The Next M&A Wave:
Fulfilling the
Value Proposition
If mergers are once again a potential
strategy for accomplishing growth objectives, the previous round
of transactions offer
several lessons.
May 2005
By Tom Flaherty and Bill Kemp
Over the last 15 months, much of the utility sector's lost market capitalization gradually has been restored. Some companies have, in fact, soared to all-time valuations on the strengths of distinguishable strategies and strong execution. However, as a whole, valuations in the utilities are again at levels inconsistent with their long-term history. Relative utility P/E multiples against the S&P Index are more than 30 percent above historical norms and absolute multiples for integrated electric companies average approximate 15x.
Keeping these lofty valuations means producing requisite earning growth. Is the time now ripe for breaking the consolidation dry-spell? If so, how should companies pursue this next wave to assure success?
Value Levels
Utilizing mergers as a means to enhance strategic position and supplement financial contribution was a popular method of driving performance outcomes in the 1990s. But, making deal outcomes successful and achieving desired market results depends on how well companies actually accomplish what they set out to do in identifying and realizing value from the merger combination. While many industrial sector transactions have foundered on the shoals of overly aggressive pronouncements of available synergies (cost savings), the experience of the utility sector stands out in contrast. The level of cost savings that are available and produced by transactions in this sector are much more tangible, creating better realization experience than in other industries where the intangibles of revenue growth are far more dominant.
The nature of synergies that typically arise from a utilities sector transaction are shown in Figure 1. These categories generally apply in most utility combinations, including in the non-regulated businesses, although that may not be the focus of the transaction. As the figure illustrates, there are a variety of potential sources of synergies that can be captured.
Although utility mergers often are conceived as a vehicle to enable further cost reduction and attainment of scale economies, other opportunities are available to management without over-reaching for unrealistic benefits. For example, in an environment where regulated generating capacity has not grown while investments were made in the non-regulated sector, there are supply short-falls that can be alleviated through transfer and contracting of capacity for customers, thus providing a benefit to both parties. Similarly, the wholesale marketing capabilities of companies differ vastly and a more diverse asset portfolio can be marketed differently.
The focus on driving out duplicative costs and capturing economies of scale will remain the centerpiece of most synergies analyses: first, because they are real opportunities that are discretely identifiable; second, because they are more controllable and easier to achieve via management action; third because the opportunities are often substantial, and; finally, because the financial markets expect the demonstrated 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.
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.
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 enhanced when all facets of deal value are considered.
None of the above matters, of course, unless the identified value actually can be captured and converted to new cash flow. Fortunately, the fact that utilities fit together more seamlessly than industrial sector companies typically do, i.e., very parallel structures and business mixes, has benefited the sector. Managements have been better able to capture the identified savings because the degrees of freedom in decision-making are practically reduced. It is not necessary to redefine the business along dimensions that are intended to conquer new markets, introduce new products, or revolutionize technology. Simply integrating the business efficiently and effectively will suffice. This is a principal reason why utility mergers are generally more successful than transactions in other industries.
Consequently, the financial community both recognizes the past successes of prior managements and expects that current managements will fully achieve, if not exceed, the level of synergies they announce.
Delivering on the Promise
Compelling strategy, disciplined pricing, promising synergies, access to talent, and attractive financial outcomes can all generate enthusiasm for a proposed merger. However, none of these attributes influences the results of a merger more than how well companies can execute on business integration and value realization.
Delivering the full expected deal value is highly dependent on three fundamental activities. First, thoughtful planning time needs to be invested upfront in defining how to integrate the companies and what approach will be adopted to combine stand-alone operations. Although many companies tend to focus on getting the deal announced-and sometimes completed-before considering integration objectives and the shape of post Day 1 operations, the relationship between back-end success and front-end planning is directly correlated. Understanding the size, complexity, and pitfalls of integration before the process is undertaken is a hallmark of effective risk mitigation rather than simply a premature exercise in preparation. Starting early, as part of the due diligence process will pre-position the companies for integration with a thorough understanding of objectives, requirements and options.
