, according to a report published by Moody's Corp. earlier this week. Moody's also noted Sempra's relatively weak credit metrics through 2020, partly because of delayed cash flow from Cameron. This helps to explain the convoluted deal structure, as Sempra can avoid consolidating Oncor for now.

Conversely, though, Sempra will buy more of Oncor down the line. By the 2020s, Cameron should be generating dividends and Sempra expects to have squared away an increased stake with Austin's regulators already.

So Sempra is buying 3 percent plus an option on growth from a higher-quality earnings stream next decade.

Yet there's a feedback loop here that investors should keep in mind.

Sempra can afford this deal because its stock trades at an all-time high, on a multiple of 23 times forecast earnings, a premium to a utility sector that already looks richly valued. And that premium owes a lot to Sempra's double-digit earnings growth target, far ahead of the 4 to 6 percent ranges common across the sector. The extra growth, though, is coming from unregulated and foreign projects that raise Sempra's risk premium down the line, which is precisely why it needs Oncor.

Before this week, investors had been expecting a buyback from Sempra in the next few years. Now, the company will instead capitalize on their enthusiasm to issue highly priced new equity to finance a convoluted deal ... to help justify that multiple.

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

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

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net