John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.
Judging by the plunge in Fortis Inc.'s shares last week, you'd think the company announced lousy earnings or suffered a massive outage at one of its utilities.
Nope. What, then, was the the terrible news that sent the stock down 10 per cent last Wednesday? This is bad, really bad: Fortis announced an $11.3-billion (U.S.) acquisition that, according to analysts, is an excellent fit for the company and will accelerate its growth in the years ahead.
Huh?
Before I get into the reasons the stock fell – and why this has created a buying opportunity – I'll quickly recap the deal and what it means to Fortis. I own Fortis's shares personally and in my Strategy Lab model dividend portfolio and I'm not the least bit fazed by the sell-off.
On Feb. 9, Fortis announced the acquisition of Novi, Mich.-based ITC Holdings Corp., a publicly traded owner and operator of about 25,000 kilometres of regulated electricity-transmission lines in the U.S. Midwest – specifically in Michigan, Iowa, Minnesota, Illinois, Missouri, Kansas and Oklahoma.
The deal is being financed by about $3.5-billion in cash, $3.4-billion in Fortis shares and the assumption of $4.4-billion in debt. Fortis intends to sell a minority stake of 15 per cent to 19.9 per cent in ITC to an infrastructure investor at a later date.
You wouldn't know it from Fortis's sinking share price, but acquiring ITC has several advantages.
The deal expands the Canadian company's U.S. footprint, complementing Fortis's acquisitions of CH Energy Inc. of Poughkeepsie, N.Y., in 2013 and of UNS Energy Corp. of Tucson, Ariz., in 2014. It launches Fortis into a new business – federally regulated U.S. transmission – known for its attractive returns. And it provides a platform for growth, as new transmission infrastructure will be required to get renewable power to market from solar, wind and hydro generation projects – on top of continuing upgrades required for the existing electricity grid.
The transaction – which is expected to close by the end of 2016, subject to shareholder and regulatory approvals – has a couple of other benefits as well. Fortis intends to seek a listing on the New York Stock Exchange, which will introduce its shares to a wider audience. And, perhaps best of all, the deal is expected to contribute to Fortis's bottom line almost immediately, with an anticipated 5-per-cent boost to earnings per share in 2017.
Dividend investors, in particular, should be thrilled: Last fall, Fortis set a target of 6-per-cent annual dividend growth through 2020, and the acquisition of ITC will help the company meet – and perhaps even exceed – its target. That makes Fortis's current yield of 4.1 per cent look even more attractive.
"This deal has it all for Fortis, and was a bull's-eye for us when we were looking at how it fit our company," Barry Perry, president and chief executive officer of St. John's-based Fortis, said on a conference call with analysts.
So why did the stock plunge? Analyst Robert Kwan of RBC Dominion Securities said that an investing strategy known as merger arbitrage – in which professional traders try to profit by buying a target company's stock while shorting the acquirer – may have been a factor.
The drop in Fortis "was less about investor concerns over the deal and more due to natural buyers of the stock (i.e., fundamental investors) taking a step back to evaluate the transaction and therefore not moving quickly to support the share price that was under pressure" from arbitrageurs, Mr. Kwan said in a note.
Potential "flow back" of Fortis's shares may have contributed to the slide, he said. U.S.-based ITC investors who receive Fortis shares as part of the deal may not be keen to hold them after the transaction closes, which could result in a chunk of shares hitting the market at once. Some investors may be reluctant to step in until that overhang passes, he said.
To be sure, investors may also have concerns about the transformational nature of the deal – which will result in Fortis generating about 62 per cent of its regulated operating earnings from the United States, up from less than 40 per cent currently.
Investors may also be nervous about the impact on Fortis's balance sheet. Following the announcement, Standard & Poor's revised Fortis's outlook to "negative" from "stable," citing the "execution risks associated with the transaction including selling up to 19.9 per cent of ITC to one or more infrastructure-focused minority investors."
S&P added that "the negative outlook also reflects the limited cushion in the credit metrics for any post-merger integration or operational issues."
When asked by an analyst whether Fortis expects to keep its A-minus credit rating or anticipates that it will drop to triple-B (the lowest category of investment grade), Mr. Perry responded that "with this size of transaction, we would have been talking to the rating agencies in advance. We'll let the rating agencies come out with their reports, but we are very positive that we will maintain a solid investment-grade credit rating."
It's normal for investors to feel skittish about a big takeover deal; Fortis's stock also fell after the UNS acquisition was announced in 2013. But Fortis successfully integrated UNS, CH Energy and other acquisitions, and I expect ITC will be no different. That's why the current slump in Fortis's shares look so tempting for long-term investors.