Institutional Shareholder Services, which advises big investors how to vote on proxies, came out with a "Yes" recommendation on the Energy Transfer Equity (NYSE:ETE)-Williams Cos. (NYSE:WMB) deal early Wednesday, sending Williams shares soaring.
The report, private information which ISS sent me after I asked to write about it for Seeking Alpha, goes well beyond the summary in Williams' press release.
In its report, the leading proxy advisory firm said despite the drop in energy prices and stock values since the merger was announced last September, the deal offers significant value - perhaps as much as $10 billion - to Williams shareholders.
It specifically references two of the biggest concerns of Williams shareholders, as seen in a letter by three former Williams CEOs. Here are highlights of the sections on those concerns, along with the conclusion.
Credibility of The ETC Currency
The unusual structure of the deal - ETE will issue publicly traded shares (ETC) to mimic the performance of its LP unit - is not unique, the report notes. Linn Energy (NASDAQ:LINEQ) offered a similar structure in 2013 to acquire Berry Petroleum. Even though the economics fell apart in the recent energy bust, the result validated the structure.
"From inception, the two securities traded in tight alignment with one another--a 99 percent correlation" and continued to do so even after Linn suspended dividends in 2015 on its way to a bankruptcy filing. In fact, the ETC-like tracking stock actually traded higher than the units 40 percent of the time, probably because the corporate structure is attractive to more potential buyers.
Skeptics might ask, given ETE's convertible preferred offering favoring its own executives, isn't there a threat ETE will "treat the two classes differently, impairing the value of the ETC currency?"
It's possible. It's also completely contrary to the point of creating the ETC structure in the first place. As acquisition currency--as the current brouhaha illustrates--begins to lose its value in the eyes of potential targets as soon as its credibility comes into question.
In addition, ETE will be the largest single shareholder of ETC, with 19 percent, and be used in management incentives, giving the general partner an incentive to do the right thing for ETC.
Finally, the deal offers contingent consideration rights (CCRs), a two-year "true up," granting ETC holders more shares if it fails to trade at parity with ETE and all but guaranteeing a fair result.
Leverage Level and Dividend Cut
The $6 billion cash payment to Williams shareholders will raise the merged company's Debt/EBITDA to 6.8x, "which may now seem high in the context of the sector risks."
However, the company "has a roadmap to reduce the debt level by 2.1 turns, to 3.7x, through both projected increases in EBITDA and using distributable cash for debt paydown rather than dividends for equity holders."
While there will be a "strain" on the holding company's finances and its credit rating will drop two notches, to B+, it still had "other levers" such as asset sales if oil and gas prices weaken again and more capital is needed.
The elimination of the dividend for two years is a negative compared to when the deal was announced. However:
Given a choice between dividends and the $8 per share in cash consideration, moreover--the dividend is being diverted into payment of the debt required to fund the cash consideration--shareholders would do better to take the latter. The combined company is forecast to generate approximately $7.7 billion in distributable cash through 2018. Williams shareholders, through their ETC shares, would receive about $3.2 billion of that between 2016 and 2018--barely half what they stand to receive at closing, in the cash component of the merger consideration.
Conclusion and Vote Recommendation
According to ISS, the deal continues to present a "compelling strategic alternative to Williams shareholders" - with cash, a more diversified customer base, and more than half the equity in a company with much stronger free cash flow than Williams on a standalone basis.
On the other side, Energy Transfer may have been "too clever by half" in negotiating the agreement, leading to its "scorched earth tactics" to try to kill it. (The fate of those attempts will likely be decided in a Delaware court next week).
Had Energy Transfer negotiated a reverse termination fee, rather than agreeing to specific performance, we would already know a precise value. As a floor, shareholders might consider that Williams would have to pay a $1.5 billion termination fee if the board changes its recommendation on the transaction. But the value may be significantly greater: the board's financial advisor, evaluating the economics Williams negotiated, peg it closer to $10 billion.
ISS hints Williams board might try to renegotiate.
It is conceivable that a better alternative for Williams shareholders might be to convert some of the cash component into equity, at an exchange ratio which fairly compensates them for giving up the certainty of that cash, and substantially derisk the balance sheet at the outset.
Finally, ISS says Williams shareholders should trust their board.
Given there are two large shareholders on the Williams board, and the entire board's commitment to doing the right thing for shareholders, (as perhaps most evident in the protections, as well as the economic terms, it negotiated in the first place), it seems wiser to preserve the value of the contract itself, and the potential value creation opportunity of the combined company, by voting FOR the transaction, and to trust the board with evaluating and negotiating any prudent revision to the terms.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.