On August 10th, Hunt Consolidated, a group of junior creditors, investment firms and the Texas teachers’ pension fund (Hunt) reached an agreement with Energy Future Holdings (EFH) in bankruptcy court for its $19 billion bid for the Oncor piece of EFH. About 10 million people or about one third of the population of Texas receive power delivered over Oncor wires. At peak load, Oncor delivers about 24 gigawatts.
In 2007, a group of investors including KKR, TPG Capital, and Goldman Sachs Capital Partners acquired TXU Corporation and formed EFH. Previously in 2006, Hunt offered EFH $10.5 billion for Oncor.
Oncor is one of three parts of the former TXU Corporation. Oncor is ring-fenced in a separate subsidiary of EFH. The other two parts of EFH include Luminant, a generation company and TXU Energy, a retail electric provider. Those two are set up in an EFH subsidiary called Texas Competitive Electric Holdings Company LLC (TCEH). As part of the deal, TCEH will be spun off to creditors in a tax free deal which satisfies $25 billion in debt owed to those creditors. This effectively values TXU Energy and Luminant at $25 billion. An analysis of this part of the transaction will follow in another article.
Hunt plans to place Oncor’s transmission and distribution assets in a real estate investment trust (REIT). REITs provide an investment structure which offer income tax relief if the REIT pays out 90% of its taxable income in dividends to shareholders. A regular C-corporation cannot deduct dividends from its net income. The REIT will lease the assets to a new operating company which retains the name, employees and management of Oncor. The new Oncor operating company will manage the operation and maintenance of the system.
The deal received a warning from Moody’s that the Public Utility Commission of Teas (PUCT) may reduce Oncor’s allowed return on equity (ROE) due to the REIT structure’s reduced income taxes. In other words, the PUCT may reduce the dividend payout from Oncor to its new owners
This may be a likely outcome. However, it should be noted that Oncor’s service territory includes some of the fastest growth of any large utility in North America, which may counteract any adverse PUCT rulings.
Market and Oncor Revenue Growth
Texas and in particular ERCOT is a relatively fast growing power market. And Oncor here is some evidence of its growth potential:
- – Parts of Oncor’s western territory grew at greater than 10% a year over the past 10 years.
- – North Texas (in particular the DFW metroplex) is experiencing significantly greater than average economic growth which directly translates to accelerated load growth. For example, Toyota recently began moving all of its non-manufacturing operations including its North American headquarters to North Texas.
- – Some utilities in North Texas are experiencing 10% growth per year. The average utility growth under normal economic circumstances is about 2% a year.
Valuation and Return on Equity
Let’s examine Hunt’s valuation. Hunt bid $19 billion this year versus its original bid of $10.5 billion in 2006. Hunt’s increased valuation of Oncor equates to a compound annual growth rate of at 6% a year. However, according to its latest 10K filing, Oncor grew net income by 8.8% for the years 2012-2014. Why is Hunt’s offer based on a 6% CAGR over its 2006 offer, when recent earnings have grown by 8.8%? If Hunt expects Oncor to grow faster than the 6% per year it projected in 2006, then perhaps the 2.8% difference will be returned to rate payers through a reduced return on equity. In other words, Hunt may already be factoring in a reduced ROE into the transaction’s value.
The structure of the deal appears to include an additional $12 billion in debt and equity added to the new Oncor’s balance sheet. This includes $4.5 billion in additional equity and an additional $7.5 billion in debt.
According to its latest rate case, Oncor’s weighted average after-tax cost of capital is 8.14%, based on a 60% debt to 40% equity ratio (10.25% return on equity and 6.73 % cost of debt). According to Moody’s Hunt is proposing to add $7.5 billion in debt to Oncor’s existing debt.  Oncor’s debt at the end of 2014 was $11.5 billion. Hunt’s proposal maintains the debt and equity proportions at current levels.
An analysis of Oncor’s 2014 10K indicates it earned about 6% on equity (after taxes) for 2014. Earnings increased by 8.8% from 2013 to 2014. Assuming an 8.8% earnings growth in 2015 and 2016, expect earnings of $490 billion and $533 billion in 2015 and 2016 respectively. However, if the deal closes as currently structured, Hunt would see Oncor’s return on equity drop to about 4% after-tax ($533 million earned on a $12.5 billion equity investment) another indicator that Hunt factored in a possible reduced ROE.
Looking at the deal using these two approaches growth and a reduced return on equity indicates that Hunt has factored in a possible decrease in allowed after-tax return on equity. As utility private equity investments go, this is probably the most expensive acquisition attempted since EFH’s purchase of the original TXU. Add in the complications of the bankruptcy and the impact the deal may have on ratepayers and you can expect this to be but the beginning of a long process.