Second, the companies need to establish clear and acknowledged leadership accountability for the outcome. While it takes a collective management effort to accomplish comprehensive operations integration, it is personal passion that drives performance and results. A committee of the many is far less effective than the responsibility of the few. When leadership accountability is vested in one or two responsible executives who view their single purpose to be producing the best results for the enterprise, then internal positioning distractions are minimized and merger outcomes become more certain.
Third, ultimate merger success is all about disciplined execution. Elegance in integration process design and planning is far less important than combining good plans with committed management to produce targeted results. Mergers that do not perform as planned typically fall victim to indecision, compromise and indifference. These fatal flaws can be avoided by adopting a rigorous process for managing results and focusing relentlessly on task-by-task performance.
There also will be opportunity to exercise creativity through the integration process. Capturing selected benefits even before closure is possible through joint ventures and contract arrangements, although these paths need to be negotiated at arms-length and stand on their own merits as well, should the deal be terminated. In many cases, the upside of potential synergies will occur when better information access provides broader insight into where and how benefits can be developed. In this sense, synergies estimates often can be thought of as a floor, rather than a ceiling.
The obvious mandate for corporate upheaval that accompanies any merger can serve as a very powerful catalyst. Everyone accepts that change is unavoidable-the only question is how far-reaching it will be.
Poised to Shrink
The industry stands again at an inflection point regarding consolidation. But this time, it is less likely to retreat from the march toward more and larger combinations. Consequently, electric utilities are on the verge of another downward step-change in industry population.
Several factors are driving the renewed interest in M&A. Strategically, the interest of companies in reshaping or repositioning themselves has never waned. Financially, it is apparent that the need to grow soon will catch up to the desire to grow. Opportunistically, coveted options for acquisition are no longer remote dreams, as a level of "fatigue" has crept into the management suite with stand-alone strategy success viewed as overly demanding, unpredictable, and draining. Couple these motivations with the reality that companies have proven that synergies are real and can be captured, and that regulators have generally been reasonable in their treatment of proposed deals, and you have a recipe for moving transactions to the next level.
The focus of managements in considering M&A has evolved from the mid-1990s to the present. As Figure 3 shows, the motivations for mergers have shifted from readiness for competition and scale for survival, to market positioning and earnings enhancement. Although these motivations are not mutually exclusive across time periods, the emphasis of managements reflects the challenges that dominate the current agenda. In today's environment, the search for earnings growth dominates management's attention. This motivation is a powerful incentive for horizontal expansion, particularly when combined with the ability to lift a company to the next level of competitive scale and asset divertity.
Utility managements certainly will pursue the next generation of transactions with a distinctive style and approach. Transactions will focus heavily on communicating a coherent strategic purpose and carefully be crafted to avoid financial risks. Some of the characteristics we expect from the next wave of transactions include:
No, to low, premiums. The era of large control premiums is past. Buyers and sellers understand that the interests of the shareholder are not advanced with exchange rates that are unrealistic and excessive.
Super-regional positioning. Proximate mergers may appear more justifiable, but are not always the most compelling. Companies will not be afraid to step outside their natural market to pursue a combination that positions them better within a wider geographic territory as a stronger competitive enterprise.
Non-regulated business attraction. The focus is shifting back again to finding real earnings growth engines. Inevitably, this leads companies back to those businesses viewed as having the right growth dynamics, albeit with a more sober appreciation of risk trade-offs.
Regulatory creativity. Fighting with regulators is recognized as a counterproductive and expensive exercise. Companies will work with regulators to fashion solutions that offer meaningful outcomes to concerns over potential market power, RTO participation, supply sourcing, or savings sharing.
Companies pursuing combinations in the near term can synthesize a variety of lessons from their predecessors:
It all starts with strategy. The rationale drives the outcome, not the reverse;
The simpler, the better. The objective is closing, not elegance in design;
Protect the shareholder. Astute financial engineering can pay off;
Pick a business model. Blending two gives you two, not one;
Stretch the targets. Aggressive people + aggressive targets = full benefits;
Spend the money. Synergies are not free. Don't starve the cash cow;
Transform later. Focus first on Day 1, then the trip to the final destination;
Discipline matters. Develop a plan, then stick to it;
Offer regulators a choice. There is more than one way, not only your way; and
Expect to succeed. The history is there, let it be a guide.
