On October 26, 2021, Algonquin Power & Utilities (AQN) announced it would buy American Electric Power’s (AEP) Kentucky Power and Kentucky Transco units for roughly $2.846 billion, including $1.221 billion in assumed debt.
Despite a price tag then equal to more than 30 percent of Algonquin’s market capitalization, the company assured investors the purchase would be accretive to earnings per share the first year after closing. After that, it projected “mid-single digit percentage accretion.” The key driver: Cost savings and rate base growth from replacing Kentucky Power’s coal-fired generation with wind—as the company has done earlier in Missouri at its Empire District unit.
For American Electric, the sale was an opportunity to cut debt immediately with no meaningful impact on long-term earnings growth. The company would also be able to focus capital spending on fewer states, while shedding an historically underperforming unit typically averaging annual return on equity of less than 6 percent.
The potential for rapid “greening” of a coal-fired Kentucky utility was also expected to be attractive to the Biden Administration. But some 14 months after the deal was announced, the Federal Energy Regulatory Commission formally rejected the deal, on the grounds the parties couldn’t guarantee there wouldn’t be an impact on transmission rates.
The companies subsequently refiled with FERC. But it was already clear the deal’s economics had changed as the parties had already negotiated a lower purchase price. Then in January Algonquin announced the somewhat painful results of a strategic review, and when 11th hour opposition to their filing from Kentucky regulators emerged, they formally pulled the plug.
For the much larger American Electric, the cost of the failed sale is on the opportunity side, tying up management’s time and use of proceeds to cut debt and invest in its business. Smaller Algonquin paid a much steeper price in both energy and financial strength, largely because it had relied so heavily on variable rate debt to complete acquisitions.
Walking away from this deal without penalty allows Algonquin to attack its variable rate debt challenges head on. It will do so quickly if management is successful with planned asset sales, with the next update on its progress due May 11. I continue to recommend the company’s 7.75 percent mandatory convertible preferred of June 15, 2024 at a price of 30 or lower.
I also like American Electric Power for conservative investors at a price of 90 or less.Management expects to cover the cash shortfall from not selling Kentucky Power in part by disposing of its contracted solar generation. It will also attempt to push Kentucky ROE higher with cost cutting and rate increases.
The FERC’s unexpected opposition to the Algonquin/AEP deal is likely to cause other utilities to think twice about M&A elsewhere in the U.S. There’s still one major merger in the works: The offer of Avangrid
AGR
Inc (AGR) and its 81.64 percent owner Iberdrola SA (IBDRY
BDRY
) for PNM Resources
PNM
(PNM).
The original $50.30 per share all-cash offer for PNM was announced all the way back on October 21, 2020. The parties then expected to wrap up the two state and 5 federal regulatory approvals needed “in approximately 12 months.” And in fact in barely six, they had secured everything including shareholder approval.
My view is this deal should close before July. And I continue to recommend Avangrid as a buy at 45 or lower, in part because the acquisition provides the means for a return to dividend growth in the next 12 to 18 months.
I don’t expect a successful close here to trigger much in the way of other utility M&A in the short term. The primal forces that have driven the literally thousands of U.S. utility mergers over the past century plus are as powerful as ever.
Complimentary businesses vary little by region, a fact amply demonstrated by the ability of employees and executives to be highly effective when they switch utilities. And greater scale has never failed to create a more efficient and profitable company thanks to enhanced access to resources, which is why no merger of operating utilities has ever failed.
Utility M&A activity, however, has varied widely over the years. There have been a handful of successful deals in recent years, most recently the acquisition of the former South Jersey Industries
SJI
by a private capital firm that closed February 1. But activity is far more subdued now than in the previous decade.
I see several reasons why that’s likely to remain the case for the next few years. First, the Biden Administration is the most merger-skeptic national government in decades. Throw in the rising populism in several states such as Kentucky and any companies wanting to do a major deal are going to have to be prepared to ultimately lose their bid, even if they’re willing to make concessions that were reasonable in previous years.
Second, utilities still have an unprecedented to invest in their core businesses, provided regulators approve their plans. For electric utilities, that’s energy transition spending on decarbonization, made all the more attractive by the Inflation Reduction Act.
For gas and water utilities, it’s replacing pipeline networks that are more than a century old in many places and have been chronically underfunded for almost that long. The return on this kind of investment is almost immediate, and so long as it is available, management teams are likely to focus there.
Ironically, higher interest rates combined with inflation may ultimately re-ignite utilities’ urge to merge, since larger companies have a better opportunity to control costs. And more than a few companies clearly intend to sell assets to cut debt.
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