At its recent investor conference (held on Oct. 22), the management of South Jersey Industries outlined its vision for integrating its recent acquisitions of Elizabethtown Gas (ETG) and Elkton Gas (EGC), reducing the debt taken on in those acquisitions in part by selling non-core (non-regulated) assets and delivering additional value to shareholders by growing its earnings base in its core regulated businesses.
SJI acquired ETG and EGC from the Southern Company on July 1, 2018. The $1.74 billion acquisition, substantially all of which was attributable to ETG, was large for SJI, which had a total market capitalization of about $4.0 billion on Oct. 16, 2017, the day the deal was announced. Although SJI issued common shares and equity units to help finance the acquisition, most of the acquisition funding was in the form of debt. As a result, the company’s ratio of debt-to-total (book) capitalization has risen from about 55% when the deal was announced to 72.1% at Sept. 30, 2018.
Besides the equity financings, SJI has stepped up its effort to pare back its non-regulated businesses to help focus management’s attention and also to raise cash to reduce debt. Along with the closing of the acquisition in July, the company announced an agreement to sell the solar-related assets of its Marina Energy subsidiary to Goldman Sachs Asset Management for $350 million. So far (through Nov. 30), SJI has received $197 million in proceeds from the sale of these assets and expects to receive the remaining $153 million in 2019.
On Dec. 3, the company announced the sale of its (non-regulated) retail gas assets to UGI for an undisclosed amount. It is also exploring the sale of its combined heat & power and landfill gas assets. When and if these asset sales are completed, SJI will only pursue non-regulated growth opportunities in wholesale energy marketing and fuel management.
Financing the Acquisitions. Proceeds from the equity offerings and asset sales are being used to pay down debt. Sometime before next April, SJI should receive about $200 million (before underwriting discounts and commissions) from a forward sale of equity shares. With those proceeds and the sale of the remaining solar assets, I estimate that SJI’s pro forma ratio of debt-to-total capitalization will decline to about 65% (from 72% currently). This is still high compared with its peer group average, so the company may seek to raise more equity during 2019 or 2020 (unless it can generate roughly $500 million in proceeds from other asset sales, which would reduce its debt-to-cap ratio to around 60%; but that is unlikely).
Besides reducing leverage, SJI will also seek to refinance as much as $975 million in debt maturing in 2019, including $765 million at the holding company and $210 million at South Jersey Gas (SJG). Holding company debt includes $475 million of Floating Rate Senior Notes issued to finance the acquisition that mature on June 20, 2019.
The maturing debt will be repaid in part with the $350 million proceeds from the sale of Marina’s solar assets as well as the proceeds from additional asset sales, including the announced sale of the retail gas assets. SJI can also use the $200 million in proceeds from the forward equity sale, assuming that it decides to receive the full amount rather than settle the difference in the share price (i.e. the change in the share price since the forward sale was executed in April 2018).
SJI can also opt to draw upon its $431.7 million in available liquidity under its various bank credit facilities or issue new debt to cover the remaining portion of its 2019 maturing debt obligations.
On December 20, ETG issued $530 million of Series 2018A First Mortgage Bonds in five tranches, at rates ranging from 4.02% to 4.52% and maturities ranging from 2028 to 2058. In its SEC filing, SJI did not indicate whether the bonds have been rated; but the pricing appears to be consistent with yields on investment grade-rated first mortgage utility bonds. Proceeds were used to repay a $530 million ETG bank credit facility that was set to mature on Dec. 28, 2018.
No Change to Strategic Priorities. Although the ETG acquisitions represents a new undertaking by SJI, the company has made no changes to the strategic priorities that it adopted in 2015. Those priorities include:
- Growing Economic Earnings. (Economic earnings are defined as net earnings from continuing operations excluding mark-to-market gains and losses on derivatives and certain unusual items such as impairment charges, acquisition costs and legal expenses.)
- Improve the Quality of Earnings. (By that, SJI means increasing investment and earnings from core regulated utility and midstream businesses and de-emphasizing riskier non-core businesses, such as solar.)
- 78% of SJI’s earnings were derived from its regulated businesses in 2017. Its goal is to increase that percentage to 82% by 2022.
- Maintaining Balance Sheet Strength. (Given the recent increase in leverage associated with the ETG/EGC acquisitions, reducing leverage should be a major near-term focus of management.)
- Maintaining a Low to Moderate Risk Profile.
Key Strategic Initiatives. SJI list of key strategic initiatives, augmented now by the ETG/EGC acquisition, are as follows:
- Complete the Integration of ETG/EGC. A key priority is to eliminate the transaction services agreement (TSA) with Southern Gas Company (SCG) whereby SCG provides certain administrative and operational services to ETG (presumably at a cost). The TSA is set to expire no later than Jan. 31, 2020. SJI hopes to take over the provisioning of those services as soon as possible. As part of this effort, SJI is working to integrate its IT platforms with ETG, harmonize the policies and procedures of ETG, EGC and SJG and adopt best practices.
