There's Trouble in Entergyland

 | Sep 14, 2013 | 7:00 PM EDT
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Entergy (ETR) and ITC Holdings (ITC) hit a brick wall. While they may be able to pull a rabbit out of the hat, their transmission line deal is in jeopardy. State regulators are balking. The deal is on hold. Hedge funds are exiting. So should others.

Under the proposed transaction with ITC, Entergy will merge its electric transmission business into ITC. Entergy is highly motivated because they are under pressure by the U.S. Department of Justice.

According to DOJ's November 2012 press release, the [Antitrust] division has been examining allegations that Entergy engaged in exclusionary conduct in its four-state utility service area spanning parts of Arkansas, Louisiana, Mississippi and Texas. The federal investigation focused on whether Entergy's power generation dispatch, transmission planning and power procurement practices constituted exclusionary conduct under the Sherman Act.

Since DOJ began its investigation, Entergy announced, (1) they intend to join the Midcontinent Independent System Operator (MISO) and (2) they entered into an agreement to divest its electric transmission business to ITC.

Until Energy delivers on its promises, DOJ's antitrust division will closely monitor developments. In the event Entergy does not make meaningful and timely progress, "the division can and will take appropriate enforcement action, if warranted."

In recent months, Entergy initiated the federal and state regulatory processes in support of these significant structural changes, secured conditional MISO approval from several state regulators, and committed its utilities to a target MISO integration date of December 2013.

The most difficult hurdle is locking in approval from all the federal and state regulators. To be successful, all regulators must approve the transmission line deal; not a single regulator can object.

Last June, Entergy and ITC received approval from the Federal Energy Regulatory Commission. FERC effectively accepted the companies' positions on the effects of the transaction on competition, rates and regulation, with the commission noting the benefits that stem from the independent ownership of transmission assets, over and above benefits that will result from Entergy's integration into MISO. The commission also largely approved rate filings, including the requested allowed return on equity and authorized capital structures, while certain other elements were set for hearing.

Two months later, the State of Texas dropped a bomb. According to Reuters, Entergy and ITC realized the Texas Public Utility Commission was objecting to its deal. The companies had no choice but to withdraw its application.

Last week, Associated Press reported, "Almost a month after Entergy and ITC withdrew their application in Texas, they haven't refiled. Since then, Louisiana, Arkansas and Mississippi have also delayed consideration of the merger."

Unless Entergy or ITC can pull a rabbit out of their hat, the delays almost certainly mean the companies will not complete the merger by year's end, as originally scheduled. Some analysts wonder whether it will be completed at all.

AP reports UBS AG (UBS) sent a note to clients claiming, "Even if the deal goes forward, the economics will likely be substantially eroded for Entergy." As such, UBS recommended investors sell their Entergy stock.

There is a path to success. When utilities want to merge or spin off assets, states see an opportunity to extracts economic benefits from the parties. We saw it when Exelon (EXC) bought Constellation Energy Group, when Duke Energy (DUK) bought Progress Energy and when Northeast Utilities (NU) bought NSTAR. We are seeing it play out again with Entergy and ITC.

AP reports Entergy and ITC already offered states more than $350 million in rate concessions, including $134.4 million in Arkansas, $129 million in Louisiana, $90 million in Texas, $77.5 million in Mississippi and $40 million in New Orleans. Apparently, they want more.

Any additional concessions will have to come from shareholders. The question is whether it is Entergy's shareholders, ITC's shareholders or some combination.

There is not much more Entergy can offer. As was reported in Entergy's Domino Effect in Nuke Closings, Entergy is managing another brush fire with respect to its merchant nuclear fleet. It appears the fleet is uncompetitive and challenged by powerful activists. If they lose their transmission lines and large portions of their merchant fleet, Entergy's shareholders may be left with a tiny utility.

ITC has a different challenge. Transmission lines are attractive assets, but they are not high-margin enterprises. Revenues are regulated by FERC; their rates are not under the jurisdiction of state or local utility commissions. Any additional concessions from transmission line revenues and ITC may be forced to walk away.

It is possible a solution will be found. Alternatively, it is also possible Entergy could be in a serious bind. Consequently, Entergy and ITC shareholders should assume this deal would not be completed in time. Consequently, investors should proceed with caution and consider hedging their positions.  

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