Description

In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments. (Charlie’s sign off after we’ve talked about an arbitrage commitment is usually: “Okay, at least it will keep you out of bars.”)

- Warren Buffett, 1988 Berkshire Hathaway Annual Letter to Shareholders

Summary Thesis

If you have more cash than good ideas then AGR is a minority-squeeze out arbitrage that may promise much greater returns than Treasury Bills while you seek out the next great long-term investment.

On March 7, 2024 Iberdrola (IBE) offered to buy out the 18.4% of Avangrid (AGR) that it does not currently own for $34.25/share, representing a $2.5bn purchase price on AGR’s market cap of $14bn. AGR closed at $36.87 on Friday 4/19, a $2.62/7.6% premium to the deal price. My view is that the deal will close in 9-12 months and be revised upward before close representing a return potential of 15% to 44%.

Background

• IBE currently owns approximately 81.6% of AGR’s capital and aims to strengthen its presence in the networks business in the United States  
• IBE is offering $34.25 per share, which is about a 10% premium to the weighted average price of the last 30 days prior to the announcement and a +7% premium to the unaffected closing price of $32.10.
• $2.48 billion dollar investment for IBE
• The consummation of the proposed transaction is conditioned upon the approval of the proposed transaction by the Unaffiliated Committee and by the Avangrid shareholders that hold in the aggregate a majority of the outstanding shares of common stock that are not held by Iberdrola, S.A. and its affiliates.
• Avangrid’s business:
  • $44bn in assets and operations in 24 states
  • Two main business lines:
    • Networks owns and operates eight electric and natural gas companies, serving 3.3 million customers in New York and New England
    • Renewables owns and operates a portfolio of renewable energy generation facilities throughout the United States
  • 8,000 employees
  • 2023 EBITDA: 2.43bn (+8% y/y)

Thesis 

The deal will close in 9-12 months and be revised upward before close representing a return potential of 15% to 44%.

I see a classic minority squeeze-out where the majority owner is highly incentivized to acquire the minority stub “on the cheap”. AGR is trading cheaply in no small part due to the poor performance in their Renewables business (segment EPS -70% Y/Y '23/'22). Conversely, AGR’s Networks business has performed well (segment EPS +16% Y/Y '23/'22) and is expected to continue to do so for the foreseeable future. The company is guiding for 8% EPS growth at the midpoint of the range for 2024.

At IBE’s Capital Markets Day (CMD) on March 21 they announced their expectation to close the deal within 9-12 months. That puts the close at sometime between December 21, 2024 and March 21, 2025. IBE also stated they are assuming the deal closes on January 1, 2025 for planning purposes. IBE already owns 81.6% of the company, putting the risk of close due to regulatory or financing at de minimis levels. As well, IBE is a $76bn market cap company and the deal requires a $2.5bn outlay or <3% of IBE’s market cap.

As part of their CMD, IBE presented a slide to its investors that included the AGR take-private in their 2024-2026 investment plan. This level of commitment to the investment community suggests IBE is serious about closing the deal. Bolstering their position in the Networks business is IBE’s stated rationale for the AGR acquisition and on the slide below you’ll see that IBE’s investment plan is weighted towards Networks investments (⅔ of 2024-2026 investments) vs. Renewables (⅓) which adds weight to my view that IBE won’t walk away from this deal. 

The reason I expect a bump from the initial proposal is the fact that the deal is conditioned upon special committee approval and a majority of the minority vote. This is best practice in squeeze-outs, and historically results in a “deal bump” for the minority holders. IBE’s incentive is to give the minorities a “fair” price and have it approved in such a way that the deal is not subject to lawsuits. The standard way this is done is to offer a low/no-premium initial bid, and then negotiate with the special committee for the true, appropriate deal premium. IBE wins by not overpaying, and the special committee wins by demonstrating their commitment to negotiating for the minorities. I borrowed this from Ray Palmer (thanks Ray you handsome devil), and you’ll see how deal premiums usually shake out in these circumstances. In some outside cases the premium was >100% to the unaffected price.

The slide above is light on utility transactions. A couple of recent precedents in the utility space include Sempra/Oncor (2018) and Riverstone/Talen (2016). Sempra beat Berkshire Hathaway in a contest to acquire Oncor, so I don’t think the premium paid is instructive in that case. In Riverstone/Talen, the purchase price was a 56% premium to the unaffected price.

Another way to approach this problem is to look at a highly conflicted minority squeeze-out and see what premium was paid in that type of transaction. The CONSOL / CNX Gas squeeze out is instructive in that regard (if you’re interested in this kind of thing I recommend checking out the link). The summary is that as part of the squeeze-out CONSOL approached T. Rowe Price and asked that they tender their shares. T. Rowe agreed since they stood on both sides of the transaction and didn’t stand to gain from a high premium for CNX Gas shareholders. Since T. Rowe held 37% of the minority float, this corrupted the “majority of the minority” vote hurdle that is meant to protect minority investors. Also, CONSOL acted against their special committee’s recommendation to not approve the deal. Despite CONSOL’s attempts to not treat the minorities fairly they still offered a 24% premium to unaffected price. The price likely would have been higher had they not conspired with T. Rowe and accepted the special committee’s recommendation. Recall in the case of IBE/AGR, the deal is conditioned upon accepting the special committee’s recommendation.

Combining all of the above, I’m comfortable that 20% is a good base case premium, and 50% is a good upside case premium.

Risks

The primary risk when evaluating a deal is that the deal breaks. IBE may find that the special committee demands too high a price, or that it has decided not to consummate the transaction for another reason. In a deal-break scenario I would expect AGR to trade at a spread to the 10-year treasury which is typical of utilities. The 10-year treasury yield has been volatile, and I don’t presume to know where it will trade in the next 9-12 months. One mitigant to the deal-break scenario is AGR’s depressed trading price relative to its recent history and its undemanding valuation at 16.3x ‘24 EPS. Given IBE’s incentives and long-term time horizon as a strategic investor, I think the risk of a break is low. The other risk is that there is no deal bump, which I do not expect given the initial low-ball by IBE. This risk is mitigated by dividend payments. See the Scenarios below for a sensitivity table.

Scenarios

Catalyst

- A revised offer ("bump") by Iberdrola within the next 9-12 months

- The deal closes