Citigroup Inc. (C) Earnings Call Transcript & Summary

Greetings, and welcome, everyone, to the Investment Bankers Roundtable. This truly is one of the highlights of this program and something that I look forward to every year. My name is Jonathan Bobinger. I'm a partner in the Houston office of Baker Botts, and I'll be your monitor today -- moderator today. Before I introduce the panelists that will be joining me, I'd like to remind everyone of the Q&A function. Please submit questions that you have for our panelists, and I'll do my best to weave them into the discussion. Now it's my pleasure to introduce our panel of experts. I am joined today by 3 very esteemed gentlemen. First up is George Bilicic, who heads Lazard's global efforts in power, energy and infrastructure. In addition, he serves as a member of Lazard's Global Executive Committee. He's been with Lazard since 2002 or largely since 2002. In parts of 2019, he was [ appointed to ] be the Group President of Sempra Energy, and in parts of 2019 and 2020, he was the President and Chief Legal Officer of Sempra Energy. In both of those roles, he had broad responsibilities across various Sempra businesses, legal, compliance, strategy and business development. He also took a short hiatus from Lazard in 2008 where he served as the Managing Director and Head of Infrastructure at KKR. At KKR, he was responsible for initiating and leading KKR's global infrastructure investing efforts and contributing to other areas, especially alternative energy and power. Next up, we have Jeff Holzschuh, who's a Managing Director at Morgan Stanley and is the Chairman of the Institutional Securities Group and a member of the firm's Management Committee. The Institutional Securities Group includes the investment management, capital markets, equity, fixed income and commodities divisions. He is also the Chairman of Morgan Stanley's Global Power and Utility Group. He's actively involved in Morgan Stanley's Sustainability Institute and its Environmental Policy Committee. He is a founding member of the US Partnership for Renewable Energy Finance and has served as the Chair of the EEI Wall Street Advisory Group and was appointed as -- he was appointed by the U.S. Secretary of Energy to serve on the U.S. Electricity Advisory Board. And last but definitely not least is Joseph Sauvage who is the Vice Chairman -- who is a vice Chairman and the Chairman of the Global Power Group at Citi. He has a wide variety of experience in power and energy sectors working with both strategic and financial sponsors, including strategic, advisory, activism defense, financial restructuring, equity and debt capital-raising transactions. Most recently, he has done restructuring, DIP and other committed financing transactions and debt and equity exit financing for PG&E Corp. He's done strategic, advisory and financial -- and financing transactions for Southern Company, including the sale of Gulf Power and Florida City Gas to NextEra. He has many others on his bio, but I deleted them out to try to keep this short.

With that, let's just jump right into the discussion. And we are going to stop -- we're going to try to cover 3 topics today. The first is going to be one that probably is near and dear to everyone's heart, which happens to be ESG and shareholder activism. So I will pick on Joe to start. He gets first up. Over the past few years, ESG has been the foundation of shareholder activism. What do you see as the broader ESG pressures on electric and gas utilities from their key stakeholders such as banks in response to regulatory, shareholder and other pressures on those institutions?

Sure. Thank you very much. The first thing I would like to say is that EEI has done a great job of working with the Wall Street banks on ESG matters. There is a template on ESG disclosures, which includes carbon intensity, et cetera, which has been developed with the banks and with EEI and their member companies. I would say -- I would break the stakeholder side of ESG into really 2 components. And I'm going to focus here really more on the Wall Street bank element as the key stakeholders. The first is simply credit implications in terms of changing business models, acceleration of the coal retirement, question about longevity of the gas LDC business in certain spots. The banks' regulators are focused on the credit quality of their portfolios, also are focused on the type of information that the banks are receiving and the questions and dialogue they're having with their clients. That is really, I think, primarily driven by the banks that have large financing and capital-raising businesses. The second part of this, which is, I think, more interesting for the sector as a whole is how the stakeholders of those big Wall Street banks are approaching ESG. And for that, you really probably can read carbon intensity and commitment to what our folks like to describe as the science, which you can shorthand for the Paris Climate Agreement. I think each of the banks that have large financing, capital-raising businesses are adopting -- have adopted or are in the process of adopting policies. Some have said they don't want -- they won't finance oil and gas exploration in the Arctic, for example. And there -- the focus, I think, initially is really on coal-fired generation. And the focus is going to be on -- for the regulated utility sector, most companies have put forth 2050 plans. They have guideposts between now and 2050, and most companies are accelerating the guideposts. The banks are going to be under tremendous pressure to hit that net zero carbon neutrality in 2050 and to hit the guideposts. So I think for the U.S. companies, the question will be how their own targets, which are to some -- going to be largely governed by either federal or state regulation, correspond to the pressures that the banks are seeing from their regulators, also from their stakeholders and shareholders. I would say that for the regulated utilities, this will probably result in conversations, et cetera, but not be a huge dislocation. I think the interesting question will be how this plays out outside the U.S. where there is greater coal intensity and the disclosure available to the financial institutions is quite different.

