Back to the Future: The New Corporate Raiders

Deck: 

A rise in shareholder activism poses questions for companies with lagging share performance.

Fortnightly Magazine - September 2006

In a throwback to the 1980s, shareholder activism has been on the rise in the energy sector since last year’s forced shakeup (and ultimate plan to merge) of independent Kerr McGee (KMG).

In the past couple of months, there have been a number of shareholder “actions,” typically taking the form of strong suggestions rather than a brash boardroom brawl. Exelon, for instance, was pressed publicly earlier this summer to consider abandoning its planned acquisition of PSEG. That effort seems to have fizzled.

A few months ago, a New York hedge fund notified Southern Union Co. (SUG) that it had garnered just under 10 percent of SUG’s publicly traded shares, and suggested strategic actions ranging from master limited partnership (MLP) formation to an outright sale of the company to address chronic share underperformance.

Most recently, Mirant backed away from its bold run at NRG, did a 180, and bowed to two of its larger shareholders—hedge funds again— to announce a 43 million, $1 billion-plus share repurchase plan that will be funded via a sale of its Caribbean and Philippines power assets.

Jana partners, which also participated in the KMG shakeup last year, proposed that Houston Exploration buy back its shares or put itself up for sale. A lackluster response spurred a Jana takeover bid and ultimately led to Houston Exploration retaining an investment bank to evaluate strategic alternatives.

In our view, the rise in shareholder activism could spur some companies with lagging share performance to initiate or accelerate strategic initiatives, including separation of functionally disparate businesses, MLP formation, selling non-core operations, or selling the whole kit and caboodle.

That said, there is value creation, and then there is looting. The universe of companies we cover is no stranger to deadwood, and many corners could stand a good cleaning. Energy also is a long-term business in the midst of a badly needed reinvestment cycle. The utility end is affected with an obligation to serve, and is deeply intertwined with local regulation and politics that cannot always be understood—much less managed—from a Park Avenue tower.

A Pirate’s Treasure, or Dead Man’s Chess?

Back in the 1980s, shareholder activism was less euphemistically referred to as “corporate raiding” or “greenmail.” Mavericks by the standards of the day, investors like T. Boone Pickens and Carl Icahn drew notoriety buying up shares of poorly performing companies and using their acquired clout to force change. Actor Michael Douglas glamorized the game (and a flammable hairstyle) under the guise of scorn in his portrayal of Gordon Gekko in the 1987 film Wall Street.

Pickens and Icahn remain (and both are very active in the energy space), and the tactics they pioneered in the 1980s are regaining prominence. The vehicle of choice today is the hedge fund, many of which are being emboldened by recent shakedown successes.

A look at the events of the past year is illustrative:

• In April of last year, KMG Corp. agreed to a $4 billion share repurchase program and separation of some of its business units after an investor group led by Carl Icahn tried to take control of KMG’s board. Last month, KMG agreed to be acquired by Anadarko Petroleum for $70.50/share. Considering that KMG shares were trading at around $30 when Icahn & Co. got involved, shareholders didn’t fare too badly.

• Houston Exploration also was recently targeted by one of its shareholders, Jana Partners. Some speculate this was more of an attempt to “stir the pot” than a serious offer, which points out a “be careful what you wish for” risk.

• A few months ago, Sandell Asset Management, a New York hedge fund, informed SUG that it had acquired just under 10 percent of SUG’s outstanding shares and sent a letter to its board suggesting a number of strategic actions to realize value in the company’s assets not reflected in the stock price, including formation of an MLP to house qualified assets, a sale of the remaining gas utilities, and an increase in the cash dividend. Failing that, Sandell suggests that SUG put itself up for sale, although no actions have been taken by the company with respect to Sandell’s suggestions.

• Recently, Mirant Corp. bowed to pressure from two large shareholders, aptly named Pirate Capital and Omega Advisors, and announced a 43 million share buyback via a Dutch tender. The share repurchase is expected to consume approximately $1.25 billion in cash— a sharp reversal of course for Mirant, which only recently had backed down from a spurned hostile takeover bid for rival generator NRG.

• Duquesne Capital, another New York hedge fund, pressured Exelon earlier this year to walk away from its planned acquisition of New Jersey-based PSEG as the breakup fee provision of the merger agreement lapsed in June; Exelon was not so persuaded.

Clearly, the shareholder returns from these actions run the gamut, and the recently announced initiatives cannot yet be judged. At the same time, there has been a lot of mergers-and-acquisition activity in energy, both upstream and down. Chesapeake, ConocoPhillips, and Anadarko all have announced big acquisitions, and deals are coming left and right in utility- land, with Duquesne Light Holdings, Cascade Natural Gas, and Peoples Energy all having agreed to be acquired within the past few months. And, of course, there are persistent rumors that other energy companies likely are takeover targets.

Rethinking the Hybrid Structure

We continue to believe that companies with diverse holdings should reconsider a combined structure. Duke Energy’s recently announced plans to separate its electricity and natural-gas pipeline businesses recognizes that the “convergence” model of the 1990s did not pan out, and further acknowledges that the individual businesses likely are worth more as stand-alone enterprises.

The rising risk profile and increased price volatility associated with the commodity side of the energy business augurs for a further separation of the unregulated commodity-centric and regulated utility businesses. Owning gas exploration and production in a utility structure does not present the same risk/reward profile today that it did back when natural gas traded 50 cents on either side of three dollars. At the same time, the increasingly complex interrelationships among natural gas, coal, crude oil, and various forms of converting those (and nuclear) fuels into electrons continue to change the upstream landscape in the electricity business.

The risks and other defining characteristics of the production and delivery ends of the value chain are becoming increasingly disparate, which causes investors to question what they own in a given stock versus what they want to own. This logic applies to several of our covered companies in both natural gas and electricity, and we wonder whether a rising tide of shareholder activism might accelerate strategic initiatives in some cases.

We’re not calling for wholesale raiding, and would be the first to point out that sustained growth in this business requires the reinvestment of capital, especially right now. Aggressive share buybacks may boost returns for short-term investors, but can lead to value destruction over the longer term. Yet, at the same time, nothing focuses the mind like the prospect of being hanged.

Editor’s Note: The article has been adapted from a Wachovia Securities equity research report titled  Back to the Future, which was published in mid summer.