THE SEARCH FOR FINANCIAL STRENGTH

Transcription

1 Utilities Energy POINT OF VIEW TODAY S UTILITY MERGERS: THE SEARCH FOR FINANCIAL STRENGTH AUTHOR Alan Feibelman Utility mergers are back, and in a big way. Utility merger and acquisition activity picked up in 2010, and has further accelerated in The first half of 2011 has experienced the highest level of US entire-company utility M&A activity since 2007 (see Exhibit 1), with a high likelihood for more deals before year-end. However, the utility M&A landscape is very different today than the prior two waves of consolidation in and Since the economic downturn, new drivers and strategies for consolidation are at work. Utility mergers are now largely driven by the need for capital and balance sheet strength. Market and regulatory pressure for infrastructure modernization and environmental compliance are pushing utilities to seek partners with financial strength, stability and investment capability now more than ever. The current economic and regulatory environment poses added regulatory approval ambiguity and increased challenges for utilities: navigating through contradictory objectives of their public utility commissions and other state officials. The current economy has put a premium on jobs, with regulators (and also utility executives) concerned about preserving jobs and minimizing job loss (labor synergies in merger-speak ). Yet regulatory commissions and intervenors want merger-related financial benefits and synergies passed on to the end consumer. Thus the regulatory and intervenor contradiction or challenge: we want significant savings or synergies for consumers but we want the utilities to focus primarily on non-labor synergies (which typically make up less than 50% of all synergies and an even lower percentage of all O&M synergies). As a result, utilities have to adapt or develop new regulatory strategies and integration planning approaches.

2 UTILITIES MERGERS: DRIVEN BY THE NEED FOR CAPITAL AND FINANCIAL STRENGTH The past two years have seen a new wave of entire-company utility mergers and acquisitions, following a period of low activity during the recession years. In terms of transaction value, the recent surge in mergers and acquisitions (2011 year-to-date) is getting close to annual levels witnessed in the peak utility M&A years of and In fact, year-to-date 2011 is already the third biggest year for entire-company utility M&A in the last 17 years (and on an annualized basis would dwarf 2007). EXHIBIT 1: UTILITY M&A TOTAL ACQUISITION VALUE $80.0 $70.0 $60.0 $50.0 $62.2 $67.0 $51.0 $40.0 $30.0 $20.0 $10.0 $0.0 $0.2 $1.4 $22.8 $20.1 $ $ $11.7 $7.2 $7.0 $25.3 $ $2.2 $1.0 $ YTD* *Partial year, January July 2011 Note: includes pending and completed power and gas utilities deals in the USA Source: SNL The rationale for entire company utility M&A has changed since the economic downturn. Unlike deals closed during these previous utility M&A waves, the current transactions are driven more by the need for capital and financial strength, than the capture of economies of scale or earnings growth. Utilities, in the discussion of merger rationale, increasingly highlight their objectives to fortify balance sheets as well as improve credit quality and financial stability, to support access to cheaper capital. Oliver Wyman has examined the publicly pronounced rationales for major US whole-company utility mergers and acquisitions over the past 12 years, and has seen a clear shift in primary M&A objectives from capturing economies to scale to building financial strength (see Exhibit 2). Today s Utility Mergers: The Search for Financial Strength 2

3 EXHIBIT 2: ENTIRE COMPANY UTILITY M&A RATIONALE MIGRATION 100% 80% 60% 40% 20% 0% Earnings growth* Complementary operations Economies of scale and best practices Financial strength and stability Source: SNL, Oliver Wyman analysis * Utilities did not specify if EPS increase was realized through economies of scale, implementation of best practices, etc. Note: includes the top 40 M&A transactions by transaction value, for whole companies, from 2000 to Some years did not include such major transactions. A relevant example is the merger of Duke Energy with Progress Energy, announced in January Jim Rogers, Chairman, President and CEO of Duke Energy, then said: Combining Duke Energy and Progress Energy creates a utility with greater financial strength and enhanced ability to meet our challenges head-on... Our industry is entering a building phase where we must invest in an array of new technologies to reduce our environmental footprints and become more efficient. By merging our companies, we can do that more economically for our customers. Another relevant example is the merger of Northeast Utilities with NSTAR, announced in October As Thomas J. May, President and CEO of NSTAR, puts it: NSTAR s very strong balance sheet coupled with Northeast Utilities impressive array of transmission investment opportunities and diversified suite of distribution businesses translates into a compelling growth story reducing the need for Northeast Utilities to issue new equity to fund its capital spending program. The recent utility M&A emphasis on capital access and financial stability is centered on companies need to support demanding investment programs, related to: Substantial generation rebuild, expansion, and infrastructure modernization programs Large transmission line projects Compliance with environmental (e.g., carbon, air) regulations, and weathering the uncertainty regarding regulatory policies and requirements Funding the replacement or upgrading of aging transmission and distribution assets Today s Utility Mergers: The Search for Financial Strength 3

