Southwest Gas Holdings Inc. faces a formidable adversary as activist investor Carl Icahn attempts a takeover of the gas utility operator. Still, some market observers questioned the billionaire's critiques in his latest energy sector campaign.

At the heart of his latest campaign is Icahn's opposition to Southwest Gas' plans to buy Questar Pipeline Co. for nearly $2 billion. Rather than digesting a large acquisition, Icahn said Southwest Gas should focus on addressing the "many problems" that he sees within the company. Icahn's success could turn on whether he is able to convince the market of those shortcomings.

To date, Southwest Gas management has disputed Icahn's assertion that the Questar deal is value-destroying. The company's leaders have also defended against his broader criticisms of Southwest Gas Corp., which distributes gas in Arizona, Nevada and California.

Some market observers also saw value in the Questar acquisition and viewed Southwest Gas' relationship with regulators less harshly than Icahn.

Looking ahead, Southwest Gas shareholders could still align with Icahn, or the company's board of directors could also recommend the offer to investors and remove barriers to his takeover.

Icahn's office and Southwest Gas declined to offer comments for this story.

Icahn's forays into energy

A review of 10 Icahn energy sector campaigns over the past 16 years showed the investor has been mostly successful in securing his initial demands from his targets, either through proxy battles for board control or in negotiations with management.

For instance, nearly 10 years ago, Icahn prevailed in his bid to take over refiner CVR Energy Inc. following a tender offer — the same strategy he is pursuing with Southwest Gas.

"The market respects Carl Icahn and what he brings to the table," Chris Ellinghaus, managing director at investment bank Siebert Williams Shank & Co. LLC, said. "He pressures companies to do things that have near-term benefits — not necessarily permanent benefits, I would say — and so the market would probably react favorably to that."

Icahn has reaped handsome profits from many of those endeavors, though he has not always fully realized his plans after securing board seats or taking control of companies.

In the case of CVR Energy, he was not able to sell the company to a larger refiner as planned — though Icahn himself warned that flipping CVR would be difficult. Icahn also wrung concessions from Chesapeake Energy Corp. and Transocean Ltd. in 2012 but exited his positions in the companies roughly four years later as their stock prices tumbled following a historic oil price collapse.

Deal's strategic fit

Rating agencies are generally aligned with Southwest Gas in their assessments of the Questar deal's strategic value. Moody's and Fitch Ratings said the deal would increase the company's scale and geographic diversity, provide stable earnings and cash flow through a highly contracted asset portfolio, and reduce earnings contribution from the higher-risk, unregulated Centuri Group Inc., an energy infrastructure construction subsidiary that has been active in deal-making.

The agencies are chiefly concerned with the deal's negative impact on debt metrics, as well as Southwest Gas' ability to execute its plan to partially fund the purchase through equity issuances over the next year. Both Fitch and S&P Global Ratings issued negative outlooks for Southwest Gas. Moody's said the deal was credit neutral for Southwest Gas and positive for Questar.

Citi analysts had a mixed view of the purchase. They saw value in diversifying away from underperforming utilities, adding to earnings and acquiring assets positioned for the hydrogen transition. However, Citi noted the deal bucks the business simplification trend among utilities and expands Southwest Gas operations into the out-of-favor midstream sector.

Some analysts said the deal looks expensive before adjusting for tax benefits. Bank of America, for one, saw the acquisition diluting EPS over the long term and constraining credit metrics due to increased business risk. JPMorgan Chase & Co. analysts said the deal's financing needs and lack of immediate cost savings suggest it was largely a defensive move — potentially a means to diversify from regulatory challenges in Southwest Gas territories.

Those challenges were core to Icahn's broader criticisms of Southwest Gas. In his view, the company has allowed its relationship with regulators to sour and costs to rise, leading to a depressed return on equity that drives utility profitability.

Icahn also believes Southwest Gas could boost its balance sheet by selling off all or part of the company's construction arm, Centuri, a source familiar with his thinking told Market Intelligence. Some analysts have said that the Questar deal could actually position Southwest Gas for a spinoff or sale of Centuri, but Southwest Gas executives have said they do not need to separate the businesses yet.

Putting ROE into context

Ellinghaus, the Siebert Williams Shank analyst, said Icahn is "dead right" that Southwest Gas needs to improve ROE. However, Icahn is leaving out key context and overlooking structural impediments in the regulatory landscape, according to Ellinghaus, who views the Questar deal favorably.

"Particularly when you have growing customers, you're going to see what he sees in the ROE and what he sees in the cost," Ellinghaus said in an interview. "The costs are definitely going to rise on an absolute basis. What your real objective is is to try and keep it somewhat stable on a per-customer basis."

Southwest Gas has controlled costs, in his view. Operations and maintenance expense at the utility business and customer count have tracked closely, each growing at a compound annual growth rate of 1.4% to 1.5%, according to his analysis.

Ellinghaus said Icahn also highlighted a particularly poor year for ROE in Nevada and ignored features of the Arizona and Nevada regulatory environment that can produce large swings in earned ROE from year to year.

State regulators are resistant to mechanisms like trackers that allow utilities to adjust rates on an expedited basis, he noted. Paired with Southwest Gas' robust capital spending plan and solid customer growth, that environment creates significant regulatory lag — the gap between when assets are placed into service and when rates go into effect to recoup the expense — he said.

"It's pretty infrequent that you earn your full ROE because of that regulatory lag," Ellinghaus said. "When you're growing this rapidly, it's hard to make your ROE for any utility."

Lillian Federico — research director at Regulatory Research Associates, a group within S&P Global Market Intelligence — agreed that regulatory lag can be a problem when companies have aggressive capital spending plans. The only way to recognize new investment is through an often lengthy rate case process that relies on a historical test year. Still, when utilities have significant customer growth, the company should also see a revenue increase from new accounts, which should at least partly offset capital spending effects that reduce returns, she said.

Thorns in Arizona, Nevada

Diversifying away from Arizona and Nevada's regulatory environment by acquiring Questar — which is subject to federal regulation — is a credit positive, Fitch said.

Regulatory Research Associates, or RRA, recently downgraded Arizona's regulatory environment, noting that the utility commission has long been politicized and its processes create substantial regulatory lag. The state has one of the most restrictive environments in the U.S. from an investor viewpoint, according to RRA's rankings. RRA ranked Nevada's regulatory environment as average.

That said, RRA analyst Jim Davis, who covers Nevada and Arizona, indicated that Southwest Gas does not stand out among utilities as having a particularly problematic relationship with state regulators.

This S&P Global Market Intelligence news article may contain information about credit ratings issued by S&P Global Ratings. Descriptions in this news article were not prepared by S&P Global Ratings.