combine two vertically integrated utilities when the market may call for disaggregation?
All deregulating industries share the same lesson: profits eventually decline, leading to consolidation. Electric utilities are no different. But as the electric industry jockeys for competitive position, and as the merger din grows louder, will prior deals prove instructive? Will they epitomize the future market? Or will more innovative mergers overtake the utility industry?
Prior to the 1990s, utility combinations often stemmed from the target company's weak management or financial condition. Others were fueled by the perceived value of transmission interconnections or the utility's desire to protect itself from an unwanted suitor. On the other hand, the mergers of today and tomorrow will more likely focus on versatility and value.
Earnings growth and market share are the elusive quarry of utility executives who seek to dominate tomorrow's competitive landscape. Utilities will seek to gain market share through customer ownership and skill extension, and to emphasize growth through product and service leverage and earnings and cash flow diversity. While the debate continues on "owning the access" versus "owning the meter," a merger may provide the best means to defend and grow the business.
Mergers and acquisitions (M&A), though not without drawbacks, can accomplish multiple objectives: improve competitive cost position, create earnings, increase market share, and provide a strategic growth platform. However, financial success and
competitiveness depend directly on the ability to identify and capture the synergies or cost savings available through integration. Utilities usually share the same core businesses (generation, delivery, retail services, and corporate and administrative support). Thus, the mirror aspect of utility combinations (em core business merging with core business (em makes synergies easier to obtain than in other industries.
Nevertheless, the industry has evolved to the point where the merger of two companies may produce more than a single new company. Instead, the merger may yield to disaggregation and create two separate companies, such as a power generator and a separate delivery and retail firm.
The Nature of Synergies
A merger enables the succeeding company to streamline operations and integrate critical functions to minimize total costs. Typically, a utility merger provides three quantifiable benefits:
Cost reduction. Avoiding duplication of the cost input required to achieve the same level of output.
Cost avoidance. The ability to forego certain types of expenditures due to a reduced need for parallel capabilities.
Revenue enhancement. The creation of additional revenue streams from existing assets.
Conventional wisdom once held that utility mergers would yield substantial cost savings because they would forestall expensive capital investment for new capacity. However, the 1990s have found most utilities long on capacity, thus minimizing the actual contribution from this savings area. Figure 1 (see page 32) illustrates the source of savings from 12 announced M&A transactions. The primary costs savings can be further quantified as follows:
s Consolidation of corporate, administrative, and technical support positions.
s Nonlabor cost reduction or avoidance from facility
s Reductions in nonlabor programs (em such as insurance and shareholder services (em resulting from consolidation of key activities or cost elements.
s Capital investment avoidance or reduction related to planned
facility additions or major projects such as operating systems.
Fuel and Dispatch:
s Reduced commodity and transportation costs through modification of existing supply and carrier agreements related to expanded options and enhanced purchasing power.
s Aggregation of gas supply volumes through supplier concentration, expansion of pipeline interconnections, modification of current gas contracts, and higher throughput.
s Reduction in total fuel and operations and maintenance cost from optimization of existing generating facilities.
s Production-related capital investment avoidance or reduction from canceled or delayed generation plants and reserve-sharing.
s Aggregation of materials and supplies volumes and services contracts to increase purchasing power.
s Reduction in standardized inventory to reduce carrying charges.
s Nonlabor-related reductions in duplicate expenditures to third parties, exercise of economies of scale, and improved use of existing resources and assets.
s Consolidation of distribution (field) or generation (plant) operations positions.
As Figure 1 clearly illustrates, the corporate function and program areas accounted for almost 60 percent of the total savings, with fuel and capital expenditures each providing another 15 percent. However, many of the 12 transactions provided no capacity expansion savings, and a couple of transactions with significant capacity avoidance potential influenced this average.
Several factors tend to affect the total level of merger cost savings: 1) relative size, 2) relative cost position, 3) location, 4) capacity profile, 5) organization, and 6) management philosophy.
The first four influence the nature and amount of merger cost savings. They define the limiting structural influences on merger savings attainment. The last two factors, however, may have more to do with actual savings attainment. Available synergies can be dramatically affected by how management elects to pursue savings on a post-merger basis. Sacrificing accomplishment by overmanaging the pace of change dilutes available synergies and penalizes both customers and shareholders.
As indicated in Figure 1, labor reductions from overlapping or duplicate corporate, administrative, and technical support functions marks the single largest source of merger savings. In
some cases (e.g., planning or
shareholder services) duplicate functions will be wholly consolidated; in others (e.g., customer service) activity volumes are relatively unaffected and resources are simply optimized across total work volumes to better manage peak staffing requirements and share existing resources.
Figure 2 summarizes the level of labor savings from potential mergers, expressed as a percentage of total combined regulated positions. The broad range reflects the unique characteristics of each merger: scale differences, registered holding company structures, combination utilities, or distribution and nuclear operations opportunities. It also reflects the relative aggressiveness of certain companies.
