MTJ489

Merger Review: Puget Energy

The WUTC order provides a scathing commentary about how much the Public Counsel has been off the mark in its arguments. Apart from Commissioner Jones' dissent, WUTC's majority view was that the deal was entirely consistent with the public interest and will not harm ratepayers. Against this backdrop, I doubt that the PC will appeal the decision. I think the more likely scenario would be that the Acquirers (the investor consortium) will seek to clarify the WUTC's order by filing a petition. This will have the effect of delaying the closing by weeks or months. And, as everyone knows, pending mergers don't age like fine fine, so any delay beyond the normal 15 days following the "Final Order" (as defined in the merger agreement), which comes up on January 22nd, will not be viewed well by the market. I believe that this is one of the reasons that the spread is trading wide.

Another reason for the wide spread is the following: According to the merger agreement, the Acquirers' liability is capped at $130MM if they were to breach the agreement. This means that if the Acquirers did not feel like completing this deal -- for whatsoever reason -- they are liable to pay $130MM to Puget, but not a penny more. Recently, deals that have blown up frequently contained a similar clause, whereby the purchaser had an option to walk away by paying a nominal break-up fee. With the stock market having raced to the bottom, most deals that were cut months ago now appear highly overpriced. What have acquirers done to compensate for their ill-timed dealmaking? They have simply walked away because they were allowed to under the merger agreement. Were it not for this seemingly innocuous clause in the Puget merger agreement, I believe the spread would be much tighter.

Having said that, I believe that this deal is not only highly likely to close, but close by January 22nd 2009, for the following reasons. If you listened to the Commission hearings in Sepember/October as well as read the hundreds of pages of WUTC briefs filed by the Joint Petitioners (Puget and the Acquiers), which I did, you will see that the Acquirers were simply "pounding the table" on wanting to complete this acquisition. Keep in mind that this was as recently as October when the financial world seemed to come to a screeching halt. Even at the height of the financial market meltdown, the Acquirers were adamant that they had the financial flexibility to not only complete the acquisition, but also fund billions of dollars of capital expenditures for the next five years -- something that Puget, without this buyout, will find extremely difficult to to. Acquirers were also adamant that the terms of the "ring-fencing" provisions, which provide a margin of safety to the well-being of the "Opco" (the operating utility), are the best such provision of any similar transaction in modern history -- and the WUTC staff singularly agreed with this argument. Here we are -- less than 3 months after the hearings and the briefs and the financial world has gotten a little calmer -- I would argue that if the Acquirers were adamant on wanting to acquirer Puget in October, I think they would want to acquire Puget today.

To elaborate on this important point, I spoke with a respresentative of Macquarie who is close to this deal. He agreed that "nothing has changed" since the hearings were held and the briefs were filed in October.

So an obvious question that comes up on all of this: Why would the Acquirers want to acquire Puget for an inflated price of $30/shr? First of all, the Acquirers are infrastructure investors,. Not only do they own Duquesne Power & Light in PA, they own water utilities, highways, bridges and tunnels all over the world. Puget is a regulated business that they want to own for the long-term. Many people view Puget as a typical LBO. That is not entirely correct. The Acquirers are putting up $3.3 billion in equity capital for Puget, nearly 50% of the enterprise value of the company. That is a lot more equity than your garden variety LBO that has 20% equity. What that means is -- the Acquirers are willing to accept a lot lower internal rate of return on their equity than a typical LBO. I believe this is because regulated businesses such as Puget generate highly predictable cash flows, and therefore, the hurdle rate on such stable cash flow stream is correspondingly lower. The Macquarie representative confirmed that this was the case.

Without further rambling --- the point is, I believe Puget acquisition, although expensive by today's utility valuation standards -- fits the profile of what the Acquirers are looking for. If they walked away from this, it will take another 1 1/2 years for them to acquire another utility -- any utility --in the U.S. Is that worth it even though they would be able to buy the next one a bit cheaper? By the time they complete their next purchase, who knows, utility valuations may come back up...

By the way, there was nothing in the WUTC Order that anyone should be comcerned about. It's a long document, but there is nothing substantively different than the multi-party settlement that Puget signed along with the Staff back in July. I would be shocked if Macquarie tries to put a negative spin on the WUTC Order conditions. As far as I know, they should be giving each other high fives since they got pretty much everything they were looking for in the Order.

I hope this helps if you are wondering why the PSD spread is so wide. It is wide for the reasons I explained above. But it being wide presents a huge opportunity to make 10.5% in a week and a half.

One final point -- if you want to own PSD stock, you should look at PSD Jan $25 calls. They are much better risk/reward than the stock (for reasons I won't go into here..) If you want to be really technical, you should buy those options and short the stock. If you get the "delta" right, you will make money if the deal completes, AND you will make money if the deal falls apart and the stock goes to $17.00 as long as this binary event happens before the option expiration next Friday.. (What a beautiful arbitrage..!!) Because, as much as I think the deal will get done, what if I'm wrong? I wouldn't want to get carried out in a stretcher...

Now go and make some money........

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