My favorite utility company has always been UNS Energy (NYSE:UNS). Since January 1, 2000, the total return on the S&P 500 ETF (NYSEARCA:SPY) is about 36%, the Utilities Sector ETF (NYSEARCA:XLU) returned about 74%, and UNS returned over 723%.
But the strange part was in 2004. I had been a large holder for a long time. KKR (NYSE:KKR) was trying to LBO the utility in a deal priced at $25.25 per share and the public utility commission (PUC) was giving them a hard time. The deal was conditioned upon receipt of approval from the Arizona Corporation Commission (NYSE:ACC). The commissioners were skeptical of the entire idea of LBOing a public utility. In their minds, if there were financial advantages that KKR saw, the ACC commissioners wanted such advantages to accrue to the benefit of the utility ratepayers. So, the deal was essentially dead on arrival, but it took a while for rigor mortis to set in. Shareholders approved the deal in March 2004. But by May, it was 100% clear that the ACC staff was unalterably opposed to the deal:
In November, the ACC's administrative law judge (NYSE:ALJ) filed an opposition to the deal:
The ACC meeting was scheduled for December 20-21.
What did I do? In the midst of the angst around a subjectively uncertain deal with plummeting odds that it could ever close, I skipped town with my family for a few weeks. First stop: plane flight to New Zealand then chopper to Blanket Bay in Glenorchy, one of my favorite places to stay anywhere in the world.
My intrepid/long-suffering wife and I went canyoning, which essentially involves putting on a helmet and wetsuit with a tire tread on the back and then jumping and slipping down waterfalls.
For what it is worth, this was extremely fun and is highly recommended. As for safety, rest assured that no survivors have ever lodged any complaints as far as I know. The ACC denied the application on December 21:
The deal was abandoned on December 30th. In terms of a regulatory outcome, this was a disaster. But what about as an investment? While the deal was running into so much trouble, the equity markets were strong - the S&P 500 was up by over 16% - and utilities were extremely strong with the sector up by over 30%.
Merger arbitrage specialists fixated on the extremely close up date to date developments such as described and shown above did not appear to focus on the downside. Utility funds with relative value sector benchmarks had a hard time holding onto any shares of UNS, because the opportunity cost was so high and any modest arbitrage spread cut in to the ability to keep up with the white hot sector. It was only after the deal collapsed that fundamental buyers reemerged. Here is what the next month looked like:
The deal's "downside" was over 20% higher than the stock's price. In dollar terms, here it the stock price:
You can see the panic selling in November 2004 when the ACC staff first publicized their opposition to the deal as well as price discovery only two months later after the deal broke.
There is still an opportunity in UNS. Late yesterday, Fortis announced an agreement to acquire UNS for $60.25, a $40 premium to their previous deal. The buyer is a strategic acquirer and 90% of their assets are regulated, so they are experienced in securing regulatory approvals. In the intervening years, the ACC has adopted a rate design structures more conducive to cost recovery. All five ACC commissioners are Republicans. UNS characterizes the regulatory environment as constructive. While the deal is working its way thorogh the approval process, UNS will continue to pay its quarterly $0.435 dividend. Here is the UNS dividend history:
The deal will probably close by the end of next year. There is a gross $1.55 spread and a net $3.46 spread which will result in an annual net return of over 5%. Incidentally, this is within 0.1% of the annualized spread a year before the prior expected closing. But the lesson from this security is that the rate of return is less important than the ratio of the upside to the downside. When, from time to time, a downside moves above the stock price, there is a true arbitrage and one worth exploiting for profit.
Invest in mispriced securities, take your family on vacation, ignore Bloomberg, and have a Merry Christmas.