Will Buffett Buy a Utility?

05/14/2019 5:00 am EST

Focus: UTILITIES

Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

I’ve personally owned Berkshire Hathaway (BRK.B) long enough to build up unrealized gains five times my initial investment. That hardly makes me unique, observes Roger Conrad, income specialist and editor of Conrad's Utility Investor.

Nor do my concerns about the next act for this investment company/conglomerate, now at $516 billion in market capitalization.

One road ahead would be to keep investing massive free cash flows ($22.8 billion last year) in well-run businesses at good prices. Management may also tie its disparate units more closely by finding new ways to work together, or they could double down on some and sell others. Also, though Mr. Buffett owns 37.34 percent of the “A” shares, activist investors are no doubt salivating about getting their hooks in eventually.

Whatever happens to Berkshire Hathaway will have huge consequences not just for shareholders, but for the industries it operates in as well. One of them is electricity.

Compared to Berkshire’s signature insurance business, electricity is almost an afterthought. Including its natural gas pipelines, the Berkshire Hathaway Energy (BHE) unit contributed only 8 percent of last year’s revenue.

Those sales were a great deal more significant in comparison to other utilities. In fact, BHE’s revenue was higher in 2018 than NextEra Energy’s (NEE) and nearly 1.5 times higher than  Dominion Energy (D). The only US peers with higher sales were Duke Energy (DUK) and Exelon Corp (EXC).

Buffett started his utility empire building in the mid-1990s, acquiring over extended MidAmerican Energy. He took advantage of the post-Enron utility sector meltdown of 2001-02 to enter the natural gas pipeline business with a high priced loan to Williams Companies (WMB).

Troubled but asset rich PacifiCorp was the next major coup in 2005, extending holdings to the Pacific Northwest and Rocky Mountains. NV Energy in December 2013 added western scale at a price many shareholders thought too low. And the next year, BHE added Canadian power distribution company AltaLink at a discount.

BHE now serves 4.9 million retail customers, generates 29 gigawatts of power and transports 8.2 billion cubic feet of natural gas per day over 16,400 miles of regulated pipeline. It also controls power distribution companies in the United Kingdom. All revenues are regulated or locked in under long-term contracts.

In the late 1990s, Mr. Buffett commented that utilities were a “good business” but should never be a “great” one. That was a response to the short-lived growth rates many power companies were then posting. But the statement explains much about the timing of Berkshire’s utility acquisitions since.

Mainly, the company has arguably never overpaid. That discipline was demonstrated once again last year, when Sempra Energy (SRE) outbid it for Oncor, the electricity distribution and transmission assets of the former Texas Utilities.

The winner got a good price, but only because Berkshire refused to be drawn into protracted bidding that would have eliminated any valuation advantage of buying these assets out of bankruptcy.

Berkshire’s Texas bid and its participation at the past few Edison Electric Institute Financial Conferences, however, also demonstrate undimmed interest in ultimately buying more of this “good” business.

Part of that zeal is no doubt due to the utility sector’s decades-long focus on core competencies and strengthening balance sheets.

That’s a stark contrast to the 1990s when managements did a lot of things Mr. Buffett didn’t like, from taking on new debt to mimicking Enron’s bravado about disrupting a century-old industry. And he’s well aware of the investment opportunity in American electricity’s ongoing shift away from coal.

High utility stock valuations are one deterrent to a new Berkshire shopping spree. The Dow Jones Utility Average sells for 20.6 times trailing 12 months earnings, the highest level since the late 2000 peak.

And the most recent utility merger to close was Centerpoint Energy (CNP) paying nearly 30 times earnings for Vectren, a utility with volatile construction operations and a low single digit growth rate.

IdaCorp Inc (IDA) would seem to be an ideal addition for BHE. Customer growth of 2.3 percent was among the highest in the US last year. The regulatory environment is reliably positive and the hydro-focused fuel mix is very low cost.

There’s also an opportunity to drive earnings higher by replacing aging coal facilities with a mix of solar, wind and natural gas, as Berkshire is doing elsewhere.

As for regulatory approval, BHE’s PacifiCorp unit already has extensive operations in Idaho that are contiguous to IdaCorp’s. That means experience dealing with key regulatory players in the state and a great case for cost synergies as well.

Idacorp, however, won’t go cheap selling at 22 times expected 2019 earnings, near its highest valuation in history. Moreover, if Berkshire’s goal is to buy a compatible, well-run company that would really move the profit meter for its power and gas utility business, Dominion Energy would be a far more attractive target.

Sure there’s some nuclear exposure. But the Virginia-based company has been reliably growing revenue in three of BHE’s key areas of interest: Regulated electric utilities, contracted natural gas pipelines and renewable energy, including solar and electric vehicles.

Buying would bring BHE to the Southeast US, an area where regulation has been every bit as positive as the Midwest and Rocky Mountain states, and customer growth faster. And there’s already overlapping territory as well, particularly in Utah where Dominion owns a gas distribution utility and pipelines.

This may be a bigger deal than Berkshire’s looking for now. But for investors, Dominion has the two essential qualities for any takeover bet. First, it operates high quality businesses that will reliably and robustly grow shareholder wealth without a takeover. Second, the stock trades at a marked discount to the typical utility.

Bottom line is investors are likely to win with Dominion, whether Berkshire bites or not. The same can’t be said for the couple dozen utilities that are already priced for high premium takeovers, and are therefore at risk to crashing and burning if they don’t happen.

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