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Fulfilling the Value Proposition

The Next M&A Wave: If mergers are once again a potential strategy for accomplishing growth objectives, the previous round of transactions offer several lessons.

Fortnightly Magazine - May 2005

Over the last 15 months, much of the utility sector's lost market capitalization gradually has been restored. Some companies have, in fact, soared to all-time valuations on the strengths of distinguishable strategies and strong execution. However, as a whole, valuations in the utilities are again at levels inconsistent with their long-term history. Relative utility P/E multiples against the S&P Index are more than 30 percent above historical norms and absolute multiples for integrated electric companies average approximate 15x.

Keeping these lofty valuations means producing requisite earning growth. Is the time now ripe for breaking the consolidation dry-spell? If so, how should companies pursue this next wave to assure success?

Value Levels

Utilizing mergers as a means to enhance strategic position and supplement financial contribution was a popular method of driving performance outcomes in the 1990s. But, making deal outcomes successful and achieving desired market results depends on how well companies actually accomplish what they set out to do in identifying and realizing value from the merger combination. While many industrial sector transactions have foundered on the shoals of overly aggressive pronouncements of available synergies (cost savings), the experience of the utility sector stands out in contrast. The level of cost savings that are available and produced by transactions in this sector are much more tangible, creating better realization experience than in other industries where the intangibles of revenue growth are far more dominant.

Figure 1 - Traditional Synergies Categories

The nature of synergies that typically arise from a utilities sector transaction are shown in Figure 1. These categories generally apply in most utility combinations, including in the non-regulated businesses, although that may not be the focus of the transaction. As the figure illustrates, there are a variety of potential sources of synergies that can be captured.

Although utility mergers often are conceived as a vehicle to enable further cost reduction and attainment of scale economies, other opportunities are available to management without over-reaching for unrealistic benefits. For example, in an environment where regulated generating capacity has not grown while investments were made in the non-regulated sector, there are supply short-falls that can be alleviated through transfer and contracting of capacity for customers, thus providing a benefit to both parties. Similarly, the wholesale marketing capabilities of companies differ vastly and a more diverse asset portfolio can be marketed differently.

The focus on driving out duplicative costs and capturing economies of scale will remain the centerpiece of most synergies analyses: first, because they are real opportunities that are discretely identifiable; second, because they are more controllable and easier to achieve via management action; third because the opportunities are often substantial, and; finally, because the financial markets expect the demonstrated