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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
Figure 2 - Industry Cost Position 2003 Adjusted O&M per MWh

production of value in this area.

With respect to opportunity level, Figure 2 provides a clear indication of why cost structure is the fundamental source of merger synergies. As the figure illustrates, there is a wide disparity among companies in their relative cost levels. In fact there is a 30 percent difference in cost levels just between the second and first quartile mid-points, indicating substantial opportunity to drive costs down through a combination that surfaces the inevitable duplication of costs and potential to streamline the corporate, administrative support, and operating business back-office functions.

A transaction also serves as a catalyst that enables companies to think differently about how to view their cost structure. This new perspective can lead to taking advantage of scale opportunities that would not exist outside the combination. These scale economies provide further sources of value as the combined company now has a different set of options available to it in areas relating to business-model alignment, technology platform, in-sourcing/outsourcing, and third-party relationships.

Figure 3 - Merger Rationale Evolution

The level of attainability of identified synergies has historically been high with companies fully capturing the amount of announced cost savings. This synergies capture has averaged 8 to 10 percent of the overall non-fuel O&M cost structure of the combined companies when the entities are similarly sized, with much higher results in areas where a greater proportion of costs can be affected, as in the corporate areas and shared services. In these latter areas, it is not uncommon for similarly sized companies to realize savings of 25 to 35 percent in those functions where duplication is highest.

Of course, where the scale of companies are very different from one another, then the level of available savings can skew dramatically as the base of affectable costs can be increased or decreased depending on the profile and size of the entities. In cases where there is substantial disparity in the size of the participants, many costs of the smaller entity can be completely avoided as the larger company simply absorbs the necessary functions within its existing resources.

Focusing solely on driving costs out of the business is, of course, but one dimension of the value that mergers create. It is also important to recognize that these transactions enable other growth initiatives to be pursued. For example, the cash flow created from a transaction can further fund the significant infrastructure investment that many companies are embarking upon. And, retained merger savings can potentially offset some of the need for near-term rate relief.

Figure 4 - Relative P/E – 2005(E) EPS

The cash flow that is created from transaction synergies-even after savings sharing with customers-provides a source of investment funding that also can accelerate other non-rate base growth initiatives. This cash flow productivity from retained savings offers an incremental source of benefit to the companies that extend beyond the direct and observed impact from the transaction. It is the potential for these types of impacts that adds substance to the strategic objectives of companies that merge.

Consequently, the potential to build the level of desired shareholder value from a combination and drive a higher multiple from earnings expansion is