BY M. DIANE McCORMICK
In the corporate world, the words “tax reform” usually conjure up happy images of less money for Uncle Sam and more money for business investment and shareholders. However, gas utilities are uniquely structured, and the potential loss of tax provisions could mean, at best, a wash in terms of the bottom line.
That’s the consensus of financial analysts who foresee varying scenarios for utilities under the Trump administration and Republican Congress but agree that tax reform proposals now being considered could erase deductibility of interest and slow merger and acquisition talks. Even the interest rate increases of 2017, generally indicating an economy on the upswing, have a clear downside for gas utilities and future capital expenditures.
Still, gas utilities have longstanding reserves of strength and stability to weather potential changes, analysts say. Besides, nothing is set in stone, and it took years for the last complete tax reform package to be enacted in 1986.
“We just have to wait and see,” said Daniel Fidell, managing director, Utilities & Infrastructure, U.S. Capital Advisors LLC. “There’s so much that goes into the soup in getting a tax reform package through. We’ve not had meaningful tax reform in this country in several decades. Whatever is ultimately going to be rolled out is not going to look like the finished product.”
Here in the early 21st century, the gas utility industry has been riding a wave of strength, pulling back from the risky ventures of the 1990s and refocusing on safety and infrastructure upgrades, said Faisel Khan, Citigroup managing director. The drop in gas prices in the 2000s gave utilities the breathing room to reinvest in themselves.
“A lot of that investment was definitely needed and had been sitting in limbo for a long time, simply because gas prices were so high, and this made it difficult for regulators to pass through additional rate increases,” said Khan. Today, “a lot of the balance sheets for these companies are fairly healthy.”
Since the elections of 2016, though, gas utility stocks are “generally flat, having underperformed the broader market,” noted John Colella, managing director, Moelis & Co. “The impact of tax reform on gas utility stocks remains more uncertain than the impact to the broader market given the nuances of the cost of service model and the question of how potential benefits will be shared with ratepayers in that context.”
Deductibility of interest is the question on which the industry’s fate hinges, post-tax reform. In general, tax reform proposals sketched out by the House of Representatives would reduce corporate tax rates but, correspondingly, would also eliminate or limit the deductibility of interest expenses.
—John Colella, managing director, Moelis & Co.
This exchange works in the favor of most corporate structures. But for many energy utilities, debt has also been issued by their holding companies, and “the interest associated with that debt is absorbed by shareholders,” said Anthony Ianno, managing director, Global Power and Utility Group, Morgan Stanley. “If you’ve assumed that the math works based on having tax-deductible interest at the holding company and you’ve lost that deductibility, your equity returns will decrease.”
With their high capital expenditures, utilities “are typically not full taxpayers,” Ianno noted. “Their corporate taxes are generally lower because of their deductions, and therefore they won’t have the same relative benefit as other corporates by lowering the corporate tax rate.”
Added Caren Byrd, managing director, Morgan Stanley, Investment Banking Division, “If the debt is at the parent company, not at the utility, shareholders will experience the loss of interest deductibility through a drag on earnings, while customers will receive the primary benefit of the lower tax rate at the utility.”
Utilities are “very much impacted by the threat of tax reform,” said Julien Dumoulin-Smith, executive director, Equity Research for Electric Utilities, Alt Energy & IPPs Group, UBS Securities LLC. “I say ‘threat’ because a lot of proposed elements would ultimately result in a net detriment going back to overall earnings of utilities.”
He added, “The Holy Grail here is how you think about interest deductibility and whether or not that’s grandfathered in any reforms, or whether that’s included at all.”
Utilities that have pursued recent consolidations and, in the process, used high levels of leverage—the debt that increases operating power but also carries more risk—would be “disproportionately impacted,” said Dumoulin-Smith. “That’s going to be a tricky subject for them.”
The hope remains that a final tax reform plan takes into account the unique challenges faced by utilities.
“All the tax experts we’ve talked to internally suggest that whatever form this tax regime comes in, there will be some grandfathering in, so people aren’t left with impaired balance sheets,” Khan said. “I find it hard to believe they would penalize companies day one from being in the capital structure they’re in. There’ll be some period of time to adjust their capital structure.”
Interest deductibility could also slow the pace of future mergers and acquisitions, analysts say.
“To the extent that companies are using it to finance mergers, that interest may no longer be tax deductible,” said Ianno. “That would increase the cost of debt associated with financing a transaction and would likely lower the price they’d be able to pay in an M&A situation.”
Any mergers already announced shouldn’t be affected, said Byrd, “but if I were management of a company evaluating a new acquisition opportunity and had this new tax reform uncertainty, I think I would pause and wait to know what the ground rules are.”
