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UIL’s Updated Connecticut Merger Filing

In late June the Public Utility Regulatory Authority of Connecticut issued a draft decision denying UIL’s merger with Iberdrola USA. UIL withdrew their application and filed a new application on July 31. The new application substantially addresses PURA’s concerns and increases the likelihood that this value creating merger will be approved. UIL Holdings (NYSE: UIL ) and Iberdrola USA ( IUSA ) (a subsidiary of Spanish utility Iberdrola (OTCPK: IBDSF )) are making their second attempt to get their merger through the notoriously difficult Connecticut Public Utility Regulatory Authority ( OTCPK:PURA ). As discussed in my earlier post , this is a merger that will create substantial value for the participants, so there was no way they would give up easily after PURA’s initial rejection. The new filing really lays out the benefits for the state of Connecticut, and should be enough to get the deal approved in that jurisdiction. PURA’s issues with the original application are summarized in this excerpt from the draft decision : The Applicants have not provided any measurable or quantifiable commitments that unequivocally assure the Authority that the public interest of the ratepayers will not be harmed. In response, the applicants have increased a number of the benefits Connecticut customers will receive, and presented them in a quantifiable way that easily allows PURA to see the advantages for customers. The draft decision also listed a number of items that had been included in recent Connecticut merger agreements. Many of the updates to the application are related to this list. A discussion of these items follows. Rate credit allocated to retail customer classes UIL and IUSA have increased the rate credits for customers from about $5M in the original application, to approximately $20M in the new one. The applicants have actually proposed three different methods to distribute the credit to customers. The first option would apply a $20M credit customers in the first year after the closing. Another proposal is for UIL to provide $26M of credits spread over ten years. The last option is essentially giving a $1.5M annual credit over thirty years. The present value of all three options is essentially the same, and the applicants are giving PURA a choice based on feedback they received from their earlier application. Commitment to accelerate the pole inspection cycle. This is basically a reliability commitment. For those unfamiliar with the issue, utility poles, like any other piece of the electric system, can wear out as they age. The end of a pole’s life can lead to a power outage or damage to property. Increasing the frequency of these inspections can reduce the number of surprise failures, resulting in fewer outages. Subsidiary United Illuminating (UI) is the custodian of 87,000 poles. In 2005 they pledged to improve their pole inspection process, and they have $700,000 budgeted for pole inspections in 2015. With an already strong commitment to inspecting utility poles, no further enhancements were made in this application. However, while UI will not address poles, they are making some quantifiable reliability commitments. In the first application UIL had only said there would be benefits from sharing best practices and better storm response, and that there would be no deterioration in service after the transaction. Now the applicants have pledged to increase investment in electric distribution system resiliency with a reduced recovery of the first $50M of this spending over a two year period. They are also making some reliability commitments at their Southern Connecticut Gas (SCG) subsidiary. UIL is promising to double the annual spending on the replacement of cast iron/bare steel pipe (from $11M to $22M per year) over the next three years without seeking recovery until the next SCG rate case. There are substantial reliability issues with these older pipes, and increasing the rate of replacement should have an impact on safety and dependability. UIL estimates the gas commitment will create a $1.6M benefit, and the commitment at UI will create a $5M benefit. Commitment to improve non-storm and storm related service quality performance at a minimum of the 10-year historical average UIL stated that they would improve a number of different service metrics by 5% by the end of the third year after the closing of the deal. These metrics were: average answering times, % abandoned calls, % appointments met. UIL also promised to maintain the high level of reliability at UI as measured by SAIDI and SAIFI. (SAIDI is the System Average Interruption Duration Index, essentially the average number of minutes a customer is out during a year; and SAIFI is the System Average Interruption Frequency Index, essentially the average number of times a customer has an outage in a year.) You can see how well they have been doing on these metrics by looking at this information from UIL’s 2015 Reliability Report . SAIFI SAIDI 2010 0.65 85 2011 0.81 102 2012 0.60 58 2013 0.58 51 Four-Year Average (’10 – ’13) 0.66 74 2014 0.56 53 2014’s SAIFI number was actually the company’s best in the past eighteen years. The 2014 SAIDI number was better than all but two of the previous eighteen years. Also, UI’s SAIDI and SAIFI numbers are better than neighboring utility CL&P. In 2014 CL&P’s SAIDI was 88.9 minutes, and their SAIFI was 0.77. It seems that UI maintaining current reliability numbers should be acceptable to PURA. Commitment to open space land UIL has not specifically addressed open space land, but they appear to be working on an issue that is related in spirit. This is regarding English Station, a retired power plant on a nine acre site that UIL sold over fifteen years ago. This