Shareholders of The Williams Companies, Inc. (NYSE:WMB) face a choice to either accept a pending takeover offer from Energy Transfer Equity LP (NYSE:ETE), or reject the offer and remain independent. What follows is an argument for the latter that relies on objective inputs and market-based signals to demonstrate the likely superiority of the standalone case for WMB.
By way of background, the terms of the proposed acquisition involve a newly formed entity called Energy Transfer Corp (ETC), to serve as merger consideration for the WMB shareholders, along with $8.00 per share in cash. As of the date of this report the combined value of the offer would be $21.26 per WMB share, representing a 10.2% premium over the latest closing price for WMB of $19.30.
The Deal that Might Have Been
In considering the standalone case for WMB it is important to remember that the board of directors of WMB abandoned a pending merger agreement with its MLP affiliate, Williams Partners LP (NYSE:WPZ) as a condition for accepting the acquisition offer from ETE. To provide an objective comparison with the ETE transaction, the standalone case for WMB should reflect the strategy that was abandoned when the board walked away from the merger with WPZ. This is where "snowcaps" come in.
The data presented below is quoted directly from page 134 of the Amended Form S-4 Registration Statement (i.e. "Proxy Filing") dated January 12, 2016. This information was included in the fairness opinion presented to the WMB directors by Lazard Freres, one of the investment banks hired to advise the WMB directors in their due diligence of the ETE acquisition offer. The "Pre-Snowcap" figures in the table represent Lazard's estimate of the intrinsic value of WMB stock under different market conditions without a merger with WPZ. The "Post-Snowcap" values assume the merger of WMB and WPZ had been executed under the terms of their abandoned agreement.
In Lazard's analysis presented below, the "Mid Case," "Market Case," and "Adjusted Market Case" represent incrementally pessimistic assumptions about future commodity prices and business conditions for both the Pre-Snowcap and Post-Snowcap business models.
Estimated WMB Stock Price
With and Without a Merger with WPZ
Pre-Snowcap Mid Case $ 39.50 - $45.50
Pre-Snowcap Market Case $ 27.25 - $32.25
Pre-Snowcap Adjusted Market Case $ 25.75 - $30.50
Post-Snowcap Mid Case $ 45.25 - $52.00
Post-Snowcap Market Case $ 32.50 - $38.00
Post-Snowcap Adjusted Market Case $ 30.25 - $36.00
Source: Lazard Freres
The key point in these valuation estimates is not the price targets themselves, because Lazard did not know about the collapse in commodity prices and valuation multiples that would occur after these estimates were made. What matters is the spread between the pre-snowcap and post-snowcap valuation estimates.
Based on the wide spread between the pre-snowcap and post-snowcap valuation estimates, the investment advisors clearly believe that a merger of WMB and WPZ would add substantial value for WMB shareholders under a wide range of assumptions for commodity prices and business conditions. In dollar terms, Lazard estimated the potential premium for WMB shareholders could be between $4.50 and $6.50 per share, based on the data in the table. In percentage terms the estimated premium ranges from 14.3% to 19.3%.
By comparison, the "premium" offered to WMB shareholders in the proposed ETE acquisition is unflattering. Using the pre-announcement value of ETE's offer of $43.50 per share (i.e. before ETE dropped 12.7% on the day the deal was announced), the best that can be said is that WMB shareholders were offered a fleeting premium of 4.6%:
Takeover Premium of the ETE Acquisition Offer
Relative to the Average WMB Stock Price Over the Preceding…
The value of ETE's offer dropped to $38.99 by the close of market trading on the day the transaction was announced, which was a material discount to the average price of WMB stock over the preceding one, five and 30-days.
To the extent that stock prices reflect the collective knowledge of market participants, the stark contrast between the market's reaction to the ETE deal versus the WPZ transaction seems telling. On the day the ETE acquisition was announced, WMB stock dropped 12.1%, while ETE sank 12.7%. By comparison, when WMB announced its agreement to merge with WPZ, the price of WMB advanced by 6.2%, while WPZ surged higher by 22.7%.