Thank you, Joe. George, do you have anything to add to that?

The only thing I'd say is that utilities have needed to focus on stakeholder issues for time immemorial. And for the outside observer, they're probably just underappreciated in terms of their skill in this area. And so it's an emerging area, but I actually think it's an area of strength for the utility industry given the ratepayer-interfacing nature of the sector and the need to work in communities.

Jeff?

No, I agree with that. I studied evolution, and we started talking about carbon 20 years ago. And this sector in particular was most impacted by NGOs and environmental groups in those days. And now it's become mainstream across the entire constituent -- shareholders, regulators, activists, as Joe described. So I think it's here to stay, and we need to figure out if we can quantify its impact on shareholder value going forward.

Thank you. All good insight. Next question, we'll turn to George. What are the transactional implications of ESG focus on the gas LDC business? I know Joe touched on it a little in his answer to the first, but love to hear your thoughts on that specific question.

The first thing to say where I touch the transactional implications is at least in our place at Lazard, we see this as an enduring business. There isn't a technology or a solution that is, in our judgment, practical to displace the gas LDC business. There are opportunities to supplement what gas LDCs have historically done through renewable natural gas and maybe over time hydrogen. But this idea that this business is going away is not an idea that we would subscribe to. For transactional implications in the area, we've seen potentially more opportunity for transactions because for example, electric companies ought to be evaluating their position in gas LDCs because they trade a little bit differently now. The perception around them is different. Valuation levels have been affected because of the uncertainties in the business, and we'd expect that to continue and be affected by concerns around the business. And particularly in some of the states, a lot of criticism of the business and concerns around the growth prospects around new construction and conversion of customers to natural gas. There is the potential for this business to be more in the hands of private capital if there's a lot of noise in the public markets around this business and taking into account the total market cap focused on gas LDCs. You could see private capital winding up owning these businesses because of their enduring nature, their cash flow profile, their yield. You could see someone in the sector who is a gas LDC or owns gas LDCs taking a point of view that it's an enduring business, the opportunity to acquire these assets is better now because prices are lower, and they decide to be a scale-based company going forward and conclude that scale is going to be very important to engage with stakeholders and also to deal with technology change. And then Joe just alluded to this a little bit, but another transactional implication is that with the noise around the business, cost of capital is a little bit higher. So financing costs around a transaction should be higher. But that's a collection of thoughts I'd have on that. Really good question.

Jeff or Joe, do you have anything to add to that?

I would -- I generally totally agree. I think it's a business -- the depth of the LDC has been way overstated. I think the multiples historically may have been too high. I think people's perception that FERC was going to continue to have premium returns for some of those asset categories was probably overly valued. But the other point that George makes, I think, is there's only 9 -- I think it's 9 publicly traded of any size. And so it's not a large part of the total capital in the space. And we do believe as well that that's likely to be consolidated or part of something else to get the scale benefits in the space.

Yes. The only comment I would add to that is that while I do think there has been some pressure on valuation multiples, I mean 5 or 6 years ago, these companies were all -- were trading at M&A multiples. Now they're trading kind of where the SMID electrics are. I think some of that is a function of the ESG matters. I think a lot of it is also just a function of the size of the market cap with most of these companies. They're relatively small, and the SMID electrics are suffering some of the same points in terms of PE multiples.

