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ECONOMIES OF SCALE AND SCOPE IN ELECTRIC UTILITY MERGERS

r 10, 2011

VICE PRESIDENT, PATHFINDER STRATEGIC SERVICES

BLACK & VEATCH MANAGEMENT CONSULTINGBILL KEMPO

ctob

er

AGENDAAGENDAAcademic and industry perceptions

Evidence for merger‐related cost savings

Allocation of benefits

Conclusions

2

ACADEMIC STUDIES MIXEDIAEE – M&A Economics 10‐10‐2011

Representative papers:

• Dube, Francis‐Gladney, Romero, Langdon (2007)• Little evidence of abnormal returns to acquirer shareholders or

increased acquirer operating cash flow for two years after close

• Becker, Mulherin, Walking (2009)E id t t/ i d ti i d t• Evidence supports cost/price reductions in mergers due to economies of scale

• No support for hypothesis that mergers facilitated by have f t d ti titi ll i tilitifostered anti‐competitive collusion amoung utilities

3• Focused on firm level data• Cost savings but few shareholder benefits

INDUSTRY PERCEPTIONS OF MERGER BENEFITSIAEE – M&A Economics 10‐10‐2011

• Depends on how you frame the question of benefits

A k l d t th t i ifi t t i b• Acknowledgement that significant cost savings can be achieved

• Assumption that geographic proximity is major driver p g g p p y jof cost savings

• Recognition that larger financial scale may be required f i f i d f ifor size of required future investments

• Widespread skepticism on whether pain is worth gain

• Belief that mergers hurt acquirer stock performance• Belief that mergers hurt acquirer stock performance

4High level of skepticism




Conclusions

5

POTENTIAL SOURCES OF COST SAVINGS IAEE – M&A Economics 10‐10‐2011

Illustrative; for vertically integrated utilities.WholesaleM i a

Nonfuel

Coststo Achieve

Avoided/Deferred Capex

Premerger Initiatives

Financing

Coal/Gas Supply Best

Practices/ Process Redesign

Margin

Non

‐Pub

lic Data

CorporatePrograms

NonfuelPurchasingEconomies

T&D Operations Positions

OtherOperations Positions

CorporatePositions

Public Data

TotalPotentialSavings

Gross Merger Savings

Net MergerSavings

Core and Facilitated Savings Strategic

Transactionspecific mix of savings

Core and Facilitated SavingsOpportunities

6

Announced Synergies as % of Utility Total O&M Announced Synergies as % of Utility Non-Fuel O&M

IAEE – M&A Economics 10‐10‐2011

ANNOUNCED SYNERGIES NOT AGGRESSIVE

FirstEnergy-GPU

BUG-LILCO

LG&E-KU

Announced Annual Synergies By Year 3 vs. Combined Annual O&M Expenses Before Closing

(1)

(2)

Exelon PSEG

LG&E-KU

Duke-Cinergy

BUG-LILCO

Announced Annual Synergies By Year 3 vs. Combined Annual Non-Fuel O&M Expenses Before Closing

(1)

(2)

PE-Enova

Puget-WE

OE-Centerior

Exelon-PSEG

Dominion-CNG

KCP&L-Aquila

Nevada-SPP

KCP&L-Aquila

Puget-WE

Dominion-CNG

FirstEnergy-GPU

Exelon-PSEG

CP&L-FPC

AEP-CSW

Union-CIPSCO

Nevada-SPP

Duke-Cinergy

IE-SIGCORP

AEP-CSW

Nat Grid-Keyspan

NSP-New Cent

Delmarva-AE

IE-SIGCORP

PE-Enova

Ameren CILCORP

Nat Grid-Keyspan

WPS-Peoples

Unicom-PECO

NSP-New Cent

Delmarva-AE

CP&L FPC

PEPCO-Conectiv

Unicom-PECO

Union-CIPSCO

OE-Centerior

CP&L-FPC

WPS-Peoples

MidAm-Pacif iCorp

PNM-TNP

PEPCO-Conectiv

Ameren-IP

ConEd-O&R

Ameren-CILCORP

medianMidAm-Pacif iCorp

PNM-TNP

Ameren-IP

Ameren-CILCORP

ConEd-O&R

PEPCO Conectiv

median

0% 1% 2% 3% 4% 5% 6% 7% 8% 0% 5% 10% 15% 20% 25%

(1) Source: SEC filings and press releases. Includes fuel/purchased energy savings(2) O&M from FERC Form 1 and 2 reported costs in calendar year prior to closing; includes all utility

operating companies reported by shown parent firms

Selling the regulators – just enough7

HAVE UTILITY MERGERS REALLY DELIVERED THEIR PROMISED BENEFITS?


DELIVERED THEIR PROMISED BENEFITS?