The industry is poised and positioned to enter the next stage of consolidation. Managements would be well-served to remember that transaction success is not just about having a good story. Merger success depends on both a strong strategic rationale and a demonstrated capability to execute flawlessly.
Tom Flaherty is a senior vice-president of Booz Allen & Hamilton, and Bill Kemp is senior associate consultant at R.J. Rudden Associates, a Black and Veatch company. Flaherty can be reached at flaherty_
tom@bah.com. Kemp can be reached at wkemp@rjrudden.com.
Ever-Elusive Growth
Finding ways to produce new earnings sources may include mergers as a primary vehicle for capturing economies in operating costs.
As the industry emerges from its entrenchment, the time for renewed growth has arrived. Smart companies did more than just weather the market credibility and financial liquidity storms of the past three-and-a-half years. These companies recognized the unique circumstances in the market and bet that seizing the available opportunities for growth would pay off when the overall market turned.
However, most companies did not have the luxury of thinking about growth when besieged by rating agencies, analysts, stockholders and debt holders. Now these companies are once again faced with positioning themselves to grow-except this time they have little momentum, lower balance sheet capacity, and less margin for error.
Are current values indicative of utilities breaking-out against the market, or has the environment of low interest rates and steady yields simply made the sector a temporary safe harbor? The tight range of multiples given the wide estimates for 2005 earnings growth suggests that the market is focused more on near-term company fundamentals than long-term growth stories. Nonetheless, it is unlikely that financial markets will continue to award high valuations to companies with both low growth rates and low yields. Investors will demand more from those companies where they place their capital. Yet, the industry has not been the beneficiary of strong organic growth paths over time.
Figure 1 captures recent multiple levels relative to expected earnings growth for 2005. As the figure shows, little correlation is apparent between valuations and planned expansion of the business. In fact, one might question whether the pursuit and delivery of growth is adequately recognized and rewarded. Nonetheless, as the profits of other sectors recover in an improving economy and as interest rates rise just as the utilities industry refocuses on refurbishing the nation's infrastructure, the challenge of protecting lofty multiples becomes more acute.
The earnings profile of many companies is presented in Figure 2. With the consensus earnings growth rate for utilities in the range of 3 to 5 percent and averaging around 4 percent, it would seem that a low threshold for success has been set. However, even with this low growth rate, the challenges to the sector are considerable. As this figure shows, average indigenous earnings growth of the typical utility's core business is a modest 1 to 2 percent, coming from increased load and new customers. This leaves at least a 2 to 3 percent gap in meeting average growth expectations, which must be filled via other means.
Of course, attacking the cost structure is a fundamental method available across any economic cycle and can provide for some portion of the gap closure. This tried-and-true approach has served managements well in downturns, but less so in expansion periods. Moreover, it is not uncommon for approximately 50 percent of base non-fuel costs to be attributable to wages, salaries, and benefits. These labor-related costs are escalating at almost 5 percent annually given the normal 3.5 percent contract wage change provisions and the double-digit growth in health-care costs. Thus, managing costs becomes a table-stakes action just to avoid eroding earnings and not the growth backfill that has been counted upon.
Certainly, companies can invest in rate base for growth or to solidify the infrastructure, and this will provide a solid source of incremental earnings. Yet, given the attrition that has built up over time, the continuing escalation in operating costs, and the uncertainty over allowable rates of return in today's economic environment, it is by no means certain that rate-case decisions will assuredly produce new revenues at the level expected. Recent allowed returns on common equity have been awarded in the unsettling ranges of 9.5 to 10.5 percent rather than the 11.5 to 12.5 percent range that many companies have enjoyed over preceding years, potentially constraining revenue levels. Thus, adding to rate base has its vulnerabilities as well.
Where meaningful organic growth cannot be counted upon and challenges exist even to maintaining current earnings levels, then other inorganic sources of growth must be tapped. Individual assets from companies continuing to rationalize their business or to improve liquidity are plentiful in the market, but often lack the requisite contracted outputs that make these facilities attractive. Further, many assets have been secured by financial buyers, thus raising the cost of acquisition to strategic buyers.
