Updated from 7:12 a.m. EST
The proposed leveraged buyout of Texas electricity provider
by private equity firms Kohlberg Kravis Roberts and Texas Pacific Group probably couldn't have come at a better time.
Short-term dynamics have beaten up TXU's stock pretty severely over the last six months, even though the long-term outlook for the company is considered by most analysts to be very positive.
Undervalued stock prices combined with strong long-term profit potential make for a good takeover target. Finding such a company is rare, but TXU has likely been appearing on value stock screeners for a while, according to analysts.
The proposed buyout is worth $32 billion in cash to TXU stockholders, or $69.25 a share. Plus, the buyout firms will be assuming $13 billion in debt. If it's approved, the deal would be the largest leveraged buyout in history.
TXU's stock bottomed out at $53.57 on Jan. 29 after reaching an all-time high of $67.83 last September. The stock closed at $60.04 on Friday and was lately jumping 13.3% to $68.01. The takeover price is a 15% premium to the prior close and a 25% premium to the stock's average trading price over the last 20 trading days.
Why is TXU undervalued? For one, natural gas prices have fallen from a record high above $15 per million British thermal units to around $7.50 today. That produced downward pressure on the company's stock, according to Daniele Seitz, energy analyst at investment bank Dahlman Rose & Co. in New York.
In Texas, electricity rates are pegged to natural gas prices. When commodity prices were high in 2005, TXU locked its rates to $11.30 per million BTU of natural gas. Prices then plunged, raising the chance that TXU will be forced to drop its rates.
"Even if TXU was clever at hedging its natural gas prices, it has become highly likely that customers and the state of Texas will demand that it lower its rates," said Seitz. Such a move will decrease TXU's earnings in the short term.
Additionally, TXU's stock price had come under pressure from increased attacks by environmental groups. The company had been betting that a program to build 11 coal-based power plants would ultimately spur growth, but the proposal drew enormous criticism from environmentalists, forcing TXU to extend the program's completion date.
TXU's buyers say they plan to cut the number of plants to three. The watchdog group Environmental Defense has been a major opponent to TXU's power-plant construction plan, and
The New York Times
said the move was meant to reach a truce with the group.
Regardless of any short-term difficulties, TXU remains well-positioned to enjoy future growth, according to Seitz. Ever-increasing demand for energy requires that the U.S. build new power plants. Ignoring near-term swings in the commodities markets, energy prices are growing steadily because of a general shortage of power in the U.S.
TXU now has 19 power plants in Texas -- 14 run by natural gas, four by coal, and one by nuclear power. Nuclear and coal plants typically have better profit margins than natural gas plants. According to Seitz, TXU's mix of plants is more competitive than most other companies in the sector.
Additionally, TXU generates $3 billion in free cash every year after paying dividends, leaving it in a good position to build new plants.
The proposed TXU buyout probably wouldn't be possible if the utility were based outside of Texas. An essential attribute of the deal is that Texas deregulated its utility market in 2002, opening it up to more participants, and giving utilities more freedom to raise rates.
Even though the proposed LBO is based in the largest unregulated electricity market in the country, it must still meet state and federal approval before the deal goes through later this year. One component that will be closely analyzed is TXU's financing structure. Regulators generally require that utilities maintain conservative debt levels to allow for future plant construction, according to Seitz.
TXU's debt level now rests at 78% of total financing. The company had been following a strict refinancing schedule, selling assets to buy back shares and pay down debt. Its managers were planning to reach a 40% equity ratio by 2011. However, this is unlikely to occur if KKR's buyout goes through.
Whether a 22% equity ratio is sufficient to pass regulatory muster is a major hurdle for the proposal, says Seitz.
The move marks a sharp turnabout for TXU, whose shares traded in the single digits just five years ago. The company said the buyout would allow it to "set a new direction as a private company."
A press release pledged that "as a result of this transaction, the newly privatized company will deliver price cuts and price protection benefits to electric customers, strengthen environmental policies, make significant investments in alternative energy and institute corporate policies tied to climate stewardship."
Flush with cash, private equity firms have been on a buyout binge over the past year. Large recent deals have included Blackstone Group's purchase of
Equity Office Partners
for $34.5 billion, including debt.