A Duke Energy power plant.

Photographer: Luke Sharett

Duke Has Bubblicious Feelings for Piedmont

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.
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Perhaps jealous of the hoopla surrounding tech unicorns, the staid utility sector is stepping up with some eye-popping valuations of its own.

Duke Energy kicked off Monday by announcing it would buy Piedmont Natural Gas, a gas distribution business also based in Charlotte, N.C., for $6.7 billion including debt. Piedmont's investors must be pinching themselves.

The stock has never traded at $60, the price Duke is offering. Shares hit a record of a little under $43 just last week. Before Monday, analysts on average expected the stock price would drop about 11 percent over the next year. Not a single one of them recommended buying it.

Duke's offer is also 46 percent higher than Piedmont's average share price in the prior 20 days. Only three U.S. utility companies purchased for $1 billion-plus can say they've commanded a richer premium, according to data compiled by Bloomberg.

Even better, $60 equates to almost 29 times Piedmont's consensus earnings estimate -- for 2017. Do you know which other stock trades at almost 29 times earnings that are being forecasted two years out? Twitter.

So this is one expensive deal for the sleepy utility sector. In such situations, the acquirer is usually keen to expound upon the synergies that make the deal more palatable. Not with Duke, even when asked by analysts on Monday morning's conference call.

This is a strategic deal, then -- which in Duke's case likely centers on the strategic imperative of meeting its earnings target.

Duke aims for earnings per share to rise by between four and six percent a year. The consensus forecast implies that it will average 4.6 percent, compounded, through 2018 compared to 2014, according to data compiled by Bloomberg.

But there's been an unfortunate shift in the underlying numbers over the past year. Analysts a year ago expected earnings to rise by 5.3 percent in 2015. The current forecast is just 1.8 percent.

The big drag is Duke's international business, and Brazil in particular, where a low rainfall has combined with a sinking economy to cap power sales. That's unlikely to reverse quickly. So while the overall average earnings growth forecast for Duke through 2018 has shifted down only slightly from the 4.8 percent projected a year ago, almost two-thirds of that forecast relies on earnings bouncing back after 2016 -- doable, but riskier when you're already treading water near the bottom end of the desired range.

With the utility sector's core electricity revenue facing structural pressure from things like distributed solar power and energy efficiency measures, Duke is taking advantage of debt costing just 4 percent to diversify further into gas, where underlying growth prospects are better.

Yet, absent synergies, it still looks like a stretch to expect Piedmont to really set Duke's earnings on fire. Duke will issue $500 million to $750 million of equity to help fund the deal. Consensus forecasts imply pro-forma Ebit of $7.28 billion in 2017. Assuming just $500 million of equity and a pro-forma interest charge of about $1.9 billion on Duke's expanded debt, you end up with pretax income of $3.5 billion. Assume a tax rate of 35 percent, and the deal looks like a wash in terms of earnings accretion in 2017.

Looking that far out, the analysis is highly sensitive to even small movements in projected profits or tax rates, so Duke could well show some accretion from the deal after it closes. So what? The company is clearly stretching to buy a company that will contribute just 5.4 percent to combined Ebit in 2017, based on current forecasts. 

Duke's announcement follows quickly on the heels of rival Southern Co.'s $12 billion deal, including assumed debt, for gas utility AGL Resources, announced in August. Southern also paid a hefty premium close to 40 percent. That said, Southern will no doubt be gratified that Duke's move makes the 21 times 2017 earnings paid for AGL look sedate by comparison.

Yet the message from both deals is the same: Meeting earnings growth targets keeps getting harder for utilities. They're scrambling for gas deals to help move the needle, leading to the same sort of M&A froth seen in other sectors. This is great news for small, focused gas utilities. 

Paying social network multiples for pipeline networks, though, shows just how tough things are for Big Electricity.

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

To contact the authors of this story:
Liam Denning at ldenning1@bloomberg.net
Brooke Sutherland at bsutherland7@bloomberg.net

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