NextEra Energy (NYSE:NEE) is clearly on a warpath to acquire or merge with another utility as news emerged recently about a recent bid. If successful, one effect this will have will be to justify the high valuation of NEE stock.
Investors should take note of this situation, as I pointed out in my last article, where I showed how high the stock is trading in terms of valuation metrics.
Not only has NextEra Energy made a bid for Duke Energy (NYSE:DUK) and was turned down, but Reuters recently reported on Nov. 9 that NextEra made another bid. NextEra made an all-stock acquisition offer for Evergy, Inc (NYSE:EVRG) which has a market capitalization of about $12 billion today.
However, at the time NextEra’s bid was apparently for $15 billion, including a premium. Nevertheless, Evergy’s board reportedly turned down the offer.
This upset one of Evergy’s large institutional shareholders, Elliott Management Corp. On Nov. 10, they put out a statement that urged Evergy’s board to “immediately reengage with NextEra and fully explore” a deal.
NextEra’s Valuation Dilemma
As I pointed out in my last article, NEE stock trades at a significant premium to its peers. This is partly from its continuing earnings growth from its Florida Power & Light subsidiary as well as its considerable investments in renewable energy.
For example, on Oct. 21, NextEra Energy reported that its Q3 adjusted earnings per share (EPS) grew 11.3% to $66.5 cents per share. This is after a recent four-for-one-stock split that took effect on Oct. 27.
Moreover, the company gave forecasts for both its 2020 and 2021 adjusted EPS. These range from $2.18 to $2.30 for 2020 and $2.40 to $2.54 for 2021.
Therefore, using a midpoint for each of these forecasts, NEE stock at $74.64 (Nov. 23) trades at 33 times expected $2.24 for 2020. And for 2021 its trades at 30.2 times adjusted earnings.
This is a good deal higher than the typical utility stock, as I mentioned last time. As a result, the company is looking to use its highly-priced shares to purchase lower price-to-earnings (P/E) companies.
How Using a High P/E Stock In an Acquisition Increases EPS
We can illustrate why NextEra Energy is so keen to use its shares to acquire another company. The fundamental reason is that a high P/E stock purchase leads to higher EPS.
Let’s say there are two companies both making $1 million and both have 1 million shares outstanding. Therefore they both have an EPS of $1. But Company A is valued at 100 times earnings, so its stock is worth $100 million but Company B has a 10 times P/E, so its market value is $10 million.
Now if Company A buys B using its stock it only has to issue $10 million worth of shares. Therefore, it will issue 100,000 shares (i.e., 100K times $100 per share equals $10 million, the market value of Company B). Now there are $2 million in earnings from the combination, but the number of shares outstanding is only 1.1 million.
As a result, the earnings per share is now $1.818, or an increase of 81.8% from $1.00 EPS before the combination. So using the high P/E shares leads to a huge increase in earnings per share. It also lowers the P/E. Assuming the stock price stays the same, $100 divided by $1.818 lowers the P/E to about 55 times earnings from 100 times. That makes the stock more attractive and would likely push it up.
Compare that to the situation where Company A and B both had the same P/E and therefore the same market value. Now there are $2 million in earnings, but there are also 2 million shares outstanding to complete the merger. Therefore the EPS stays the same at $1.00.
What to Do With NEE Stock
This is why NextEra wants to use its higher than average P/E to acquire lower P/E energy companies. The problem is that its P/E is not substantially higher than its peers.
For example, I recently wrote about Nvidia (NASDAQ:NVDA) and its purchase of the semiconductor company ARM using its high P/E shares. Nvidia has a much higher P/E ratio stock, more than 50 times on a forward basis. This is because of the huge growth of the company. This makes it easier for sellers to acquiesce to the all-stock purchase.
Therefore, I suspect NextEra Energy is going to find it difficult to use NEE stock as an acquisition currency. It may have to start offering more cash in its deals.
Until then, most investors might want to wait to see what tricks the company has up its sleeve in its next purchase offer. That might make NEE stock have a lower P/E and a more worthwhile investment target.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Mark Hake runs the Total Yield Value Guide which you can review here.