UniSource Deal Flips a Switch in Energy Sector

Industry watchers say the take-private plan could spark a revival in this sputtering industry.
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Normally, it takes more than one big merger -- or even two -- to ignite talks of an industry trend.

But the utility sector has grown so cold that even one odd deal can spark heated discussions. Take the buyout recently announced by

UniSource

(UNS)

. Until last month, UniSource was just another small-cap utility that had trouble pleasing even its own stockholders. Now it is being snatched up, at a rich premium, by outside investors who are accustomed to high-return thrills.

Kohlberg Kravis Roberts

, a high-profile private equity group with backing from

J.P. Morgan

(JPM) - Get Report

and

Wachovia

(WB) - Get Report

, plans to spend $853 million in cash, plus some $2 billion more in debt assumption, on the Arizona utility. If the deal goes through, it will mark one of the first times in recent history that a public utility has been taken private.

So industry experts see plenty to talk about.

"The announcement ... is a significant energy industry event for numerous reasons," said Mark Williams, an energy consultant and visiting scholar at the Boston University School of Management. "The

leveraged buyout is at least acknowledgement that radical changes needed to occur."

Like many energy experts, Williams views the pending sales of UniSource and

Portland General Electric

(PGB)

-- both to private buyers -- as "two early signs that this battered sector is finally on the rebound." He is examining the UniSource deal, in particular, for industrywide meaning.

Shares of UniSource, trading for less than $20 when KKR made its offer, added a penny Wednesday to $24.65.

Ugly Duckling

Less than a month ago, UniSource was still disappointing investors.

The company posted third-quarter profits of 79 cents a share that, while better than a year ago, fell 17% shy of market expectations. Even Tucson Electric -- the company's core division -- missed earnings targets because of an unscheduled power plant outage. Meanwhile, the company's unregulated Millennium unit continued to bleed.

Following last month's report, Power Insights analyst Maurice May promptly suggested that UniSource sell at least part of the company to improve its overall value.

"We believe that if UniSource would liquidate the unregulated operations at Millennium ... the market would ... easily send the stock to $23 per share," May wrote on Oct. 30. "Perhaps if the market really liked Arizona growth prospects, it would capitalize the earnings even higher and propel the stock upwards of $25 per share."

Within two weeks, KKR offered to buy the entire company for $25.25 a share. Many experts believe the firm will now quickly dispose of Millennium's money-losing assets. In the meantime, KKR partner J.P. Morgan has already pointed to Arizona's growth -- which is double the national average -- as a good reason to buy.

"UniSource Energy satisfies the energy needs in one of the fastest growing regions in the U.S.," said Jeffrey Walker, managing partner of J.P. Morgan Partners. "We look forward to supporting their continued growth."

The KKR offer came shortly after a pair of positive developments at UniSource. The company closed on a transaction that should add nearly 20 cents to fourth-quarter earnings and used the cash to buy a distribution system viewed as a long-term investment that will immediately boost company profits.

"Hats off to management for this one!" May declared. "Progress is not coming as fast as investors would like, but we believe it is nevertheless coming -- with positive ramifications for the stock."

Then KKR stepped up with its generous offer. Still, it plans to keep the same UniSource leaders -- the ones who have frustrated investors for so long -- in place. KKR said it had found in current management "the right team with the right game plan" to lead UniSource to success. But it would have paid up to $18 million in severance if it had decided otherwise.

According to UniSource's bylaws, all senior executives would be entitled to three times their salary and bonus -- plus retirement and stock benefits -- if a new owner fired them within five years of a takeover. But Williams, for one, questions whether KKR will even hold on to the utility that long.

Just Flip It

For its part, KKR has expressed a clear commitment to the endeavor.

"As long-term investors," Stuart announced, "our goal is to invest in the highest quality businesses and back the strongest management teams we can find, providing them with the financial resources to implement their strategic initiatives."

But Williams is skeptical. Typically, he said, leveraged buyouts are targeted at high-risk investments that promise similarly high rewards. He views the UniSource buyout -- financed with considerable debt -- as risky enough. But he questions just how KKR plans to achieve acceptable returns.

"The real test will be how this company will be able to become profitable given that it is taking on additional debt to the tune of $970 million," he said. "To meet these debt payments, any additional income generated will have to come from the cost side, not the revenue side, as utility rates are highly regulated."

Williams did acknowledge that KKR could improve revenues through growth in volume, rather than pricing, due to Arizona's rapid expansion. But he still sees more opportunity on the cost side of the equation. For example, he pointed out that interest rates are currently at 40-year lows, so the utility's debt load -- while larger -- could be cheaper to service. Even so, he says, the company will have a tough time slashing its overall cost structure.

"Costs related to plant and line maintenance are closely scrutinized to ensure that adequate capital is spent for reliability and dependability," Williams said. "It's going to be hard for KKR to cut corners."

He also sees roadblocks to the "classic leverage buyout strategy" of selling off nonstrategic assets to quickly pay down debt.

"The company will be hard-pressed to get 70% to 75% of book value for generation in the current depressed energy sector," he said. "There are a lot of merchant assets for sale but few takers at current prices."

Instead, Williams expects KKR to quickly unload the entire company. He said a

sweeping energy bill -- still alive at the time KKR and UniSource were negotiating -- would have repealed an old law that restricts mergers in the industry. While the bill itself is now stalled, due primarily to unrelated concessions, any new bill is expected to keep the repeal proposal in place.

"The repeal of this act would have potentially opened the door for a wave of mergers and industry consolidation as the purchase of multiple utility assets across state lines would have been more easily obtainable," he said. "It would

have instantly created a whole new group of potential buyers for UniSource, KKR's newest acquired asset."

Williams believes KKR purchased UniSource in anticipation of the repeal. He also expects the repeal to materialize -- perhaps early next year -- and pave the way for KKR to sell off UniSource, at a tidy profit, to some other utility seeking improvements through economies of scale.

Alternatively, he said, KKR may choose to sell the utility at a much higher multiple through an initial public offering. He pointed out that KKR snatched up UniSource for just 7.5 times future earnings before interest, taxes, depreciation and amortization as compared to, say, the 10.5 times current EBITDA that

AEP

(AEP) - Get Report

-- a much larger utility -- fetches. By quickly paying down debt and strengthening the company, he said, KKR could seek a much higher price for UniSource just a couple of years down the road.

To support his claims, Williams pointed out that Lehman Brothers took Peabody Coal private then public, at a significant profit, in less than two years. He did acknowledge that the Peabody IPO took place when buyers were still "enamored with the growth prospects for the deregulated energy sector." But he's convinced that repeal of the Public Utility Holding Company Act -- which has kept private investors like Warren Buffett from expanding their utility assets -- will make the sector suddenly attractive.

Indeed, he foresees a merger frenzy like the one that followed the repeal of restrictive laws in the banking industry over the past two decades. And he believes that KKR is simply the first in a long line of investors who plan to cash in.

"They're banking on being able to flip it," he said of UniSource. "The big bet is the Public Utility Holding Company Act. If it's repealed, that opens up the floodgate for potential buyers. ... I do see this as a clear trend."