property has substantial environmental issues, and there is a big dispute over who should pay the cleanup costs. The applicants have stated that if the merger is approved they will end the legal wrangling, and agree to pay for the cleanup of the site. This cost is currently estimated at $30M. (More information on the English Station dispute can be found here .) Seven year commitment to not move headquarters out of Connecticut The applicants have proposed to create a new management position entitled the President of Connecticut Operations. The President of Connecticut Operations will be headquartered in Connecticut, and the applicants state that the headquarters will remain in Connecticut for at least seven years. (I’m pretty sure we know where they came up with that length of time.) One issue that was not in PURA’s bullet list, because this is the first time it has come up in a Connecticut utility merger case, is ring-fencing. UIL has dramatically increased the robustness of their proposed ring-fencing provisions. The applicants have proposed creating a special purpose entity (SPE) adding another layer of separation between UIL and IUSA. 100% of UIL will be owned by the SPE, and IUSA will own the SPE. The SPE will have at least one independent director, and a “Golden Share” provision. This Golden Share has a non-economic interest in the SPE and will be owned by an administration company in the business of protecting special purpose entities. The Golden Share has the right to vote on certain matters, primarily with respect to the filing of bankruptcy. (More information can be found in Attachment 2 of the merger application.) UIL and IUSA have made a dramatic improvement in their merger application. The benefits Connecticut customers will receive have been increased and quantified, so it is easier to see the advantages of the deal for the state’s citizens. The applicants have specifically addressed many of the items PURA brought up in their earlier draft decision. In particular they have substantially beefed up the ring-fencing provisions, so a problem elsewhere in Iberdrola’s operations does not hurt any of UIL’s subsidiaries. Based on these changes it seems like the merger should have a very good chance of getting PURA approval. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Investing Lessons From Baseball’s Active Managers

By James T. Tierney Jr., Chief Investment Officer – Concentrated US Growth As the popularity of passive investing continues to gain momentum, take pause to think about a lesson from baseball. The question is: what kind of equity lineup creates a winning team? Nobody can deny the increasing shift of equity investors toward index strategies. Net flows to passive US equity funds have reached $21.7 billion this year through June, while investors have pulled $83.7 billion out of actively managed portfolios, according to Morningstar. In this environment, active managers are increasingly challenged to prove their worth and justify their fees. Building a Winning Lineup Baseball provides an interesting analogy for the active equity manager. Across all players in Major League Baseball, the batting average this season is .253 , as of August 6. Yet even in today’s statistics driven environment, you won’t find a single team manager who would choose to put together a lineup of nine players who all bat .253-even if it were possible. The reason is clear and intuitive. For a baseball team to be successful, you need to have at least a few hitters who are likely to get hits more often than their peers. And to create a really robust lineup, a manager wants a couple of power hitters who pose a more potent threat. Of course, some hitters will trend toward the average and slumping players will hit well below the pack. That’s why you need a diverse bunch. A team comprised solely of .253 hitters is unlikely to have the energy or the momentum needed to win those crucial games and make the playoffs. False Security in Average Performance So what does this have to do with investing? When an investor allocates funds exclusively to passive portfolios, it’s like putting together an equity lineup that is uniformly composed of .253 hitters. This lineup might provide a sense of security because returns will always be in synch with the benchmark. But it’s little consolation if the benchmark slumps. A passive equity lineup won’t be able to rely on any higher-octane performers to pull it through challenging periods of lower, or negative, returns. Still, many investors fear getting stuck with a lineup of .200 hitting active managers. We believe the best strategy to combat that risk is to focus on investing with high conviction managers, who have a strong track record of beating the market, according to our research . Passive and Active: The Best of Both Worlds Passive investing has its merits. Investors have legitimate concerns about fees as well as the ability of active managers to deliver consistent outperformance. The appeal of passive is understandable. Yet we believe that putting an entire equity allocation in passive vehicles is flawed. It leaves investors exposed to potential concentration risks and bubbles that often infect the broader equity market. And with equity returns likely to be subdued in the coming years, beating the benchmark by even a percentage point or two will be increasingly important for investors seeking to benefit from compounding returns and meet their long-term goals. There is another way. By combining passive strategies with high-conviction equity portfolios, investors can enjoy the benefits of an index along with the diversity of performance from an active approach, in our view. Baseball managers don’t settle for average performance. Why should you? The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.