- Infrastructure Modernization Program. SJI sees an ongoing opportunity to upgrade the infrastructure of both SJG and ETG. For years now, SJG has been replacing its bare steel and cast iron mains. Under its Accelerated Infrastructure Replacement Program II (AIRP II), approved by the New Jersey Board of Public Utilities (NJBPU) in 2016, the utility aims to replace the remaining 300 miles of steel and cast iron mains in its system by 2021. Similarly, while ETG has also been upgrading its infrastructure, SJI will seek approval from the NJBPU to replace another 400 miles of mostly cast iron and older gas pipeline in ETG’s distribution system.
- Customer Growth. SJG has consistently achieved above average customer growth through both conversions and new construction. It anticipates to grow its customer base at an average rate of 1.6% over the next five years, consistent with its long-term historical average. ETG on the other hand, which operates in a more mature territory, achieved 0.9% annual growth in its customer base from 2009 to 2017; but SJI believes that it can lift that rate of growth to 1.4% annually over the next five years, primarily through conversion opportunities of households that have gas service, but do not use gas to heat their homes and also from a large number of customers who live on or near ETG’s mains but have no gas service.
- ETG Decoupling. As it has already with SJG, SJI sees an opportunity to decouple ETG’s rates into separate service and usage components. This will make ETG’s earnings less susceptible to weather-related demand fluctuations.
- Rate Base Growth. With the focus on customer additions and infrastructure upgrades, SJI thinks that SJG will growth its rate base at a rate of 8%-9% annually over the next five years (down slightly from its average rate base growth of 10% from 2010-2017). It is also targeting annual rate base growth of 13%-14% for ETG over the same period, nearly double ETG’s historical average from 2009-2017. Both SJG and ETG are required to file base rate cases with the NJBPU in 2020, but SJI could decide to accelerate one of those filings as part of a regulatory plan to stage its filings. On a combined basis, SJI is targeting annual rate base growth of 8%-10%.
- Midstream Opportunity. SJI has a 20% equity stake in the proposed PennEast pipeline, which would bring 1.0 billion cubic feet per day of natural gas from the Marcellus into southeastern Pennsylvania and New Jersey. The project, which is still seeking regulatory and court approvals, would cost $1.0 billion or more (so SJI’s share would be $200 million or more). To date, SJI has invested $44 million in PennEast and anticipates spending roughly $30 million in 2019 and $125 million in 2020, assuming that the project receives all necessary permits and approvals. Once completed, SJI figures that its share of PennEast’s earnings will be $12-$15 million annually, which would represent a pre-tax return on investment of 6%-7.50%.
- Non-Regulated Businesses. As already noted, SJI is seeking to divest most, if not all, of its energy production assets, including solar, CHP and landfill gas. It will retain its wholesale energy marketing and fuel management businesses, both of which form the Energy Group within South Jersey Energy Solutions (SJES). (In wholesale energy, SJI is a trader and marketer of natural gas; in fuel management, it supplies natural gas to power plants and other larger users.) SJES has had a very strong year in 2018, with anticipated earnings of more than $40 million, about double its historical average. SJES’s earnings have been so strong in fact, that it does not expect to grow its earnings over the next five years. (It projects flat earnings over the five-year forecast period.)
Financial Performance Targets. Given SJI’s strategic initiatives, it has developed the following performance targets:
- Annualized Economic Earnings per Share growth of 6%-8%.
- Annualize Rate Base Growth of 8%-10%
- Annualized Dividend Growth of approximately 3%.
- A target rate of 80%-90% of economic earnings derived from regulated businesses.
Included in this plan are anticipated capital expenditures of $2.5-$2.6 billion over the five-year forecast period (2018-2022). This would be the largest deployment of capital in the company’s history. Approximately 98% of that spending would be earmarked for SJI’s regulated businesses.
That level of capital spending will likely exceed the cash flow that SJI generates from operating activities for the 5-year forecast period. Common stock dividends will also be an important use of cash for SJI going forward. My back-of-the-envelope projections indicate that SJI will at best show no improvement in its debt-to-total capitalization ratio and could even see its proportion of debt increase several points. Consequently, SJI will likely have to issue additional equity periodically to maintain its balance sheet strength (which as noted above is one of its key strategic priorities). Indeed, at its recent investor conference, management acknowledged that the company might have to raise additional equity in the future.
As long as SJI is delivering on its earnings performance targets and the growth in its debt remains in line with the growth in revenues and earnings, it should have no problem issuing the equity that it needs to maintain its balance sheet strength. In my mind, however, that assertion will require that the economy remain relatively healthy and interest rates and natural gas prices remain reasonable and attractive over the forecast period.
SJI’s common stock has underperformed its peer group especially over the past three months, as highlighted by the above comparison against the Dow Jones Gas Distribution Index. The shares fell sharply on October 22, the day of SJI’s investor conference, primarily because management gave disappointing guidance for 2018, which now serves as the base year for its five-year earnings outlook. The lower guidance reflected mostly increased costs associated with the ETG/EGC acquisition.
Given the recent underperformance, SJI’s stock now trades at a modest discount to its peer group’s average forward earnings multiples for 2018 and 2019. The stock also carries a 4.2% dividend yield, well above the peer group average of 2.7%. The current consensus estimate implies virtually no increase in earnings for 2019, which is out of step with management’s guidance. Consequently, if management can deliver on its guidance, the stock should have modest upside, especially against its gas utility peers.
December 27, 2018
Stephen P. Percoco
839 Dewitt Street
Linden, New Jersey 07036