Measuring the Merger: Fact, Fiction, and Prediction

Fortnightly Magazine - October 1 1996

Some shareholders do find bottom-line value

in a "marriage of convenience."

With six merger and acquisition (M&A) deals announced between May 1995 and January 1996, and three more so far this year, the long-predicted consolidation of the electric utility industry is taking hold. At least 23 utilities, with business-combination transactions pending, are part of the frenetic domestic M&A activity that has swept the industry. With over 150 major players in the industry, expect swift consolidation, especially on the electric side (em deals of all shapes and sizes, not just the traditional mergers of the past.

The Table below presents key information on selected mergers announced in 1995 and the first seven months of 1996.

The merger participants are generally low-cost providers with similar cost structures (see Graph 1).

s All eight transactions involve at least one combination or gas company.

s Five pair a company with nuclear operations with a nonnuclear company (a significant shift from the past, when the electric industry was basically divided into nuclear and nonnuclear groups).

s All the mergers are structured as stock-based, tax-free transactions, and six expect to be considered as pooling interests. (Stock exchange ratios for three transactions precluded any premium offers at the announcement date; market premiums for the other five averaged 27 percent, with premium offers ranging from 11 to 48 percent.)

s Four of the newly merged companies expect to become PUHCA registered companies. (None are currently registered under PUHCA.)

s Six of the transactions merge an electric company with a

combination or gas company, enabling the combination company to expand its gas services to a new customer base.

The first six transactions presented above have many common characteristics. The merging companies in general display similar cost structures and relatively strong competitive positions. All but Public Service of Colorado and Southwestern Public Service have contiguous service territories.

The last two transactions (em the Texas Utilities acquisition of the gas distribution and pipeline company ENSERCH Corp. and Enron's acquisition of Portland General Corp. (em differ significantly from the others. They represent the first of many "deals of the future" expected from converging energy markets. Analysts, however, disagree over Enron's ability to achieve its plan to make Portland General Corp. a regional player.

Great Expectations:

Merger as Strategy

Although merger participants cite increased shareholder value, improved competitive positioning, and reduced costs as the chief benefits of their respective deals, other driving forces include:

s Increased prospects for growth in both revenues and earnings

s Potential for sharing of merger savings

s Horizontal integration in preparation for possible vertical disaggregation

s Strengthened financial condition and flexibility

s Diversified business risks (generation, customer mix, load patterns, and regulatory jurisdictions).

Nevertheless, a section in NIPSCO Inc.'s Annual Report, "Where Have All the Flowers Gone," critiques the rationale for recent mergers:

"When competition upset the formerly regulated worlds of banking, railroads, and airlines, the response was inevitably merger. Bigger must be better. Better must be bigger.

One hundred major railroads collapsed into fewer than 10. Several hundred of the largest banks disappeared into a handful of huge bank holding companies. Western, Frontier, Republic, Southern, Piedmont, and dozens of other airlines were merged off.

The energy business is no different. During the last 10 years, over 40 electric and gas companies have found merger partners. In the recently privatized British electric industry, 70 percent of the new

companies have been acquired, leaving those without a mate to wonder if they've become wallflowers.

Why mergers? The usual answer is synergy. With a merger, costs can be saved, there will be economies of scale, plants can be closed. Will two companies, with high costs or low growth potential, somehow emerge as a single new dynamic competitor, with new ideas, new vigor, and new direction?

Experience says otherwise. Put two unfocused or unimaginative companies together and all you typically get is one larger, unfocused, and still unimaginative company.

Most mergers are opportunistic. They are tactical, not strategic. They are done because they can be done, not because they should be done.

If you're going to do a deal, do it for the right reasons. Do it for success, not synergy. Do it with someone who shares your vision, not your fears. Do it with a strategic purpose. Do it for shareholder value.

Find the value, not the flowers. In the end, the flowers wind up in the graveyard."

Are mergers of equals the way to go? Or are they marriages of convenience?

Although merger transactions can be costly (em in terms of out-of-pocket fees as well as in the attention and time they demand of key management (em the need to protect and enhance shareholder value will continue to drive many utilities to forge themselves into integrated energy services companies. The resulting synergies and access to new markets may ultimately enable management to realize greater values for shareholders.

