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2 Utilities Mergers: Should Dividend Investors Be Concerned?

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters--he's the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. There have been some recent big mergers in the utility space. We're going to talk about what impact that's going to have for dividend investors.

Josh, thanks for joining me.

Josh Peters: Good to be here Jeremy.

Glaser: Let's look at these two deals: Southern Company (SO) buying AGL Resources (GAS) and also, just recently announced, Duke Energy (DUK) buying Piedmont Natural Gas (PNY). Are there any similarities between these deals. Why are these companies trying to get bigger?

Peters: I think there are a lot of similarities. One is the financial backdrop, which is that you have the opportunity for companies to raise money--long-term financing at very low interest rates. I think for Southern and Duke, both coming into this period with strong balance sheets, it's like money jingling in their pocket. If interest rates go up later, you don't have the opportunity to do deals like these. They'd just be too expensive. So, that's part of it.

Another is that there is a broader theme right now that zeros in more on the electric side of the utilities industry than the natural gas side, which is that growth has slowed. Energy efficiency seems to be catching up with the rise in demand. So, you are not seeing as many opportunities to expand in electrical generation. Now, there are still a lot of opportunities out there, but that load growth is not there. It's more environmental retrofits, transmission investment, renewable energy, or natural gas replacing coal. Those are all good things. Those are all enough to power pretty good growth for the industry in general, but you don't have people using more and more electricity the way they had in the past.

I think this is, then, compared with the natural gas side, where after so many years now of such low gas prices, you've actually got growth. There's more growth going on on the natural-gas-delivery side of the business than the electric-generation-and-delivery side. So, there is a strategic rationale for this, and if you look at the states involved, Southern Company--headquartered in Atlanta--buying what was once known as Atlanta Gas Light. Duke Energy is buying Piedmont; it was pointed out by the company that Piedmont's natural gas system was originally owned by Duke, and it was spun off decades ago. Now, it's coming back into the fold. So, there is a lot in common between the two deals.

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Glaser: So, we have the strategic rationale, and the money is available, but is it being spent wisely? Are they getting a good price for these assets?

Peters: Shareholders of Piedmont and AGL are getting fantastic prices. It's much harder, I think, to come to the conclusion that Duke or Southern are actually making the best capital-allocation decisions here. Again, it's mitigated by the low cost of financing. The strategic rationale makes sense. And in both cases, you've got rate-based growth at these natural gas utilities that provides them with something to invest in as well as what both companies are calling "platforms" to pursue bigger pipeline projects and become much bigger players in natural gas in the future.

That's all very fine and good, but the premiums that Southern and Duke are paying to buy these smaller natural gas utilities are almost to the chokepoint. In Piedmont's case, Duke is offering $60 a share in cash; that's exactly double our fair value estimate for Piedmont on a standalone basis. So, yes--that makes it a little tough. And I should say, as a shareholder in both Southern and Duke--but not in AGL or Piedmont--it's been kind of difficult to watch these acquisitions. You can agree with a lot of it, but the price paid really makes you scratch your head.

Glaser: When you look at those hefty premiums, then, do you think it's going to slow dividend growth at either of the acquisitors?

Peters: Well, that's where the story, I think, is a little bit better. The mitigating factors to these giant premiums are twofold. One is that, from a dividend-growth perspective, I think that both deals probably will be neutral to slightly positive for long-term dividend growth but at the risk of both of these buyers--Southern and Duke--running with higher leverage ratios than they have in the past. Because they are funding most of these acquisitions with debt. That's the way to do it. That's the only way to make them accretive when you're paying such a steep premium. But it does introduce a little bit more financial risk to the companies; it's not something I'm really worried about, but it introduces a little risk. The other thing is that these are still very, very large companies, and AGL and Piedmont are much smaller than their respective buyers.

So, even with the big premiums essentially going out the door, our fair value estimates did not change that much. Southern's fair value came down by $1 a share. Duke has come down by $2. But both stocks at this point are among the higher yielding, certainly, in the utilities industry. And you've got baseline-dividend-growth prospects--3% or 4% for Southern. I think that AGL might move them from, say, the 3% side more toward the 4% side. With Duke, you still have their assets down in Latin America that may be a little more of a drag with what's going on in Brazil--the rapid depreciation of the currency. This [acquisition] is going to add some growth to offset some of those negative forces, so that will hopefully keep them in that 4% to 6% range. But in both cases, I think those are attractive total-return prospects. So, I may not agree with the capital-allocation decision here--paying these giant premiums is not the decision I would make--but I think it's OK.

Glaser: Josh, thanks for your take on these mergers today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.