• Were promised levels of synergies achieved? YES

• Widespread success in meeting or beating announcedsynergy targets

• Expectations framed by merger announcement

• High enough to win investor support

• Low enough to keep substantial benefits out of regulatory gain‐sharing

• Cost savings actually achieved (within three years) Cost savings actually achieved (within three years)typically 120‐200 percent of announced synergies.

• Failures to meet expectations less common

• Based on public and proprietary data8

32 U.S. Electric Utility Merger Transactions, 1997-2007

POST‐TRANSACTION CHANGES IN ELECTRIC UTILITY COSTSIAEE – M&A Economics 10‐10‐2011

282%300%

y gSum of Separate Utility Costs in Year Prior to Closing vs. Combined Utility Costs 4 Years Later (1)

Greatest Increase, Greatest Decrease, and Median Change 751%

180%

150%

200%

250%

Cos

t (2

)

Median

crea

se

118%139%

49%59%

50%

100%

150%

ge in

Rea

l C

Cos

t Inc

-33% -44%-23%

-38%-57%

49%

0%-7%

6% 0% -4%

-53%

-10%

-50%

0%

50%

4-Ye

ar C

han

crea

se

-108%-100%

57%

-150%

-100%

4

Cos

t Dec

(3,4) (3)

(1) Source: FERC filings(2) Adjusted for inflation at CPI(3) Generation non‐fuel O&M excluded for transactions with firms that divested generation(4) Uncollectible accounts excluded from all costs

More consistent cost reductions in back office 9

STATISTICALLY SIGNIFICANT COST REDUCTIONS VS. NON‐MERGER UTILITIES


Function Mean 4‐Year Cost Change(1) tStatistic

Comment

Merger Group

Non‐Merger GroupGroup Group

Generation Non‐Fuel O&M ‐0.64% 8.90% ‐2.06 Significant at >90%

Transmission O&M ‐27.70% 17.39% ‐4.67 Very highly significant

Distribution O&M 3.75% 4.83% ‐0.33 Much weaker merger impact

Customer Service 0.04% 24.01% ‐3.72 Highly significant

A&G ‐5.30% 7.08% ‐2.12 Significant at >90%

• 32 merger transactions vs. 19 utilities without mergers

Total Non‐Fuel O&M ‐2.42% 9.68% ‐1.64 Significant at almost 90%

(1) Constant dollars

g g• Real reduction in cost over a 4‐year periods (year before to 3 years after close)• T test for significance of difference in sample means• Also samples tested to confirm no significant secular time trends

Statistical analysis tells the same story 1010

DECLINING IMPORTANCE OF GEOGAPHIC PROXIMITY IN MERGER CHOICES


PROXIMITY IN MERGER CHOICES

• Changing pictureP ili i l b i hb• Past utility mergers mainly between neighbors

• Recent trend of business model creation and extension

• MidAmerican Energy / PacifiCorp, Duke Energy / Cinergy, Next Era / Entergy, AGL / Nicor

• Less dependence on proximity‐related cost savings• Distribution O&M savings larger for close pairs of firms but not

a large driver of merger savings

• No meaningful difference between A&G and transmission f l d f fO&M savings for close vs. distant pairs of firms

• Customer service savings much larger for distant pairs of firms

• Total achieved savings level not related to proximity• Total achieved savings level not related to proximity

11

PROXIMITY VS. REALIZED SYNERGIESIAEE – M&A Economics 10‐10‐2011

Mean Cost Changes in Utility M&A TransactionsDistant vs. Close (1)

20%

25%(1) Close = adjoining or

overlapping; Distant = all others

(2) Includes non

[5 Distant Pairs vs. 11 Close Pairs]

5%

10%

15%

nsta

nt $

)

(2) Includes non‐normalized fuel/purchases

(3) Several close pairs had large RTO‐related increases in transmission costs; rising transmission

-5%

0%

5%

AnnouncedSynergies Non-

Fuel O&M

Total Non-FuelO&M

Electric O&M A&G Cust Service Dist O&M Trans O&M

n C

ost C

hang

e (C

on rising transmission costs for almost all pairs

(4) T test of statistical significance of difference in sample means between Distant vs. Close

(2) (3)

-20%

-15%

-10%Mea

n Distant vs. Close groups

-25%

20%

Cost Category Distant CloseStatisticalSignificance (4) high low moderate low very high high low

Announced Year Before Closing vs. 3 Years Later

• Distant pairs of firms extracted higher Customer Service savings• Close pairs of firms achieved savings across broader range of functions 12

NEW SOURCES OF SCALE ECONOMIESIAEE – M&A Economics 10‐10‐2011

• Growing significance of information‐related synergies

• Portability of metering data, customer data, back office data

• Large savings from combining non‐T&D systems and processes

• More aggressive execution by separated utilities

• Emerging technologies reinforcing economies of scale

Ad d i d S G id h l i• Advanced metering and Smart Grid technologies

• Customer relationship management technologies

• Back office (ERP) systems and delivery modelsBack office (ERP) systems and delivery models

