LILCO Bid: Bright Idea or Election Gambit?
Wall Street is skeptical about the Cuomo proposal for the state of New York to buy the expensive electric utility, Long Island Lighting Company
NEW York Gov. Mario Cuomo surprised a lot of people on Oct. 13 with an audacious $9 billion proposal to buy the Long Island Lighting Company (LILCO).
For the past two weeks, state officials have been meeting with investment bankers in an attempt to convince skeptical Wall Streeters that the takeover is possible. Their task is to prove this is not just an election ploy to win votes by reducing electric bills for Long Islanders.
If the takeover is to be successful, New York State must somehow fashion the largest tax-exempt bond package in history to raise $8 billion to $9 billion.
The Cuomo proposal is serious, LILCO officials attending the Edison Electric Institute's annual conference in San Diego this week told security analysts. Officials say they are planning to hold discussions with the state. ``I think the offer was considered very political, but after LILCO said it would open discussions, it was taken more seriously,'' says Amy Sonne, an analyst with First Albany Corporation, a brokerage firm in Albany.
However, investment bankers and securities analysts familiar with the state's proposals say there are some high hurdles ahead for the plan, which was announced only weeks before the Nov. 8 gubernatorial election.
* The savings from the merger would only amount to 10 percent of an electric bill. ``Long Island would still have among the highest rates in the nation,'' says Ellen Lapson, senior director of global power at Fitch Investors Service, a bond rating agency in New York.
Investors would likely require some form of legislative assurance that LILCO would not be subject to competition from other power providers, Ms. Lapson says. ``Given the size of the financing, the Long Island Power Authority (LIPA), [the state agency that will would run LILCO], would require some extra degree of protection to get the deal done, but that type of protection would certainly limit future flexibility,'' she says.
* It is unclear what bond rating the new entity would secure. LILCO currently has a BBB rating (a low-end investment grade), reflecting the utility's financial straits. ``How do you get it to the same level as the New York Power Authority,'' an investment banker asked S. David Freeman, president and chief executive officer of NYPA. A proponent of the takeover, NYPA has an A- rating, an investment grade one notch better than LILCO's rating.
Fitch Investors, noting the timing of the proposal, told its clients that ``until there is further clarification of a buyout proposal, Fitch will continue to maintain a declining credit trend for LILCO.''
* With interest rates rising, will the state be able to afford the takeover? Every half of a percent increase in rates costs New York $500 million more to complete the deal. If the bonds were sold today, the state would have to offer 7.5 percent to attract investors, Fitch estimates.
If interest rates rise, the whole plan could fall through. ``This plan will not go forward unless we can guarantee an immediate 10 percent reduction in electric rates,'' says Richard Kessel, chairman of LIPA.
LIPA currently estimates that it can get the savings from a reduction in taxes (it would pay no federal income taxes), by not paying dividends, and possibly by paying lower interest rates because of a better investment rating.
The investment rating, Mr. Kessel says, ``will depend on the management plan we devise between LIPA and NYPA.''
The management plan will be critical because LIPA has no experience operating a power plant. Its sole activity has been decommissioning the Shoreham Nuclear Power Plant, a $4 billion facility the state purchased from LILCO for $1. The plant never ran at full power and was closed because of evacuation safety concerns.
The timing of the Cuomo proposal is unusual because the Public Service Commission, the state utility regulator, will soon hold hearings on how the state can lower costs and the tax burden on utilities. ``One of the things that is alarming about the LILCO deal is that it is one-off,'' Lapson says.
``There is no indication of how it relates to other issues,'' he adds.
If the purchase goes through, LIPA may have to spin off some LILCO operations to reduce the debt load. A prime target would be the natural gas business, which brought in $529 million in revenue last year.
``It is an option we would look at,'' Kessel says.
But selling the gas operations might create competition for LILCO and risks reduced revenues, Lapson notes. The LILCO deal is likely to be financed by selling bonds that make payouts based on the revenue generated by LILCO's sale of electricity. Wall Street worries that if LILCO electric customers started switching to gas, LILCO revenues would fall.
LIPA is also considering other ways to reduce the debt burden, such as selling off one or more of LILCO's generating plants.
``There are lots of innovative things we can do, but ... our first goal is to take over the company,'' Kessel says.
Convincing Wall Street of the plausibility of the takeover will require a lot of work. ``The questions keep piling up, and there are not too many answers,'' says Daniele Seitz, an analyst with UBS Securities, in New York.
One investment banker says he rates the odds of the deal going through at less than 25 percent. Kessel, however, says he has yet to find an investment banker who says the deal can not be done.