Khan agreed. “If you’re the CFO and you’re staring down the barrel of all these proposals coming from Congress, it makes sense to slow down and figure out what’s going to happen before you decide to do a big transaction,” he said. “That makes common sense.”
When the dust settles, Canadian companies could resume their U.S. buying spree. Canadian companies “have a competitive advantage from a lower cost of capital, which could be further enhanced if they continue to benefit from tax deductibility of interest expenses, where their U.S. peers don’t,” said Ianno.
If the ability to deduct net interest expenses disappears in the United States, “Canadians may maintain relative cost of capital advantage to the extent they are able to continue to deduct in Canada,” said Colella. “But having said that, the loss of deduction in the United States still brings their cost of capital up a little bit, which means that everybody’s ability to pay a premium comes down, but potentially a little less so for Canadians.”
In recent years, utilities have sold at generous premiums, where buyers pay by “borrowing more and putting more debt into the holding company box,” said Colella. That debt has been “relatively cheap,” which helps facilitate the high premiums.
“But if we assume many of these tax reform elements are relatively net income-neutral to the operating utility, the big piece left is the holding company debt,” he said. “You lose that tax deduction, everything starts to look much more expensive. It becomes more difficult to pay the premium that you used to, and it’s harder to make deals accretive to acquirers. This has the real potential to put a damper on utility M&A or at least reduce the size of the premiums we’ve been seeing lately.”
However, Fidell sees a scenario where tax reform and potential rate increases could lead to lower stock prices for “higher-profile takeover candidates, which are largely local distribution companies,” and when stocks drop, “typically, that’s when the acquirer vultures tend to circle,” he said. “We would think the group is ripe for some weakness as we head into the latter part of the year.”
In the M&A space, Ianno is advising gas utilities “to continue to execute on their business plans,” given the relative strength of gas utilities versus electric, along with continued low gas prices.
Khan predicts little to affect mergers and spinoffs, “whether that’s in the midstream space or the gas utilities space, unless the capital markets completely dry up.”
Analysts differ on the impact of rising interest rates.
The Federal Reserve’s interest-rate increases of late 2016 and mid-March 2017—likely heralding more to come—will spark conversations on how to pass along the extra expense, said Dumoulin-Smith. “Interest-rate hikes would be negative for utilities overall and negative for utility bills. That’s definitely something that’s of concern across the entire sector.”
However, in tax reform, Dumoulin-Smith sees a net-net outcome, as lower tax rates could afford gas utilities “spending opportunities to do work they would have otherwise delayed or waited on. You’re going to see acceleration in capital expenditures across the gas utility sector.” It is not necessarily additional spending, he added, but capital projects shifted forward “that would be done otherwise in later years.”
Colella predicts that a potential rise in interest rates would likely result in continued stock underperformance relative to the broader market. As yields move up, utility price to earnings ratios and stock prices will decline, he said. In recent years, gas utility share price performance has outpaced the broader markets, largely driven by P/E multiple expansion reflecting lower cost of capital. If the sector starts trading closer to historical means on a P/E basis, “earnings growth likely will not sufficiently offset the impact to share price declines.”
Even amid interest rate increases, borrowing rates remain “very attractive,” said Khan.
“We’ve been as high as 3 and 13 or close to 3 and 14,” he said. “We’re still at relatively low levels. Once we reach 3.5 or 4 percent, then the returns on equity we’re seeing across the group have to change.”
From a macro standpoint, utilities are trading well, and as interest rates rise, there’s “a decent likelihood” that the ratio of share prices to earnings compresses a bit, said Fidell.
The net result of various offsets within tax reform make it “difficult to quantify which one is going to overpower the other until the details of the plan are more clear,” said Colella. “Every company is going to be in a different position in terms of the size of their deferred tax liabilities versus the size of their annual capital expenditures at the operating company level.”
When an operating company incurs debt, regulators can pass the associated costs to ratepayers. “If taxes are lowered, the customer’s bill goes down,” said Colella. “On the flip side, if companies no longer can deduct interest expense, the ratepayer bill goes up. You’ve got various offsets where the ultimate impact will remain to be determined.”
So, for energy utilities, what’s next? Analysts warn that all the tax reform talk is purely speculation. The final laws and regulations will depend on “the political back-scratching and sausage-making that goes into putting these deals together,” said Fidell.
“American Gas Association has always been a very strong proponent for representing the gas companies,” he said. “Many would prefer not to have a significant change in tax policies that would affect their operations or their ability to execute on their growth strategies. We’re just going to have to wait and see how this fleshes out.”
