A Hydro One sign is seen on the wall of a building at 483 Bay St. in downtown Toronto, on July 10 2017.Fred Lum/The Globe and Mail
After a sharp drop in morning trading, shares of Hydro One Ltd. bounced back as investors warmed to its $4.4-billion acquisition of U.S.-based electricity and natural gas provider Avista Corp.
Shares of the Toronto-based utility declined as much as 5 per cent in the morning, but pared back those losses throughout the day to close at $22.67, up 0.6 per cent.
The all-cash transaction, which was announced late Wednesday, will see Hydro One pay for Avista by borrowing $3.4-billion in the U.S. debt markets and by issuing $1.4-billion of debentures that can be converted into Hydro One common shares.
Hydro One is offering these debentures through instalment receipts that would see holders pay one-third of the cost to own them up front, with the remaining two-thirds paid when the acquisition closes. That is expected to occur in the second-half of 2018. Net of fees, Hydro One's initial proceeds will be $441-million, while its net proceeds from the final instalment will be $909-million. (Underwriters also have the option to purchase as much as 10 per cent more.)
This financing structure is not used frequently in Canadian deal making but it's not totally new, either. It's been used before by Fortis Inc. in 2013, Emera Inc. in 2015 and Algonquin Power & Utilities Corp. in 2016 to finance acquisitions. Like Hydro One's purchase of Avista, these deals also had extended regulatory review periods.
The Hydro One debentures will bear an interest rate of 4 per cent a year, but the effective annual yield of the first instalment is 12 per cent, meaning investors could earn an attractive return as they wait for the Avista deal to close. Then, the debentures will be converted to Hydro One shares at a price of $21.40 a piece, a 5-per-cent discount to Wednesday's closing price.
"Normally with convertible debentures, there's a concern that people will buy the debentures and short the stock," said Michael Simpson, a portfolio manager at Sentry Investments Inc. He manages about $9.2-billion in funds, which own shares of Hydro One, on behalf of Sentry clients.
"But given how the market's come back, I think it shows that people are looking at the accretion of the deal and the potential for more dividend increases and diversification outside of Ontario, and adding natural gas distribution as a new stable business in a new regulatory region."
Hydro One's transaction for Avista comes two months after the province of Ontario unloaded a $2.8-billion equity stake in the Toronto-based utility, reducing its ownership to slightly less than 50 per cent.
That share sale in May, which was done as a bought deal, did not go so well for Hydro One's underwriters – co-led by RBC and CIBC. They were forced to sell a large chunk of the offering for a bigger discount after investors balked at the deal's initial price tag of $23.25 per share.
The difference between the two financings mainly comes down to use of proceeds.
In May, the province was pocketing the proceeds. This time, Hydro One will look to put the money to work by buying a company that will help it expand beyond Ontario and into new markets, such as in Washington state and Idaho.
During the past few months, Hydro One's chief executive officer, Mayo Schmidt, made no secret that the company is on the hunt in the United states for acquisitions. In a research note, analysts at Wells Fargo Securities said Hydro One could look to acquire additional small to mid-sized utility companies in the Pacific Northwest after gaining "a stake in the ground" with Avista.
In this deal, Hydro One agreed to pay $53 (U.S.) for each Avista share, a 24-per-cent premium to the company's stock price prior to announcing the takeover. Including debt, the total value is $6.7-billion (Canadian). To get this transaction over the finish line, Hydro One says it needs a green light from Avista's shareholders, as well as regulatory approval in the United States from both state and federal levels.
The debenture sale, which was completed on a bought-deal basis and can't be sold into the U.S. market, is being co-led by RBC Dominion Securities, CIBC World Markets and BMO Nesbitt Burns. They will earn a 3.5-per-cent commission, with half payable on closing and the rest payable on the final instalment date. The sale of debentures is expected to close on Aug. 9.
U.S.-based Moelis & Co. LLC acted as financial adviser to Hydro One on the Avista deal.