Admittedly, there is room for debate about the magnitude of signal versus noise in any single day of stock market trading. Even so, the substantial difference between the stock price movements affiliated with these two deals cannot be ascribed to mere noise. "Mr. Market" seems to believe that only one of these two transactions makes any sense.
To understand why the stocks of WMB and WPZ might have reacted the way they did to the proposed ETE acquisition, consider the following elements of the deal from the perspective of a WMB/WPZ shareholder (recall that WMB shareholders would receive shares in ETC as consideration for the takeover):
· ETC and WPZ would be a junior securities to ETE; whereas WMB is currently not junior to anything, and WPZ is the MLP affiliate of WMB.
· WPZ would be burdened with incentive distribution rights (IDRs) that require it to pay a large percentage of cash flow to ETE; whereas WMB does not owe IDRs to anyone, and the WMB/WPZ merger would have eliminated WPZ's IDR commitment to WMB.
· The IDR burden at WPZ would have the effect of reducing the growth rate of cash flow available for dividends, thereby dampening the likely valuation multiple for the stock; whereas the WMB/WPZ merger would have eliminated IDRs to encourage a higher valuation multiple for both stocks.
· Shareholders of ETC would have no authority to elect or remove members of the board of directors that governs its business; whereas shareholders of WMB currently enjoy such rights.
· ETC would be governed by a board of directors whose members are selected by one individual, who also serves as chairman of the board.
· Based on disclosures included in the Amended S-4 Registration Statement, the board that governs ETC would be held to a lesser standard of fiduciary duty relative to a typical corporation, including WMB.
· There would be inherent conflicts of interest between ETE shareholders and WPZ shareholders due to the IDR arrangement between ETE as the general partner, and WPZ as limited partner; whereas the WMB/WPZ merger would have eliminated a similar conflict of interest by removing the IDR between them.
· ETC shareholders would be powerless to prevent ETE from taking actions that benefit ETE shareholders at the expense of ETC shareholders due to the poor governance structure of ETC.
· WMB is currently included in the S&P 500 Index, whereas ETC would not be.
To understand why ETE stock may have dropped more than 12% in reaction to the proposed acquisition, consider the following elements of the deal from the perspective of an ETE shareholder:
· Based on data from Bloomberg, ETE's balance sheet carried a net debt-to-EBITDA ratio of 8.2x as of September 30, 2015, while the ratio for its largest affiliate, Energy Transfer Partners LP (NYSE:ETP), was 6.4x.
· The industry threshold for the net debt-to-EBITDA ratio in order to sustain an investment grade credit rating is typically 5.0x or lower, depending on the rating agency.
· ETE would need to add $6 billion in debt to a balance sheet that is already rated below investment grade by the major rating agencies in order to finance the cash portion of the WMB acquisition.
· The projected $2 billion in commercial synergies presented by ETE as a primary benefit of the transaction would require $5 billion in capital spending, as disclosed in multiple press releases and investor presentations from ETE.
· It is difficult to understand how ETE might raise $5 billion in capital to pay for the projects needed to achieve $2 billion in possible commercial synergies.
· If ETE fails to achieve the projected $2 billion in commercial synergies the post-acquisition balance sheet leverage at ETE may be challenging to manage.
It is worth noting that the stock market's negative reaction to the WMB/ETE acquisition looks prophetic today because ETE and WMB have been forced to dial-down their previous forecast for $2 billion in commercial synergies. The following disclosure is a new addition to the Amended S-4 Registration Statement dated January 12, 2016:
"However, WMB believes that the above prospective financial information is no longer valid because it was prepared several months prior to the date of this proxy statement/prospectus, and since such time the industry in which WMB and ETE operate has been under pressure as a result of lower commodity prices and higher costs of capital."
The above statement calls into question the $2 billion in projected commercial synergies that had been elevated as a primary benefit of the proposed acquisition in multiple media releases and investor presentations since the merger announcement, and in the initial S-4 Registration Statement filed in November.
