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Is There A Merger Arbitrage Opportunity In Cleco?

Summary Cleco agreed to be acquired by a group of North American infrastructure investors led by Macquarie Infrastructure and Real Assets (MIRA). We believe the likelihood of the deal closing is high. The deal is expected to close in the first quarter of 2016. Shares look appealing with a weighted return profile of 22.87%. This article discusses the potential merger arbitrage opportunity in Cleco (NYSE: CNL ). On October 20, 2014, a group of North American infrastructure investors, led by Macquarie Infrastructure and Real Assets (MIRA) and British Columbia Investment Management Corporation (bcIMC) (Group), entered into a definitive agreement to acquire Cleco for $55.37 per share in cash. The deal is valued at $4.7 billion, which includes ~$1.3 billion of CNL’s debt. Cleco is a public utility company and owner of regulated electric utility Cleco Power LLC. It has served residents and businesses in Louisiana for almost 80 years. It owns 11 generating units with total capacity of 3,340 megawatts. This partnership will allow the company to operate as an independent and local business, which will help it stay focused on keeping its strong culture. Cleco is a well-run utility with a dearth of knowledge, experience, and expertise. It’s a very attractive infrastructure business, which just so happens to operate in a regulated, but stable industry. These attributes should help the company grow long term. Here’s what Bruce Williamson, Cleco’s chairman, president and CEO, had to day about the deal: “With this agreement, Cleco’s existing investors will receive an exceptional value for their shares to top off a superior total shareholder return of the past few years, and our customers and employees can expect us to retain our strong commitment to service and reliability. The board and management worked together in structuring this transaction to deliver a premium valuation to our public shareholders and ensure a continued local presence in the communities Cleco serves. This agreement is the right transaction for our shareholders, employees, retirees, and customers of all types. The new owners understand the value Cleco brings to the region and are committed to Cleco’s strategy as a safe, reliable electricity provider positioned to meet Louisiana’s long-term power needs.” So is there opportunity as a merger arbitrage candidate? Let’s dive in and find out. Despite the drop in commodity prices, this group led by Macquarie has very deep pockets. The new owners plan on refinancing Cleco’s debt at closing. The group of investors includes Macquarie, British Columbia Investment Management Corporation, and John Hancock Financial. We do not see a high probability of failure given the group’s strong capital position. The deal is said to close in Q1 of 2016 (three months); both sides appear to be excited about the deal and the synergies involved. Final stages of the state regulatory approval process have pushed the initial timeline back to Q1 2016. Initially, the deal was supposed to be finalized in Q4 2015, but utility deals always seem to take longer than expected. The Louisiana Public Service Commission (LPSC) stated that it was “recommending strong commitments” from the investor group. The investor group filed testimony with more than 70 commitments addressing concerns raised by the LPSC. The commitments appear to be more than adequate, and management expects the deal to go through in Q1 2016. Cleco is currently priced at ~14x FCF, which gives an implied yield of 7.26%. In addition, the company sports an EV/EBIT of 14.85. Although shares are not significantly undervalued at current levels, we would be surprised by a takeover either. However, the current commodity depression may hamper and potential bidders. There are many uncertainties around potential mergers, such as anti-trust approvals, multiple government reviews, changes in market conditions, shareholder approval, and due diligence. If the deal was not completed, we would expect prices to drop to the pre-deal price of $48.50, or a loss of $3.55. We give the deal a 95% chance of being complete based on the parties and terms of the buyout offer. If we look at the recent quote, the stock is trading at $52.05 per share, $3.32 below the announced cash offer of $55.37 per share by the investor Group. We calculate our expected return with the probability of a successful deal ($3.32 x .95 = $3.15). And we subtract that from our expected loss with the probability of that loss occurring (3.55 x .05 = $0.18). This is the expected weighted return, which gives us a potential return of 5.72%, or $2.98 per share. To calculate our annualized expected return, we divide that by the expected time of holding in years (three months = .25). This gives us an annualized expected return of 22.87%. Bottom Line The Cleco acquisition is an interesting deal. And we do not see a high probability of failure given the investor Group’s strong capital position. The regulatory interference concerns us some; however, it appears that the recent commitments from the investor Group may be more than adequate for a state regulatory approval. This appears to be an interesting opportunity at current levels with a potential 22.87% annualized return profile. The return appears to justify the risk in this case. Notable Shareholders: Abrams Capital Andromeda