Predictably, there are substantial impediments to following only purely organic and targeted inorganic paths to achieve planned earnings growth. These facts are well recognized by companies and their boards, which has reignited M&A as a topic and potential growth strategy. Couple the real limitations on organic growth with a highly fragmented and diffused industry of more than 70 free-standing investor-owned electric companies and the ingredients for consolidation are present.
Thus, delivery of adequate growth will require companies to pursue a number of simultaneous strategies:
Build the rate base to meet supply security and reliability concerns;
File for new rates to match current costs and recover past attrition;
Attack all costs to reduce the rate of growth and minimize fixed costs;
Simplify the business to remove unnecessary costs of differentiation;
Deploy capital effectively to improve investment productivity;
Reshape regulatory policies to provide for current investment recovery;
Develop the top line to create new revenue sources; and
Play the M&A card to capture earnings from consolidation.
Companies cannot safely conclude that promised growth can be achieved either organically or operationally. Accordingly, M&A is more than just an adjunct strategy, it has once again come center circle as a real, viable, and necessary method of capturing earnings potential.-T.F. and B.K
Harkening Back
Mergers between utilities have been a principal strategy for growth, but not always with intended results.
Given the shaky financial standing of the sector, the last few years have produced little activity in the area of equity transactions. Most deals have been conducted around assets like power plants, pipelines, storage, and isolated pieces of operating properties.
In the not-so-recent past, however, equity transactions eagerly were awaited by Monday-morning financial headline readers. Over the period 1995-2000, almost 50 domestic stock transactions were announced affecting electric U.S. utilities. In addition to domestic mergers or acquisitions, a number of U.S. companies announced international transactions in Great Britain, Australia, Brazil and other far-flung locations. And, coming back across the waters, several international acquirers established beachheads in the U.S. sector.
At the early stages of consolidation, companies were driven to prepare for the widely anticipated deregulation and unbundling of the industry, leading them to consider the adequacy of their scale and the depth of their capabilities for successful navigation of more competitive waters. This also precipitated the roll-up of some entities and the regionalization of companies. Figure 1 illustrates the number of announced electric stock transactions that occurred through this time frame, along with the number of remaining electric U.S. utilities.
This figure clearly indicates that transactions tend to come in waves as market conditions, financial positions, competitive realities, regulatory changes, or management attitudes dictate the specific circumstances surrounding industry consolidation. Interestingly, the high-water mark for transactions in the United States was 1999, well after the first wave of combinations driven by readiness for competition. This succeeding wave of transactions, however, was not a product of new or uniquely different circumstances. Many of the transactions of the late-1990s were initiated because companies had an opportunity to view the results of those preceding combinations and were more comfortable with the indicated outcomes.
Both waves of previous consolidation reflected a sentiment among utility managements that stand-alone survival was not assured or, similarly, that success was more likely with a larger, more stable, and diverse portfolio. The combinations that occurred over the 1995-2000 time frame changed the landscape of the sector and reshaped the list of top 10 largest companies. The new entries to that list have largely continued to increase their market capitalization and are among the most highly valued today.
Not surprisingly, "conventional" thinking always has suggested that mergers seldom produce the results anticipated and that shareholders are better off without the risk and the headache. For sure, excessive premiums that create long-term anchors to the acquirer are difficult to overcome. Another potential drawback is that extended regulatory approval periods can practically "lock-out" other strategic initiatives of the companies if not anticipated.
The track record of the utility sector, truthfully, is mixed. Traditional analyses of relative stock price, shareholder return, and other value metrics do not uniformly produce positive results. Clear conclusions are difficult to draw from these analyses, however, because the impacts of M&A transactions are commingled with those from other non-merger events. Elements such as regulatory decision outcomes and general market conditions that are unrelated to a transaction can depress financial results and stock performance. These impacts may send misleading signals to analysts over how a merger is affecting value creation, particularly given the positive track record of the sector in realizing operational synergies.
Strikingly, one can point to several serial acquirers in the sector that have clearly been satisfied with the results they have achieved and hold attractive valuations today. These companies externally are viewed as being able to successfully execute on transactions through leadership commitment, management skill, and regulatory prowess in a way that demonstrably produces value. Of principal importance are the abilities to exercise discipline in pricing of the offer, to craft creative but equitable plans to secure regulatory approvals and to aggressively pursue expected results.
-T.F. and B.K.
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