Thank you again for the insights. We're going to quickly touch on Larry Fink's most recent letter to CEOs. He recently came out and set a net zero target of 2050. Jeff, what do you think that's going to do? What effect do you think that will have on utilities and power generation?

Yes. When we talked a little bit a bit about it, look, Larry is obviously well respected and his letters are read widely, and he's certainly one of the largest investors in the world. So I think CEOs and people in the industries take it to heart. But I would concur with George's earlier point. I think this industry has done a very good job of getting ahead of understanding their current footprint, understanding what mitigation measure is so realistic and many of which have already come out, made the commitments to 2050 or sooner. I think the question always becomes how realistic is it to be at net zero by 2050. I think the target has certainly become somewhat accepted. It's going to be a function of technology and storage, how we deal with intermittent resources as those continue to be a larger piece of the portfolio. It's going to be a function of timing of electric vehicles and electrification of transportation in general. But I have no doubt that the largest investors in the world are doing more screens on ESG and are more sensitive to it and are going to have an impact on governance, whether it's management teams or boards, of being sensitive to how quickly they're able to get to that target.

Joe, do you have anything to add to that?

No. I agree with that. And I would say that when we go to do strategic presentations now, if we're talking about potential merger partners, et cetera, 2 years ago, we wouldn't have done this. Now we wouldn't go to a meeting without someone's MSCI rating, sustainability rating and some discussion overall of their posture on carbon and on other key ESG matters.

Thanks. George?

The only thing to add -- those are great answers, it's just that it's easier to have a discussion with your stakeholders about investing in elements of the energy transition and rate base when folks like Larry Fink and others are talking about this. So it's a positive for ensuring you get a fair return for your investments through rate base.

Thank you. Hey, we're going to shift gears a little bit and talk about power and gas M&A generally. We're going to start this one off with George. 2020 and 2021 have been challenging years, we'll say, for utilities and power generation -- generators. Rates have gone up. We now have a new administration. We have increased regulation. Obviously, the Keystone decision came down recently. COVID happened. And then obviously, just last week, we had what we -- in Texas called the Texas freeze. What is the macro environment for power and gas M&A?

So those are -- that's a collection of uplifting thoughts there that you -- I'm not sure. I feel like I need to lay down on the floor in my house here for a moment to recover from that negativity. But I would say 3 buckets about M&A, the macro environment for M&A. First, regulated utility M&A. It's not to oversimplify, but the environment is always about this is a consolidating industry. It's going to slowly consolidate. It's going to be hard for the industry to consolidate, including because of the history between a lot of the parties, the unusual nature of this industry where value is shared with ratepayers, the social issues associated with headquarters. But it's an industry where there may be bursts, but it's going to be steady as she goes. Like molasses flowing on a cold winter day, you're going to see utility M&A consolidation. On the fossil generation, merchant generation, natural gas-fired generation, it's a tough marketplace. I mean this is a place where advisers have spent a lot of time over the last 25 years. It's a tough market. But we think there'll continue to be activity in that area. Just very tough to get transactions done, complicated, not a lot of depth. And so -- and with the investment thesis being unclear, you have to buy it right. And what the duration of those assets will be is a great question for the owner of the asset. And then on the renewables area, the energy transition area, and I know we'll get to this a little bit later. But with the SPAC phenomenon, it's robust. It's as active an environment as I've seen in my career. And so we would expect that activity to continue in a robust manner at all sorts of different levels across software companies serving utilities, renewables developers, new technology companies, energy services companies, EPC companies, et cetera. So this is an area where the environment is robust.

Thank you. Joe, do you have anything to add to that?

Yes. Since I think I'm going to get a question on traditional M&A, I won't comment, but I agree with George broadly. I do think that on the conventional generation side, that business has almost become a private -- it has become a private equity business. You have 3 public -- we have 2 publicly traded companies. You have a couple of privates, and then most of the rest of the industry is held in private equity hands. And I think one of the issues they're all confronting is, somebody sold this, I bought it at 2x. Somebody bought it from me at 2x. Who's going to buy it from that guy at 2x? And I think that you've seen some very creative approaches in terms of continuation funds, taking portfolios, carving them up, et cetera, that you're going to continue to see in terms of the private equity exit of that business. And I agree that our group is like SPACs to the right, SPACs to the left, SPACs in between. You can't really count the number of situations that we're working on in that area. And I think that the renewables again is much more, I think, about private -- not a private equity, a pension fund trading business and then a few big people looking for platforms.