The Standalone Case
It is possible to construct an objective measure of the standalone value of WMB without relying on what-ifs about alternative histories, or subjective forecasts of future business conditions and valuation multiples. One objective input is the 12.1% decline in the WMB stock price on the day investors learned about the deal with ETE. It seems plausible to anticipate an approximate 12% uplift for WMB stock if the acquisition is either terminated, or voted down by WMB shareholders. A 12% increase would merely reverse the value destruction that occurred when the deal was first announced.
A second objective input is the roughly 6% increase in WMB, and 22% increase in WPZ on the day these companies disclosed plans to merge. Presumably, this value-accretive transaction would become possible again if the ETE acquisition does not happen. Investors would likely assign at least some probability to a rekindled WMB/WPZ merger which could be worth an increase of 6% or so to the stock price of WMB, and possibly more for WPZ.
Based on these objective market signals there may be up to 18% of upside in the WMB stock price if the merger with ETE is terminated, or if WMB shareholders vote it down. This estimate includes approximately 12% upside to reverse the value destroyed by the proposed ETE transaction, plus 6% (for WMB) to recapture the possibility of a WMB/WPZ merger. Interestingly, 18% upside would be consistent with the fairness opinion from Lazard referenced earlier in this report. Lazard estimated the lift to the intrinsic value of WMB from a merger with WPZ could be 14.3% to 19.3%.
The ETE Case
In contrast, the offer from ETE would deliver a junior security with limited voting rights and an uncertain future for the dividend once the equalization scheme expires in two years. For the next two years this junior security would be linked to the dividend policy and stock price of ETE at a time when ETE would need to add $6 billion in additional debt to a balance sheet that is already rated below investment grade by the major rating agencies.
Meanwhile, management at WMB/ETE has already changed its tune on the $2 billion in projected commercial synergies, as disclosed in the Amended S-4 Registration Statement. Without these synergies, the future cash flow available to support ETE's balance sheet and dividends to ETC would be materially lower than originally forecast when the acquisition was announced in September.
The Opportunity for WMB Shareholders
A preponderance of evidence from objective inputs and market signals suggests the optimal course of action for the board of directors at WMB and ETE would be to jointly agree to terminate the proposed acquisition. Unfortunately, this outcome would require a sensible decision from the same cast of characters who voted for the acquisition in the first place.
It seems likely that the proposed acquisition will be submitted to a vote of the WMB shareholders. The WMB stockholders have an unusual opportunity to remind the leadership at these two publicly traded companies that common shareholders have the power to reject irresponsible corporate governance when the board of directors fails to do so.
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 WMB shareholders are entitled to a choice of all stock at a ratio of 1.8716 shares of ETC per share of WMB; all cash at $43.50 per share of WMB; or a combination of 1.5274 shares of ETC plus $8.00 per share in cash. Since the total consideration for all shareholders cannot exceed $8.00 per share in cash, and shareholder requests would be pro-rated to this limit, it is logical to assume that all shareholders would receive the pro-rata combination of 1.5274 shares of ETC plus $8.00 in cash due to the substantial discount of the WMB stock price to the $43.50 all-cash option.
 Even though the all-cash option of $43.50 per share is still available to WMB shareholders, it is highly unlikely for any shareholder to receive $43.50 when the alternative elections of all-stock, or stock-plus-cash, are valued substantially below $43.50. This is due to the pro-rata limit of $8.00 per share of cash on average for all WMB shareholders in the proposed deal terms.
 Stock price data in this section is sourced from Bloomberg.
 The S&P 500 Index tracks the price and yield performance of approximately 500 stocks that represent the leading companies in all major industry groups in the U.S. economy. The index is capitalization-weighted.
 EBITDA is the acronym for "earnings before interest, taxes, depreciation and amortization," a widely utilized measure of cash flow in business accounting.
 Source: Barclays Capital
Disclosure: I am/we are long WMB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.