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The Business for Co-Op Acquisitions

IOUs considering co-op acquisitions are finding fertile territory for growth.
Fortnightly Magazine - January 2005

of revenue on average, compared with about 7.6 percent before the aquisition.

Additionally, the resulting pre-tax return-on-equity (ROE) figures for acquired co-ops (at their current leverage) ranged from about 2.5 percent to a high of over 15 percent, with a simple average of about 8.7 percent and a median of about 8.4 percent. Given WireCo's feasibility threshold of 6 percent pre-tax ROE, more than 80 percent of the co-ops in the study population represented theoretically feasible acquisition prospects.

This business case quantified pre-tax return of equity (ROE)-a common valuation benchmark, and the one that WireCo requested. Of course, co-op profits that were previously tax-exempt will become taxable upon acquisition. Quantifying these tax impacts is an imprecise exercise, because the tax rate imposed will vary based on the consolidated income of the acquirer and the acquired co-op, as well as the tax strategies the acquirer employs. Indeed, such a calculation is largely irrelevant, given the focus on pre-tax ROE. Nevertheless, some general after-tax estimates can be offered.

Using the most conservative approach (a 39 percent marginal tax rate on all post-consolidation profits of the acquired co-op, without regard to accelerated depreciation or any other favorable tax treatment), the result is about a 120 basis-point reduction from pre-acquisition profit margins. To be more precise, the average co-op in the study, with 7.6 percent pre-tax profit margins before the acquisition, would conservatively have around 6.4 percent profit margins after-tax, after the acquisition (versus around 10.5 percent post-acquisition, pre-tax profit margins). This estimate includes the maximum marginal cost of post-acquisition savings and costs considered in the study.

A final factor worth noting is the study's treatment of capital credits refunds from generation and transmission (G&T) cooperatives. Just as distribution co-ops earmark a portion of their customers' bill for patronage capital, G&T co-ops collect patronage capital from their wholesale customers, and refund it over time. This study assumes that acquired co-ops' wholesale power contracts with their G&Ts will remain intact, and thus patronage capital costs and credits are included in their post-acquisition financials. But even if the wholesale contracts do not survive the change in ownership, the new owner will be entitled to continue collecting the former co-op's G&T capital credit on an annual basis--at least until the acquired co-op's credit balance is exhausted.

For the 10 co-ops in the sample population that collect G&T capital credits, the study characterized those credits as income. An acquirer might treat them as income or conversion of a capital asset into cash (The latter having no affect on income) depending on its own objectives and practices. Even if, however, G&T capital credits are not treated as income, more than 60 percent of candidates in the population still met the 6 percent ROE threshold.

Moving Ahead

After conducting such a macro-scale feasibility analysis, the next step involves screening and prioritizing individual acquisition candidates. Given the wide range of factors affecting the attractiveness of co-op acquisition prospects, any gross screening methodology can inadvertently eliminate compelling candidates; the best ROE in the WireCo study, for example, was yielded by a co-op with about