Thank you, Joe. Jeff, did you have anything to throw in?

Yes. I'd add a couple of things. I think macro-wise, I think most of us are expecting rates to go up, inflation to reenter. The performance of the share prices, the companies has been quite poor relative to the S&P, which has always put a bit of a damper on overall M&A. And I'd also say we saw a lot of activity this past year in kind of separating assets or categories of assets to simplify some of the business models, whether it's Dominion and its gas or the non-reg gen or international assets. We announced this morning that Exelon is going to separate its generation fleet, much like PEGI and others. So I think that activity continues to simplify some of these businesses' models and to try to get multiple expansion in those places where the models become your more pure play. The only other thing I'd add is that we've seen a fair amount of activism in this space. It hasn't led always to M&A, but it's led to management board decisions. I continue to think we're going to see a reasonable amount of that relative to the size of the space as well.

Thank you. So as Joe alluded to, I will give him a question on traditional utility M&A. What are the prospects for traditional utility M&A? Will we see companies that have dry powder actually use it? Or are they just going to hold on to it?

I think first that you have to realize that this is a relatively small industry. Jeff used to do a great slide when we had presentations of here are the number of utility companies 10 years ago, here it was 5 years ago, here it is today, and the number has been going down like this. So that means 2 things: there are fewer buyers, and there are fewer really attractive companies left to partner with or to transact. I think that -- and one of my predictions is going to be, there will be at least one significant M&A transaction this year. I think there will be one. There may be more than one. But it's a very, very difficult industry, and M&A is really bespoke in the sector for all the reasons that George mentioned. The companies that have firepower, if you went back several months, you had a whole group of companies, maybe 6 or 7 trading above 20x earnings, maybe a little bit 22, 23x earnings. And a bunch of guys trading 7, 10 multiple ticks below that. Some of the folks that were trading in that bottom quartile have done transactions like business separation transactions and their share prices have moved in response to the business separation. Secondly, a fair number of those folks at the top end have lost some of that PE multiple advantage as I think other companies became more pure play regulated, some made management changes, some made other restructuring items. I think in some respects, when your whole position is just fabulous, it's really, really hard to decide to transact because that -- when you weigh the risk -- the probability weights on the outcomes, if your quarterback's Patrick Mahomes, you're not going to want to take a lot of chance with the rest of your team. So I think some of that has held back. And when we've been dealing with the companies with firepower, they have been very disciplined. Even though the math said we could do this, they said, "Yes, but we think value is here, and we think our shareholders think value is here." So they've been very disciplined. I think you will see activity. I wouldn't be surprised to see more than one transaction. And the other hard fact is that 3 -- the 3 largest market cap companies after NextEra are all kind of in a relatively narrow trading range that doesn't give them tons of firepower relative to the rest of the sector, and they don't have tons of balance sheet capacity.

Thank you, Joe. George or Jeff, do you have anything to add? And specifically, where do you see growth in the industry? Do you see it as organic or through acquisitions? Are we going to see more projects built by individual utilities? Or what are you seeing?

I'll just quickly supplement what Joe said and focus on the growth. I mean I think the -- for the electric companies that have generation, there's growth. They can be super long-dated around changing the generation fleet. There's good growth organically for the gas LDCs around investing in system resiliency, pipe replacement and things like that. And then as technology develops and the grid needs to be -- to function in a more dynamic way, there are investment opportunities. And the growth rates, 5% to 7%, 6% to 7%, plus the yield that's available in the sector provides a super attractive risk-adjusted total return for investors. And then there's always growth through M&A, but the thing -- these transactions need to be priced the right way or you're not really helping yourself, as you know. So I know we're going to come to valuation levels at some point, but that's some thought on the organic observations.

Thank you. Jeff?