The stock market has already reacted to the Federal Reserve's plan to taper its quantitative easing, with dividend-paying stocks leading the sell-off. For example, the Dow Jones Utility Average is now flat for the fourth quarter, after being up better than 5 percent through mid-November.
Ironically, despite their reputation, utility stocks haven't demonstrated a meaningful correlation with benchmark interest rates since the 1980s. In fact, utility stocks are still well in the black for 2013, despite the yield on the 10-year U.S. Treasury note increasing by 63.8 percent. And the recent weakness in utility stocks has attracted patient, long-term money.
Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) continues to close in on its purchase of NV Energy (NVE). (See Rating Berkshire's Offer for NV Energy.) And Canadian utility giant Fortis (OTCPK:FRTSF) last week announced the US$2.5 billion all-cash purchase of Arizona-based UNS Energy Corp (UNS).
Fortis' first foray into the U.S. utility sector was the US$969 million all-cash buyout of CH Energy Group. The deal closed in June 2013, after New York regulators approved the transaction in exchange for a rate freeze. The Canadian company should close its takeover of UNS Energy by the end of 2014.
The purchase price of $60.25 per share represents a premium of better than 30 percent to UNS Energy's pre-deal stock price. It's also more than 2.2 times the company's book value. And Fortis' management has almost certainly factored in rate concessions and possibly an additional sweetener for shareholders to approve the deal.
This takeover bid is a strong vote of confidence in UNS Energy's value, and because Fortis made an all-cash offer, the value is both locked in and limited. But investors who continue to hold UNS Energy will collect several quarters of dividends while the deal awaits approval.
Fortis hit a new 52-week low on the takeover news--not an unusual development when an acquirer pays such a large premium. The stock now trades at 1.36 times book value and yields 4.3 percent.
The purchase of UNS Energy will grow Fortis' total assets by 33.5 percent and increase regulated operations to 92 percent of its base. More important, the acquired operations in Arizona should grow their revenue at a faster rate than Fortis' legacy assets in Canada.
Like all utilities, Fortis is an invest-to-grow story. And this deal will push the company toward its stated goal of increasing its rate base at an average annual rate of more than 7 percent.
The acquisition also reduces the risk embedded in Fortis' portfolio of utility assets by diversifying into a new geographic region. And over the past few years, Arizona has evolved into a favorable regulatory environment for utilities.
Don't think that Fortis' bid for UNS Energy will be the Canadian company's last acquisition in the U.S. And the lower that near-term worries about rising interest rates push utility stocks, the more likely that deal flow will accelerate in the sector.
Ripe for the Picking
PNM Resources (PNM), which fetches a little more than book value, could be one potential takeover target.
This undemanding valuation doesn't reflect a company that's on track to meet its 2013 guidance of $1.35 to $1.41 in earnings per share and recently increased its dividend by 12 percent.
PNM Resources' 2014 forecast calls for its earnings per share to range between $1.42 and $1.52, providing ample support for this higher payout.
Growth in capital expenditures underpins these projections.
Management expects its customer base in Texas to grow at an average annual rate of 1 percent through 2014. But PNM Resources has also asked state regulators for permission to retire two coal-fired plants, recover $205 million in undepreciated assets and incorporate its share of unit three from the Palo Verde Nuclear Generation Station into its rate base.
The operating performance of this nuclear power plant has improved markedly over the past decade; regulatory approval to add this facility to PNM Resources' rate base would eliminate the utility's exposure to the uncertain wholesale market and further stabilize its earnings.
(As an aside, Arizona-based Pinnacle West Capital Corp (PNW), the operator and majority owner of the Palo Verde Nuclear Generation Station, could also be a takeover target; however, the company's $5.81 billion market capitalization would require a buyer with more firepower than Fortis.)
Approval of PNM Resources' application to build a 40-megawatt solar-power installation and a 177-megawatt gas-fired "peaker" plant that would run during periods of peak demand would also drive revenue growth.
During a conference call to discuss the utility's 2014 guidance, Chairman, President and CEO Pat Vincent-Collawn stated he expects Arizona regulators to decide case by early next fall.
In the meantime, the partners have hedged anticipated electricity production from the Palo Verde plant for next year, limiting PNM Resources' exposure to the volatile wholesale-power market.
PNM Resources continues to tackle the challenge of strengthening its balance sheet. But the utility has divested most of its unregulated operations and will refinance its 9.25 percent notes due May 2015 with cash. Management also expects to cover its planned $2.1 billion in capital expenditures without issuing additional stock.
Prospective suitors may wait until New Mexico's regulators rule on Palo Verde and other proposed projects. That being said, PNM Resources meets the most important test for any takeover target: The utility can grow earnings, boost dividends and strengthen its balance sheet, even if no one ever makes an offer.
Be sure to check out My Top Essential-Services Stocks for 2014 for another name that could be in play as an acquisition target.