Taking Stock:

Mergers and the Market

To measure the short-term impact of the merger transactions on shareholder value, we compared participants' stock prices at the month-end prior to each merger announcement to their prices at the month-end of July 1996. The stocks generally either outperformed the S&P Utility Index, or underperformed the Index by at least 10 percentage points (see Graph 2). These results reveal the market's generally positive reaction to the merger transactions, as well as a generally positive, albeit modest, enhancement to shareholder value.

Shareholders for many of the merging companies will receive increased dividends as a result of the merger. Based upon announced postmerger dividend rates and the stock exchange ratios of the merger transactions, six of the merging companies will increase dividends by more than five percent (see Graph 3).

The merger participants predict cost reductions due to enhanced operating efficiency and elimination of certain fixed costs and duplicate functions. Of the selected transactions, six estimates of undiscounted expected savings over the 10 years following the effective merger date ranged from

approximately $550 million to $2 billion, net of merger-related costs. On average, the annual savings represents approximately 3.5 percent of premerger operating expenses (see Graph 4).

Labor reductions are expected to produce approximately half of the merger savings (see Graph 5). Five of the merger transactions have announced employee reductions ranging from approximately 3 to 10 percent of the premerger workforce.

While most companies did not disclose significant details about merger savings in their annual reports, CIPSCO reported:

"Approximately two-thirds of the savings ... will be achieved by eliminating duplicate corporate and administrative programs, from purchasing economies and reduced electric production and natural gas costs. The balance of the savings ... will be achieved through reduced labor. As duplicate functions and services are eliminated, we foresee a workforce reduction of about 300 positions, or 3.4 percent of the

combined workforce. Both companies instituted a hiring freeze in 1995 to begin this reduction. Because this reduction is expected to be accomplished essentially through attrition, no early retirement or voluntary severance programs are anticipated."

But how much of these savings derive strictly from the merger (i.e., elimination of duplicate functions) and how much from process reengineering?

In the last several years, many utility companies have adopted reengineering programs that have led to workforce reductions either through early retirement, attrition, or voluntary separation programs. To the extent that these programs continue successfully, the portion of postmerger savings due to labor reductions will decrease as a percentage of total postmerger savings. This potential decline in labor savings may not, however, produce a corresponding decline in merger-related costs. Hence, the net savings derived from the merger may decline.

Five of the transactions estimated merger-related costs (em excluding acquisition premiums,

if any (em ranging from $41 to $248 million, or 7 to 15 percent of total gross estimated merger savings. These merger-related costs include transaction costs, transition costs (costs to achieve merger savings), and costs for premerger initiatives between the companies. The tension between these necessary merger costs and a potentially declining pool of savings will likely push utilities toward strategic alliances and partnering to enhance shareholder value. As the universe of low-cost, contiguous utilities shrinks, competition to find attractive merger partners will increase (em as will unsolicited offers and hostile takeovers.

Taking Over:

Mergers as Weapons

Although no hostile takeover has ever succeeded in the electric

utility industry, two attempts were launched in the midst of the "friendly" deals discussed above.

In August 1995, PECO Energy Co. offered $3.8 billion for PP&L Resources, Inc. (PP&L). That offer, firmly rejected by PP&L's board of directors, met with strong opposition from PP&L customers and state legislators who feared higher rates and local job losses. A sweetened October offer of $4.3 billion was also rejected by the PP&L board, which argued that merger with the higher-cost PECO would expose PP&L's shareholders to greater risk of stranded investment.

Still pending is Western Resources' hostile attempt to break up the friendly Kansas City Power & Light (KCP&L) merger with UtiliCorp United, one of the most contentious battles in the utility industry. After its initial $1.7-billion offer was rejected by the KCP&L board of directors in April 1996, Western Resources undertook a multimillion-dollar advertising campaign that included full-page advertisements in The Wall Street Journal, and filed proxy materials with the Securities and Exchange Commission (SEC) to take its offer directly to KCP&L shareholders.

In response, KCP&L and UtiliCorp postponed the shareholder votes on the merger from May 1996 to August 1996, and modified the exchange ratio about 10 percent in favor of KCP&L. The utilities also converted the legal structure of the transaction to a "two-step reverse triangular merger," which may be approved with affirmative votes from just 50 percent of the shares present at the shareholder meetings. However, an August 2, 1996, federal court decision held that the merger was subject to approval by two-thirds of company shareholders, further delaying the vote on the merger. Meanwhile, KCP&L's board of directors rejected Western Resources' June 1996 sweetened offer of $1.9 billion.