My Favorite Ratios – Part 1

When the dog bites, when the bee stings, when I’m feeling sad, I simply remember my favorite things, and then I don’t feel so bad!” -The Sound of Music When Julie Andrews sings about bright copper kettles and whiskers on kittens, she’s trying to calm her charges during a violent thunderstorm. When the market gets turbulent and frightening, I turn to my favorite indicators of financial performance. I’ve noted before how – sooner or later – stock market performance has to come back to fundamentals. There has to be a way to evaluate how well a company is performing, whether it’s providing insurance or selling tractors. Most analysts use financial ratios. But there are literally hundreds of these, evaluating credit quality, efficiency, growth, even management’s language in their quarterly conference calls. Which ratios should we choose? I like to look at financial disclosures as a tripod, the three legs being the income statement, the balance sheet, and the statement of cash flows. The most basic analysis looks at earnings per share and (perhaps) sales as an indicator of how a firm is doing. But management sometimes manages those numbers. An investor once told of visiting a corporate loading dock on September 30th at lunch time. He asked the shipping manager how the quarter had gone. The manager looked at his watch and said he couldn’t tell, the quarter was only half over. Principal Financial Statements. Source: Douglas Tengdin But it’s hard to manipulate the entire financial picture. So I look at ratios that evaluate how these three principal disclosures interact. The most basic relationship is that between income and the balance sheet. This indicates how efficiently management is utilizing the assets that are under its control – how effective they are at turning an investor’s cash into earnings. So I use Return on Invested Capital – net earnings divided by the book value of equity and the market value of debt. I like to include debt in this analysis, because that doesn’t incent management to borrow money just to boost their return on equity. Second, I evaluate the ratio of cash from operations – part of the Statement of Cash Flows – to net income. This gives me, in broad terms, an indication of how much of the corporation’s earnings are based on cash receipts, versus accruals of one sort or another. Warren Buffett has said that cash is to a business as oxygen is to an individual. This relationship can give us a sense whether a company might need CPR soon. Finally, I examine the ratio of cash delivered to shareholders – both through dividends and net share buybacks – to the market value of equity. This ratio is the Shareholder Yield . This gives analysts a sense of how committed management is to returning cash to the company’s owners. We may be uncertain about many things that companies may disclose, but one thing we can be sure of is how much they pay us to hold their stock. And stock buybacks are important, as they can be a more tax-efficient way to return money to shareholders. Each of these numbers is independent of a company’s size. A mega-cap like GE (NYSE: GE ) with billions in capital is on the same footing as a 1000-person firm like Box. But taken together, they measure how efficiently a company is at generating cash from their businesses and how willing they are to send some of it to their investors. These indicators aren’t perfect. They are biased towards established companies that are in the process of paying shareholders – rather than taking in money and using it to grow, or even just redeploying their own internally-generated resources. And it’s important to look at footnotes as well, especially when accounting standards are changing. But when things go wrong, it’s comforting to know that a company’s management team is committed to distributing cash to me quarter after quarter. When a firm can do this from its own efficient operations, this can become an anchor of value in a storm of market turbulence. So, to paraphrase Maria (from The Sound of Music ), when the economy slows, when interest rates rise, when investors are feeling sad, I simply remember my favorite ratios, and – hopefully – my investments won’t do so bad.