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Reconsidering Synergies

Cap-ex plans raise the stakes for utility mergers.

Fortnightly Magazine - July 2011

regulatory filings, Duke and Progress indicated they will take an unapologetic approach to post-deal synergies: “Progress and Duke expect to realize synergies in a number of areas, particularly where the companies have duplicative operations and functions. The efficiencies we expect to result from this transaction will help us mitigate the future customer rate increases we expect for our customers as we reinvest in the business for the future.” In addition to merging back-office functions, the companies have also announced plans to engage in joint dispatch of generation and will seek other fuel-related efficiency gains. In a recent interview with Financial Times , Duke Chairman Jim Rogers emphasized these cost savings as a key deal-driver: “In the Carolinas, we will jointly dispatch our units, and that will reduce our fuel cost, between $600 and $800 million, over a five-year period. So [our customers will see] a reduction in the cost of electricity … as we gain efficiencies.” 6 Duke CFO Lynn Good echoed that sentiment: “The accretion that we expect to achieve in the merger transaction will ultimately be created by the synergies that we deliver as a combined company and growth that we can pursue as a combined company.” 7

Even if North Carolina regulators take an aggressive approach to flow those savings to ratepayers, analysts appear bullish on the shareholder value driven by the ability to share large capital investment costs. Jim Hempstead of Moody’s said: “The inherent logic behind the merger is the consolidation of two homogenous, capital-intensive companies, to spread fixed costs across a larger asset platform.” S&P reiterated its A- grade for Duke, and put Progress, previously BBB+, on watch for a potential upgrade.

The merging parties appear willing to convey savings from administrative and operational synergies in large part to ratepayers, while shareholders will benefit from financial synergies—specifically the ability to address pending new EPA regulations of coal-fired generation. Indeed, Progress CEO Bill Johnson stated: “we believe the new company will be well positioned to meet the new EPA MACT regulations expected later this year and into 2012. We still have much work to do to comply with these new rules, which could require significant additional capital investment and additional announced plant closures.” (See “Is EPA Driving the Urge to Merge?”)

Providing Benefits

So, what do these trends suggest about the historical tension between investors and customers when it comes to merger synergies? We might be seeing a new alignment of interests that provides benefits for both groups. Shareholders need assurances that the new EPA regulations won’t destroy their investment value, and mergers appear to be providing financial synergies by spreading risk across broader platforms. They also appear to offer defensive protection against credit rating downgrades and increases in capital costs—all things investors value that should in turn protect or increase dividend yield.

Meanwhile, state regulators and customers might see their interests aligned with investors because there might be less tension with the investor side regarding operational and administrative savings at the time of the sale, while the investor community is satisfied by financial synergies. Moreover, customers