Real Life:

Mergers as Measured

A quick look at reported benefits for two recently completed mergers, Cinergy and MidAmerican Energy, illustrates the dynamics of today's merger environment.

Cinergy was formed in October 1994 by the merger of Cincinnati Gas & Electric Co. (CG&E) with PSI Resources, Inc (PSI):

s Operating revenues increased $133 million, or 4.6 percent; operating expenses decreased $8 million.

s Earnings per share increased from $1.30 in 1994 to $2.22 in 1995.

s Savings from nonfuel operation and maintenance (O&M) costs reached $42 million, compared to initial estimates of $21 million for 1995.

s Workforce reductions exceeded 800 positions by December 31, 1995, compared to a projected reduction of 450 positions in the first three years after the merger.

s Capital expenditures reached $170 million (em 35 percent below originally budgeted amounts for the two stand-alone companies.

s Ratings on CG&E and PSI securities secured upgrades at four ratings agencies.

s Total shareholder return for 1995 reached 39.1 percent, compared to the S&P Electric Index's 31.1 percent.

MidAmerican Energy Co. was formed July 1, 1995, by the merger of Midwest Resources Inc. with Iowa-Illinois Gas and Electric Co.:

s Operating revenues increased $32.7 million during 1995; operating expenses increased $5.2 million.

s Earnings per share stayed at $1.22 for 1995, unchanged from 1994. (The 1995 earnings per share includes costs to complete the merger, which reduced earnings per share by 24 cents.)

s Workforce reductions hit 700 positions by December 31, 1995, an overall reduction of 17 percent of premerger levels.

s Electric price increases (2) totaling $20.6 million were approved by regulators during 1995.

s Construction costs for 1996 are budgeted 20 percent lower than 1995 construction costs.

Both Cinergy and MidAmerican expect the benefits of their respective merger transactions to continue. Cinergy disclosed this outlook for its earnings through 1998:

"Our objective over the 1995-98 period is to achieve earnings growth averaging 6 to 8 percent annually. By comparison, several analysts estimate that the industry as a whole will have average growth rates under 2 percent over a similar timeframe. Achieving our earnings growth objective will depend on continued merger savings, including net savings from reengineering ... beginning in 1997. Our estimate of earnings growth also depends on successful outcomes from pending gas and electric rate cases.

"With the rapidly changing industry environment and the numerous changes merged companies undergo each year, it becomes increasingly difficult to identify and measure the achieved benefits versus the planned benefits of merging."

A Process in Progress

Accelerating competition and deregulation in the industry brought many utilities to the negotiating table this past year (em a merger being their primary strategy for progress and survival. While the six merger transactions announced from May 1995 to January 1996 share similarities, three announced since then are unique: The Texas Utilities/ENSERCH transaction is not subject to the lengthy FERC approval process. The Enron/Portland General Electric transaction gives Enron its first crack at the retail electric markets; the Houston Industries/NorAm Energy Corp. transaction is similar. This change in merger activity can be attributed to:

s FERC merger policy under consideration

s Comprehensive, proposed federal legislation

s Potential modification or repeal of the Public Utility Holding Company Act and the Public Utility Regulatory Policies Act

s FERC Order 888

s State retail wheeling initiatives.

But another possibility exists: Much of the low-hanging fruit has already been picked. Most of the mergers cited here involve low-cost contiguous utilities (em a shrinking population. Many utilities have already implemented restructuring and employee reduction programs that will strip costs out of their companies, thus eliminating or reducing some of the potential merger benefits.

As the rules become more clearly established under transition, we anticipate:

s Noncontiguous combinations

s Continued combinations of electric and gas companies

s Continued unsolicited offers and hostile takeover attempts

s Strategic or operational alliances

s Acquisitions of utilities immediately before or after bankruptcy

s Transactions with other energy-related and telecommunications companies

s Acquisitions by global energy companies (domestic and foreign)

s Disaggregation/spinoff transactions

We expect to see energy companies redefined in many shapes and sizes. The tumultuous changes on the horizon provide a business environment ripe for continued, albeit potentially modified, M&A activity. t

Michael J. Hamilton is a partner at Price Waterhouse LLP, and chairman of the U.S. Utilities Industry Services, World Utilities Group.


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