These reduction levels reflect total combined company positions, although the merger actually affects far fewer functions and locations. Field operations (em such as customer offices and service centers (em and generating stations are generally unaffected due to their geographic dispersion. Yet most positions typically fall within these areas; therefore, the merger analysis deals with only approximately 35 percent of the total company. A merger's impact on positions is substantially greater than that of reengineering or process improvement initiatives because it relates wholly to overlapping or duplicate positions in a limited portion of the companies. The actual experience of merged companies supports these estimates (em achieved savings typically exceed original estimates.
Islands and Clusters
Tomorrow's utility business is actually likely to be several businesses rather than today's version of energy delivery. Competing effectively may mean developing a broad portfolio of business segments as a compelling strategic weapon. Utilities seeking earnings and market-share growth are presented with several options involving core or noncore business expansion. Core expansion opportunities extend operations across related but new markets through contiguous or more geographically dispersed M&A. Noncore expansion extends into additional nontraditional sectors, such as telecommunications or energy services.
To thrive in a competitive marketplace, utilities will need to focus on customer ownership, either through market reach or acquisition. Clustering customers (em as cable television companies have done (em reduces the costs of marketing and supports more concentrated sales in markets where familiarity and brand identity can be capitalized upon. A "cluster" strategy would tend to support a local or regional expansion plan focused on larger load or customer centers. Such an approach could also include combination with a nontraditional provider, such as a complimentary technology purveyor or a telecommunications or cable television company.
Focusing on energy services as a national market, however, could influence utilities to adopt a more geographically far-reaching strategy of customer accumulation, promoting the emergence of national energy service companies. Most utilities serve large customers that operate locally but are managed beyond the service territory. These national accounts offer an opportunity to provide "customer following" services, regardless of location. Merger with or acquisition of a noncontiguous, extra-regional utility can create a powerful national market entrant and anchor an aggressive expansion. Such a strategy still offers certain synergistic opportunities, although these are limited by geography, interconnections, common suppliers, and capital resource sharing. This approach leads to energy "islands" within the national market and places
a premium on the ability to
generate incremental revenues, obtain highly valuable assets, extend strong management and competencies, or extract superior financial contribution.
Subsequent disaggregation from "islands" or "clusters" into more discrete, focused sectors (e.g., delivery and retail) as a long-term strategy is compatible with
earnings and market share growth through M&A. The future energy industry will consist of more discrete segments, regardless of whether utilities elect to or are allowed to participate in each. These segments will have different characteristics and risks that will be reflected in different valuations of each sector. The value of the total enterprise may be maximized by capturing key load centers and market share, building a portfolio of competitive assets, and subsequently disaggregating the total business to bring market focus to each sector. t
Thomas J. Flaherty is the national partner-utilities consulting for Deloitte & Touche, LLP.
The Merger Isn't EverythingUtilities considering M&A should ponder several notions:. Make customers paramount.
Build market share; retention is not enough. Growth must begin by securing the customer base and fulfilling market needs.
. Think energy services.
Be a single-segment provider. Customers demand total energy solutions in multiple markets.
. Build toward to next deal.
M&A is a means to an end(emnot the end itself.
. Keep things moving.
Merger approval can easily deffect attention. Management must balance multiple expansion strategies simultaneously.Primed for Success: The Creation of PrimergyThe announced merger of Northern States Power (NSP) and Wisconsin Energy (WEC) created quite an industry stir at the beginning of May. Both companies were already strong and successful in their own right, and more commongly thought of as acquirors than merger partners. Neither company needed to merge, but both believed combining would create opportunities beyond their stand-along reach.
The NSP-WEC combination was dramatic in its design and bold in its structure. Both partners focused on preserving financial strength from the outset and wanted to achieve a true partnership. Adopting a registered holding company structure was an unusual step for combination electric and gas utilities, particularly where nonregulated operations existed beyond the core business. Both companies, however, believed that the evolving marketplace demanded a total energy solutions approach and that federal regulation would recognize these market-driven changes.
Primergy creates potential merger synergies of approximately $2 billion between 1997 and 2006. While larger than previous merger cost-savings estimates, these synergies come from many of the same sources. Their magnitude was a principal factor behind the merger; such cost reductions were not otherwise achievable. Both companies recognized this potential and the benefits that might be available to customers in the form of lower rates and to shareholders through value creation.
The composition of the merger synergies reflected a broad cross-section of cost-reduction and -avoidance opportunities throughout the companies. Although the generating stations and distribution operations areas would not be directly affected by the merger, most other areas would provide opportunity to avoid overlap, gain economies of scale, and reduce parallel expenditures (see Figure). As in most previous transactions to date, capacity-deferral savings were not a primary contributor to Primergy's total estimated merger synergies.
The creation of Primergy may not provide a model for assessing how other proposed transactions may occur in the future. One thing is certain, however; Mergers provide real opportunities to reduce costs and offer benefits to both customers and shareholders that are not otherwise attainable. In an era of increasing marketplace change and competitive pressure, such opportunities can make a real difference in the strategic position of utilities.
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