Will This Acquisition Change the Game for Hydro One Ltd.?

Hydro One Ltd.  (TSX:H) announced on Wednesday that it will be expanding its reach beyond the borders of Ontario, agreeing to acquire U.S.-based Avista Corp. for US$6.7 billion. The US$53 per share offer represents a premium of 22% on Avista’s share price as of Wednesday’s close.

This premium is in line with what other Canadian utilities companies have been forced to pay to acquire American utilities assets, assets which tend to carry significantly higher growth rates than comparable assets based in Canada. The consensus among analysts and industry experts is that growth has been, and is likely to continue to be, somewhat constrained in the Canadian market, and Canadian utilities companies such as Hydro One will need to continue to diversify and acquire abroad to meet internal growth rates and IRR hurdles which may otherwise be in jeopardy.

With an appreciating Canadian dollar making U.S.-based acquisitions much more attractive of late, a number of analysts believe that this trend may continue for some time, as Canadian utilities companies such as Hydro One are forced to diversify geographically to attain higher returns over time.

The Canadian utilities market is a heavily regulated one, and in the case of Hydro One specifically, having all of the company’s golden eggs in a highly regulated and restrictive basket (compared with most other regions in North America) has forced the company to look outward, and Avista Corp. presented an interesting opportunity to gain access to western U.S. states that have economies which are expanding at a faster rate, on average, than the rest of North America. Demographic trends in these areas, along with regulatory environments that are much less restrictive than those in Ontario, are also much better — something I have argued Hydro One was in dire need of previously.

At the end of May, I wrote an article with an outright bearish stance on Hydro One. The key driver of my bearish long-term outlook for the utilities company was its extreme exposure to an extremely unfriendly Ontario market. Ontario’s “Fair Hydro Plan” will change the underlying fundamental economics of the utilities business in Ontario and will result in reduced profitability for the foreseeable future — something I contend could result in significant downside for some time to come.

Bottom line

While this recent acquisition expands Hydro One’s geographic reach significantly, which I believe was necessary for management to do, I am hesitant to jump at the opportunity of purchasing Hydro One’s shares at current levels. Given the significant premium paid for Avista Corp., the debt and equity dilution effects which will stem from the structuring of the deal (bonds and convertible debentures), as well as the fact that the majority of the company’s revenues will remain in Ontario (a market which is now one of the worst for a utilities company from a profitability standpoint), I believe significant downside remains for Hydro One moving forward.

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Fool contributor Chris MacDonald has no position in any stocks mentioned.

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