Capital Bryn Mawr Capital LMR Partners Adage Capital GAMCO Diamond Hill Capital Please share your thoughts in the comments section below, as I learn just as much from you as you do from me. It can be a time-consuming endeavor, but I answer all of your comments and questions myself. Your patience and understanding are greatly appreciated. Disclaimer: Merger-arb can be tempting for investors to use leverage to increase their annualized return on high probability events…Resist the urge! Many Wall Street firms conduct merger-arb as their main business and they will normally have 50 or more merger-arbitrage investments at any one time. They understand that if a couple of deals go bad, the winners will more than take care of the loses. Merger-arb can be a very crowded strategy at times. Similar to value investing, it can be cyclical and go in and out of favor over time. The key to merger-arb is to focus on the few deals that are highly probable (ideally ALL cash deals) with minimal regulatory hurdles and an acquirer with a great capital base. And if you’re new to merger-arb, watch a few deals play-out over various industries to get an understanding of the deals. If you do invest in merger-arb situations conduct proper due diligence and make sure to spread your risk appropriately. If you are so inclined to learn more about these types of special situation, I highly recommend Graham’s writing on arbitrage in his Security Analysis book.

NorthWestern Corporation – A Year After The Near $1 Billion Transaction

Summary Cash flow generation outpaced dilution from the acquisition. The debt level is acceptable. The stock isn’t cheap, but you are paying a fair price in exchange for stability. NorthWestern Corporation (NYSE: NWE ) is a utility company that operates in Montana, South Dakota, and Nebraska. The company is both a generator and a distributor of electricity and a distributor of natural gas. In November 2014, the company completed a significant transaction, buying up hydroelectric generating facilities for $904 million. The idea is that this will decrease the company’s overall risk profile, since this transaction would decrease the company’s reliance on purchasing agreements. This is similar to how Questar Corporation sources natural gas from its own subsidiary instead of just being a typical distributor. Thus far, investors have been indifferent, as the stock hasn’t gone anywhere in a year. Is there anything wrong? To complete the transaction, the company issued 7.77 million shares at $51.50/share and $450 million of debt at 4.2%. The debt seems cheap, but the share issuance increased total share count by 20%, so there was significant dilution. However, this doesn’t seem to be a problem, as the company has significantly increased its cash flow generation. Year to date, the company generated $304 million of operating cash flow versus $205 million from last year. This represents an increase of 48%, well above the dilution. If we ignore the working capital changes, the improvement is more subdued (+15% from $207 million to $238 million), but is still impressive nevertheless. From an earnings perspective, the company seems to have gotten into a bit of trouble in Q3, as EPS dropped 33% from $0.77 to $0.51. As we’ve discussed earlier, the company was quite healthy from a cash flow perspective, so what caused this discrepancy? The answer lies in the income tax expense. In Q3 2014, the company benefited from the release of some unrecognized tax benefit. This was not repeated in 2015. For that reason I think the company’s performance is better judged by its earnings before tax, which mirrored the cash flow growth, rising from $12 million to $30 million. Looking at the balance sheet, I don’t see any reason for investors to worry either. Although there is $2 billion of debt, there is no major redemption until 2019, when $250 million would be due. Considering the company’s high cash flow, I believe that the company should not have any problem paying it off or rolling it over. From a coverage perspective, the company currently has an EBIT/interest expense ratio of 2.8x in 2015. For companies in other industries, I would be very cautious, but since the company is in the utility industry, investors do not have to worry about wild swings that could jeopardize the company’s current capitalization. From a valuation perspective, the company’s P/E ratio has steadily climbed to 18x given the multi-year long bull market. While the stock is no longer cheap on an absolute basis, I believe if you are looking safety, NorthWestern Corporation will still fit the bill. In other words, you are paying a fair price in exchange for the company’s stability. Keep in mind that the stability I’m referring to is the company’s ability to generate a profit, not revenue. Due to swings in the commodity market, revenue will not experience steady growth, but as a utility company, the company should continue to generate steady profits. (See below) Takeaway The company has continued to deliver good results in 2015. I believe that the relative muted response from the market can be attributed to the overall pessimism in 2015. As we head towards year-end, it has become apparent that a multi-year long bull market is finally coming to an end. As we step into a more uncertain future, I believe that defensive investors should be very confident about holding on to a company like NorthWestern Corporation.

