Thursday, July 20, 2017

Special Update: Hydro One's $1.4 Billion Convertible Debenture Offering

Quick update on this bit of news that crossed the newswires after market close yesterday (July 19).  Hydro One, Ontario's largest electricity transmission and distribution provider, announced that it is buying Spokane, Washington-based Avista for US$5.3 billion in cash, which will effectively create a top-20 North American utility focused on regulated transmission as well as electricity and natural gas local distribution.


Associated with the deal, Hydro One also announced a $1.4 billion bought deal offering of convertible debentures, which will be initially represented by instalment receipts until the acquisition closes, which isn't expected until the middle of 2018.  I haven't had a lot of time to research and analyze the issue, but here are some quick thoughts:
  • $1.4 billion, in sheer dollar terms, is massive for a convertible debenture offering in the Canadian market.
  • This is a bit of a complex structure and unconventional for a convertible debenture, so interested investors will want to read the press release carefully and speak with their investment advisors before subscribing.
  • The convertible debentures are being sold on an instalment basis at a price of $1,000 per debenture, of which $333 is payable on the closing of the offering (which is expected August 9) and the remaining $667 is payable on a date (sometime in mid-2018) following the satisfaction of all conditions precedent to the closing of Hydro One's acquisition of Avista.
  • The instalment receipts bear an annual interest rate (paid quarterly) of 4.00% per $1,000 principal amount until the closing date of the acquisition (again, which is expected in mid-2018).  However, because only $333 of a $1,000 investment in the instalment receipts is payable upfront (on August 9), an investor is in effect getting $40 worth of interest on an initial $333 outlay, which translates to approximately a 12% effective annual yield.  
  • After the acquisition closes (in mid-2018), the interest rate on the convertible debentures drops to 0%, sweet nothing.
  • The convertible debentures are convertible into common shares of Hydro One at any time after the acquisition closes in mid-2018 until the maturity date.   The conversion price is $21.40 per common share.  Note that Hydro One closed yesterday (July 19) at $22.53, so this issue is technically already in-the-money.
  • The debentures mature on September 30, 2027, so nominally, this is a 10-year convertible debenture.  A 10-year convertible debenture is rare in the Canadian convertible debenture market.
  • However, I say the convertible debentures are nominally 10-years because as long as Hydro One shares don't completely tank and stay above (or near) the conversion price of $21.40, most (or substantially all) of the convertible debentures will be converted far before the issue is scheduled to mature.  With a 0% interest rate after the acquisition closes, there would be little incentive to hold on to the convertible debentures long-term in the (probable) scenario of Hydro One share price not completely crashing.
  • For an investor, I view this offering of convertible debentures essentially more like owning an in-the-money call option on Hydro One shares over the next 10 years.  But instead of "paying" for the option, Hydro One effectively pays the investor 12% on the invested portion upfront (recall, 4% interest on a $1,000 debenture, but only $333 is payable upfront on August 9) for the option.  I know it's not a perfect analogy, but this is just my simplified way of viewing things.
  • For Hydro One, this is effectively a deferred equity issuance, disguised as a convertible debenture.
Quick pros that I see of the Avista acquisition and the Hydro One offering of convertible debentures:
  • Hydro One gets a foothold growth platform into the US. 
  • According to Hydro One, the deal looks to be accretive to earnings in the mid-single digits (percentage-wise) from year one. 
  • The terms of the offering, though complex, seem attractive as long as you are comfortable with the business and prospects of Hydro One. 
Quick risks and cons that I see:
  • As a utility, Hydro One will be negatively affected by rising interest rates. 
  • The Ontario government will still own over 40% of Hydro One after the Avista deal closes; some investors consider the Ontario government's ownership block a negative, as political interference may be a perceived or real risk. 
  • Hydro One isn't cheap, and by my count, is trading at a trailing P/E ratio of about 19.7x.
Bottom line: I've taken a flyer on this issue and subscribed.  We'll see if I get any allotment of the instalment receipts (convertible debentures).

As always, remember this blog is for information only.  Please remember to consult a professional investment advisor before making any investment decisions.

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Chasing waterfalls. Sk√≥gafoss, Iceland. Copyright © 2006 Felix Choo / dingobear photography

2 comments:

  1. This issue looks identical to ones that ema and fts have done in the past couple of years. Both of those were very profitable investments. I received a 75% fill of my order via RBC direct investing.

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    1. Hi Peter, thanks for your comment. When I saw the press release for Hydro One's offering, I vaguely recalled a utility or two (but couldn't remember which ones) that had done similar offerings. Thanks for reminding me. I was less lucky ... I received zero fill on my order, too slow on the draw I guess. Opportunity missed. But I do hope you do very well on your allotment. Happy investing!

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