4 It is not yet clear how the current market turmoil will affect utility M&A during the second half of On one hand, utility M&A activity collapsed in the aftermath of the 2008 economic downturn, only to recover in 2010 and However, current market instability could reinforce utilities need to achieve greater financial strength and stability, and might drive weaker positioned companies to seek buyers. SYNERGY SAVINGS CATCH-22 With the utility M&A focus on increasing financial strength and stability, synergy savings have been highlighted less often and less visibly by utility executives announcing a transaction. Five or ten years ago, the lead paragraphs of utility M&A press releases typically highlighted the large value of synergy savings that would accrue over a 10-year period. Today, synergies are mentioned (and 10- or 20-year savings estimates provided) in roughly only half of the current transactions, and rarely in the opening paragraph of a press release. Given the current economic climate, synergy savings especially labor-related savings are often downplayed or even glossed over in merger announcements. Today, many utilities involved in post-integration planning are focusing first on capturing non-labor synergies, which typically represent less than half of all potential M&A-related synergies. On the surface, this would appear to fully align with regulators and government officials interests: The retention and preservation of jobs and employment in a region is vitally important to regulators and elected officials (and of course also utility executives). Thus, labor synergies are typically not a primary focus today and, in fact, when it is a priority post-merger integration (PMI) plans center on achieving the labor synergies through attrition without layoffs or, in some cases, even voluntary severance programs (very different from 5 or 10 years ago when almost every utility merger relied on voluntary early retirement or severance programs as a staffing reduction tool). Yet regulatory commissions and intervenors want significant merger-related financial benefits and synergies to accrue to the end consumer, often pushing for greater synergies to be passed on, and passed on sooner, to customers. A particularly relevant example of this is found in Massachusetts, where regulators recently changed the merger approval requirements, moving from a no net harm to a net benefits test, after the Northeast Utilities-NSTAR merger was announced. As a result, utilities often face a Catch-22: they want to avoid aggressively reducing jobs in the near-term but, to get the transaction approved, may need to promise and deliver greater synergies sooner. In addition, special interest groups, in some cases supported by the regulators, use the leverage provided by the regulatory approval process as an opportunity to request funding for key initiatives such as low income rate subsidies, economic development, energy efficiency or renewable power programs. For example, the Kentucky PSC in its August 2, 2011 approval of the Duke-Progress merger stipulated that the companies contribute Today s Utility Mergers: The Search for Financial Strength 4

5 $165,000 for each of the next five years to support low-income weatherization programs and economic development, as well as continue to offer a full range of cost-effective energy efficiency and conservation programs, in Duke Energy Kentucky s service territory. EXHIBIT 3: SOURCES AND USES OF SYNERGY SAVINGS Laborrelated 50-65% Labor available longer term when attrition occurs Labor available short term Job retention pressure Regulatory approval process pressure Shareholder earnings growth Customer rate decrease Nonlabor 10-20% 5-10% 5-15% 5-15% A&G Facilities Supply chain Information services Typical sources of merger savings Total synergies available in early years Environmental and other programs Typical uses of merger savings Source: Oliver Wyman analysis The end result is that even though one might expect an easier and shorter path to state regulatory approvals because of the increased emphasis on stability and infrastructure investment, the opposite can be true. The regulatory approval process, objectives and timeline may exhibit increased ambiguity and therefore increased challenges for utilities. SO WHAT IS A UTILITY TO DO? As a result, utilities have to adapt or develop new integration planning approaches and regulatory strategies: 1. First, utilities must recognize that the M&A climate and rules of the game are different today than they were 3, 5 or 10 years ago. They should be prepared to adapt should the official regulations or unofficial rules change even after the deal has been announced. As a direct consequence, utilities ought to build flexibility into their integration and transition planning approach. This means for example: Plan to start early on Day One (merger close) planning and preparation, but prepare integration teams to be able to adapt to a moving Day One target and a changing timeframe. Today s Utility Mergers: The Search for Financial Strength 5

6 Split (a) Day One preparation, (b) operational and organizational integration, and (c) synergy identification and capture into clearly differentiated modules that can be managed according to varying timelines and adjusted separately based on regulatory reviews. Furthermore, focus first on non-labor synergies, later on labor-related savings. Build the integration approach in such a way that senior executives rather than the functional integration teams manage and retain control over organization design, so that they can adapt to a changing regulatory timeline and keep organization structure and people-related decisions confidential until the appropriate time. 2. Utilities also have to be prepared to interact with an increased number of players, who may have difficulty in making trade-offs between conflicting objectives and political interests. At a minimum, that requires, to ensure eventual approval of the merger, crafting the concise and compelling merger rationale that can build support for the deal within key constituent groups. Specific non-financial (customer, environmental, community, etc.) and financial (rate, investment ability, etc.) benefits of the deal should be carefully considered when initiating a transaction and crafting the communications. More importantly, plans to build political support for the merger, potential approaches to key individuals or groups, and possible concessions or agreements should be outlined and developed before the deal is announced. 3. Labor-related synergies and the effective use of people deserve specific attention. Although labor savings will likely be realized over time through natural attrition, utilities should continue to aggressively develop integration plans and build a sustainable organization with clear accountability for the future. Typically, operating an integrated entity on a day-today basis will require fewer people than running two businesses separately. The additional human capital available after merger could be used, for example, for the implementation of special projects that will help capture key operational benefits and non-labor synergies (e.g., sourcing savings, integrated information systems). Even though this wave of consolidation in the utility industry differs from prior waves, one thing remains the same: utilities can reap significant benefits from mergers and acquisitions. The keys to success, and to realizing those benefits, lie in developing plans and management approaches that reflect today s changed environment and that build in flexibility and adaptability for the changes yet to come. Today s Utility Mergers: The Search for Financial Strength 6

7 With offices in 50+ cities across 25 countries, Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. The firm s 3,000 professionals help clients optimize their businesses, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is part of Marsh & McLennan Companies [NYSE: MMC]. For more information, visit Oliver Wyman s Energy team helps utilities and related energy companies address strategic and operational challenges through proven, results-oriented approaches. We have completed hundreds of engagements for more than 75 leading electric, gas, and water utilities across North America and Europe, creating sustainable shareholder value. For more information, please contact: David Hoffman Practice Leader David.Hoffman@oliverwyman.com Alan Feibelman Partner Alan.Feibelman@oliverwyman.com Mark Hirschey Partner Mark.Hirschey@oliverwyman.com Copyright 2011 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report may not be sold without the written consent of Oliver Wyman.