Entergy Corp. Reports Solid Cash Flows From Operations

Summary This utility with a 5.14% dividend yield deserve a closer look. The decline in natural gas prices has led to a droop in wholesale electricity prices, harming Entergy’s profits. We use the company’s trailing 12 month P/E to get a better price comparison with industry peers. Regularly generating cash profits is an essential component of successful businesses. It only makes sense that’s how many investors wish to see their investments perform as well: as cash machines. Shark Tank investor “Mr. Wonderful” Kevin O’Leary agrees, emphatically stating, “cash is king.” And dividend payers like Entergy Corporation (NYSE: ETR ) churn that stuff out. The utility sector has recently crashed, with many companies trading at or near 52-week lows. Choosing the strongest companies from the lot is a fantastic opportunity to lock in great long-term deals on serious cash machines. Entergy Corp. trades at $66.69 per share, near its 52-week low of $61.27. Their dividend yield is a juicy 5.16% at this price level. During the third quarter, Jim Simons’ hedge fund increased their holdings in this company by 1.02 million shares – that means his research team concluded the company is trading at a discount to its intrinsic value. A clear indication that Entergy is worthy of further investigation. Entergy Corporation serves the growing suburban markets of Texas and operates in Arkansas, Mississippi, and Louisiana. They also distribute natural gas which is becoming more commonly looked upon as a commodity of growing importance in man’s fight against climate change, even as natural gas producers themselves are not presently thriving due to vast oversupply. The company is off of its 1-year high by 27.5% as the utility sector has generally gotten whacked by the market since February of this year. Financial Results & Removing A Big Non-Cash, One-time Impairment Charge Focusing on their operations, the company has announced the shut down of two loss-making power plants. The impairment write-offs and writedowns associated with the closure of the Pilgrim and FitzPatrick nuclear power plants took third quarter results to a net loss of $4.04 per share. I’d like to get closer to the Price-to-Earnings figure without this one-time charge baked in. After we removed the one-time charge we can easily compare the per share price ratios of Entergy Corp with its industry peers. First we’ll take a look at what third quarter 2015 results look like with and without the unusually high impairment charges, then we are going to bake-in Other Income, Interest Expense, and Income Taxes to arrive at an earnings figure that is comparable to industry peers. Note: The company’s 2012, 2013, and 2014 annual reports indicate asset impairment charges of ($ in millions) $255,524, $241,537, and $179,752, respectively. We will use the average of these three annual figures, divided by 4, to estimate the typical impairment charges per quarter. This will allow us to take a view of the profitability of the company aside from the plant write-offs associated with management’s work to improve operations. The average of the indicated impairments for 2012, 2013, and 2014 is $225,604. Divided by 4, that’s $56,401 of average quarterly impairments — the figure used in the image below. Time to review operating expenses with and without the recent quarter’s decommissioning related impairments: Taking another step closer to an industry-comparable earnings per share figure we’ll add in Other Incomes of $43,179 and subtract the quarter’s Interest Expense of $171,349. Our income before income taxes comes to $492,617. On Entergy’s very profitable 2014 they paid 38% tax on the aforementioned figure. Taking income taxes into account for the quarter we come to our net-of-decommissioning write-off 3rd quarter net earnings figure: $305,423. Finally, we will now find our remapped, industry peer comparable earnings per share and price-to-earnings figures for the 179,151,832 common stock shares outstanding: Retuned 3rd Quarter 2015 Earnings Per Share of $1.70 I selected Southern Company and FirstEnergy Corp. as they are among those enjoying profitability and similar dividend yields. Other peers