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Reconsidering Synergies

Cap-ex plans raise the stakes for utility mergers.

Fortnightly Magazine - July 2011

“Hearing utility executives talk about merger synergies is a bit like watching paint dry—except that paint sticks.” This remark by MarketWatch utility analyst Liam Denning 1 reflects the conventional wisdom. Wall Street has historically been skeptical about synergy claims in utility mergers, assuming that regulators will insist that any savings flow to ratepayers—or at least dilute the value that can flow to shareholders. Indeed, recent deals illustrate the ongoing debate over whether investors or ratepayers get the better deal when it comes to savings.

However, as economic woes and environmental regulations bear down on the utility sector, merger synergies may be increasingly appealing, not just to the merging parties, but also to usually skeptical Wall Street. Anticipating large capital investments needed to comply with upcoming EPA regulations of coal-fired generation, analysts seem increasingly attracted to the shareholder value driven by the ability, as another analyst said recently, “to spread fixed costs across a larger asset platform.” The benefits of this type of financial synergy appear to outweigh traditional concerns about whether operational and administrative synergies will be diluted in the regulatory approval process.

Some recent deals provide clues on what role synergies play in contemporary utility mergers, in a context of changing perspectives among regulators and investors.

Synergies and Skepticism

When we think of “synergies” in a utility merger setting, we traditionally think of three broad categories that appear to be garnering interests of merging parties: 1) operational synergies, such as joint dispatch and fuel procurement savings; 2) administrative savings, such as back-office and overhead expenses; and 3) financing synergies, permitting the merged party greater financing options and potentially lowering capital costs.

Traditional views of mergers in any industry tell us that synergies and efficiencies are primary motivators that would cause two firms to merge, in hopes that combined revenue can be maintained (or declines mitigated) while costs are streamlined and lowered through elimination of duplication and redundant cost structures. Indeed in most industries, identifying and capturing these synergies can be a core deal driver, and one of the most important metrics analysts review in handicapping the business combination.

But, when regulated utilities merge, analysts become immediately skeptical about synergies. The importance of synergies, and their relative achievability in utility deals, has been a subject of debate for decades. Shareholders and stock analysts often discount merging parties’ claims about synergies, largely assuming that regulatory review will dilute any savings or direct the savings to ratepayers. As has been pointed out in these pages, 2 savings and efficiencies are “the primary economic driver for utility mergers and acquisitions,” but:

The investment community recognizes the same reality. MarketWatch recently quoted Gordon Howald of East Shore Partners remarking how hard it is to justify paying a premium for a utility with merger synergies so hard to realize. Some investment analysts and credit rating agencies have also historically voiced skepticism: