Elevated Shares Ahead of the Spinoff

 | Apr 05, 2013 | 4:30 PM EDT  | Comments
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itc

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exc

Entergy (ETR) just popped above its 200-day moving average even though the company recently shared some bad news: A serious industrial accident occurred at one of its nuclear power plants last Sunday, involving one employee death and three injuries. While the stock halted its climb the next trading day, it resumed rising two sessions later.

The market was wiser than many would expect. It figured out early on that there was no need to panic -- that the issues at the Arkansas Nuclear One (ANO) plant were contained and that Entergy was managing their problem. It turns out that the market was right, because the accident was not nuclear-related, having occurred in a building that's physically isolated from the nuclear reactor.

If the company's future appears uncertain, it's for completely separate reasons: an inclination to sell off its critical assets. A few years ago, for example, Entergy was concerned about the deregulated power markets -- so it attempted to spin off its merchant fleet of nuclear power plants into a separate company called Enexus Energy. But the spinoff was called off in 2011 after New York regulators denied Entergy's petition.

Now Entergy is planning to spin off its electric transmission lines. In a deal announced with ITC Holdings (ITC), and pending likely final approval, the company will merge its electric transmission business into ITC. The spinoff is targeted to close this year.

Dividend Seekers Beware

One concern associated with this deal is a likely shift in Entergy's solid 14x price-to-earnings ratio. (Among its larger peers, Duke Energy (DUK) is priced above 23x, and Southern Company (SO) and NextEra Energy (NEE) are each valued at around 17.5x.) One driver to utility P/E ratios is dividends, and Entergy currently has a 5% dividend with a 70% payout ratio. But if the transmission-line spinoff is completed, Entergy's earnings will drop and the company is expected to "right-size" its payout. This makes sense, because Exelon's current shareholders will likely end up owning about half of ITC, one of the nation's largest electric transmission companies.

That makes ITC an important consideration. Today, it has an enterprise value of approximately $8 billion, and its market capitalization has soared 30% to almost $5 billion as the Entergy deal has approached reality -- coupled, of course, with a shrinking dividend yield. It is currently under 2%, with a payout ratio of less than 40%. While ITC bumps up the payout each year, its policies may change after the deal closes.

Still, it expects to declare a special one-time $13 dividend after the deal is approved by regulators but before it closes. ITC is also set to issue about $700 million worth of unsecured debt. After the merger is closed, ITC will essentially double its outstanding shares.

On Entergy's end, market value remains elevated by the deal, and shareholders will remain partially isolated from the volatilities of the nuclear-power market until the pact closes -- at which point the company will also shrink in size. To New York's chagrin, Entergy will end up looking more like the old Enexus and Exelon (EXC). But, unlike Exelon, the new Entergy will have some nuclear assets safely protected by its rate base. Some of its nuclear plants will always provide shareholders with prudent returns, whereas others will be subject to the whims of the power markets.

All of this, then, seems to further explain the continued bid under Entergy despite the recent tragic accident. We send condolences to the family who lost their loved one, and hope for a full and speedy recovery for those injured.

Nuclear power has an incredibly impressive safety record, and this accident is an anomaly -- and had, of course, nothing to do with its nuclear materials.

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