in the energy utility sector include NRG Yield, Inc. (NYSE: NYLD ), Calpine Corp. (NYSE: CPN ), The AES Corporation (NYSE: AES ), and American Electric Power Co., Inc. (NYSE: AEP ). Entergy’s retuned Trailing P/E of 12.24 compares favorably to larger and slightly larger peers Southern Company (NYSE: SO ) and FirstEnergy Corp. (NYSE: FE ). Entergy enjoys a higher dividend yield and a competitive price-to-sales ratio with its market capitalization neighbor First Energy. Another favorable indicator is the firm’s Price-to-Sales ratio below the average of its peers. Cash Flow from Operating Activities Cash flows from operating activities, net of nuclear fuel purchases and resale, and net of financing costs, bring us to 3rd Quarter cash earnings of $329,628,000. This figure far exceeds their quarterly common stock dividend of $.85 per share, or approximately $154,038,000 inclusive of preferred dividends. It appears that the company can reliably generate enough cash to pay its dividends. Marketplace Interest in Entergy Corporation When a hedge fund with a small army of highly-qualified analysts and access to 3rd party consultants at costs of hundreds of thousands of dollars takes interest in a company by executing significant buy orders, I get interested too. Now, there’s no way to know the exact reasons for the following recent purchases I will outline below but you can be generally assured that these guy’s goal is to make money in a long position through the receipt of dividends and capital appreciation. As mentioned earlier in this article, Jim Simons’ hedge fund added 1.02 million shares of Entergy Corp during the second half of this year. That’s a 70% increase in the size of their position in the company, bringing Jim Simons’ funds’ total position to 2.47 million shares. Millennium Management increased their position by $54 million during the most recent quarter. They own 1,525,275 shares with a value of $99 million. Buying by Hedge Funds far exceeded selling during the second half of the year reported as of September 30th, which is a bullish indicator of smart money sentiment. Conclusion I like Entergy Corp.’s at its yield of 5% and greater. They serve a diverse geography from Texas, to Louisiana, Arkansas, and New York, among other locales. Their earnings figures are solid aside from the one-time decommissioning charge associated with the closure of money-losing nuclear power plants in Plymouth, MA and the FitzPatrick plant of New York State. The Plymouth plant closure is expected to be complete during the first half of 2019 and FitzPatrick’s closure during early 2017 at the latest. Most of the company’s production of electricity is by nuclear power plant. Their profitability has suffered with the collapse in the price of natural gas because it has brought down the wholesale price of electricity in their markets. In general, Entergy’s free cash flow should easily support its quarterly dividend for a long time coming. Utilities such as these folks are the classic example of long-term cash machines. Due to my belief that the marketplace has generally underappreciate Entergy’s ability to reliably pay its dividend, tempered by a reluctance to catch a falling knife where we don’t know whether or not natural gas prices will continue to drag on electricity prices, I rate Entergy Corporation a hold. If natural gas — hence wholesale electricity prices — start climbing again and all else stays the same, Entergy Corporation becomes a clear and even a screaming buy. Click +Follow next to my username to get the latest research beamed to your inbox in realtime Additional disclosure: This article represents the opinion of the author as of the date of this article. This article is based upon information reasonably available to the author and obtained from public sources that the author believes are reliable. However, the author does not guarantee the accuracy or completeness of this article. It is merely the author’s interpretation of the information contained in the article. The author may close his investment position at any point in time without providing notice. The author encourages all readers to do their own due diligence. This is not a recommendation to buy or sell a security