• Total achieved savings level not related to proximity

13

FEW STUDIES OF ECONOMIES OF SCOPEIAEE – M&A Economics 10‐10‐2011

• Most utility mergers involve firms focused on production of same commodity servicey

• Electric and gas utility mergers do produce savings

• G&A and Customer Service synergy levels similar to electric‐electric or gas‐gas mergers

• Very limited synergies in operations functions. Fuel procurement, logistics support.p , g pp

• Economies of scope for regulated and unregulated services complicated by required ring‐fencing

• Poor utility industry performance in entering unregulated markets, especially outside of same industry

14Little evidence for significant economics of scope




Conclusions

15

CLEAR SHORT‐TERM BENEFITS TO CUSTOMERSIAEE – M&A Economics 10‐10‐2011

• Lower rates• Regulators and utility negotiate allocation of cost savings

T i ll 50% f i fl h h• Typically 50% or more of core savings flow through to customers

• Utilities attempt to keep facilitated and strategic benefits off h blthe table• Not directly related to redundancies and scale economies

• Compensation for shareholder risk and management initiative

• Improved service

• Larger post‐merger utility can adopt new technologies more quicklyquickly

• Improved access to capital, ability to finance needed investments

• Longer term impacts on generation costs less clear16

DID SHAREHOLDERS END UP BETTER OFF?IAEE – M&A Economics 10‐10‐2011

• Shareholders of acquired entity clearly benefit• Acquisition premium received

• Assumes stock fairly priced pre‐announcement

• Mixed picture for acquirers

• Most acquirers’ stock performed about as well as the S&P Utility Index

• Slightly more clear outperformers than clear g y punderperformers

• Larger acquirers accounted for disproportionate share of recent growth in industry stock valuerecent growth in industry stock value

• Points to two major challenges

• Excessive acquisition premiumsExcessive acquisition premiums

• Regulatory capture of cost savings17

ACQUIRERS’ RELATIVE STOCK PRICE PERFORMANCEIAEE – M&A Economics 10‐10‐2011

Acquirer Stock Price Performance vs. S&P Utility Index - 16 Acquirers, 18 Transactions250%

150%

200%

rman

ce (

1)

100%

150%

tock

Pric

e Pe

rfo

LowHighMeanMedian

50%

Rel

ativ

e S

(1) Indexed to 100% at time of closing; 100% = same performance as S&P utility index over period

(2) Sierra Pacific significantly lower

(2)

(2)(2)

0%1 Year Later 2 Years Later 3 Years Later 4 Years Later 5 Years Later

significantly lower than range of other acquirers

(2)

( )

Time From Closing

• Mergers typically depress stock prices before and after close• Stock performance improves 23 years after close, as savings are realized 18

OBSERVATIONS ON ACQUIRER STOCK PRICE PERFORMANCEIAEE – M&A Economics 10‐10‐2011

● Major outperformers● Generally used mergers to pursue clearly defined strategy

E g merchant generation or electric deli er● E.g., merchant generation or electric delivery

● Major underperformers● Resource short; Street concern about full recovery of market purchases; y p

● Market performers (bulk of acquirers)● Lagged utility index during integration process

● Many outperformed utility index in the period 3‐5 years after transaction, but later regressed toward average group performance

● One‐off deals created little long‐term value for acquirer

Longterm shareholder value from utility mergers requires:g y g q• Sound, extendable strategy• Disciplined execution of both transaction and integration

19




Conclusions

20

CONCLUSIONSIAEE – M&A Economics 10‐10‐2011

• Utility mergers do produce abnormal cost reductions• Variety of utility mergers have achieved significant non‐fuel

cost savings in both real and industry normalized termscost savings, in both real and industry‐normalized terms

• Typical savings of around 8‐12% of the combined firms’ non‐fuel expenses

i b f i l• Savings vary by functional area

• Percentage savings not related to deal size

• Similar core business models• Accessible economies of scale

• Manageable execution risk

E i f t i ifi t• Economies of scope are not significant

• Challenging to achieve financial benefits for acquirer • Regulatory strategy to meet both public and private interestsRegulatory strategy to meet both public and private interests

• Timely savings realization

• Serial acquisitions in pursuit of well‐defined strategy 21

QUESTIONS?

BILL KEMPVi P id t

QUESTIONS?

Vice President,Pathfinder Strategic Services

Cell (941) 448‐5674

Office (941) 342‐6941

[email protected]

2222

REFERENCES


• S. Dube, L. Francis‐Gladney, R. Romero, and W. Langdon (2007), Merger Motives For U S Utility Acquirers: Evidence From Performance Risk Metrics

REFERENCES

Motives For U.S. Utility Acquirers: Evidence From Performance, Risk Metrics, And Executive Compensation, Journal of Business and Economics Research, Vol 5

• D. Becker, J. Muherin, R. Walking (2009), Synergy versus Collusion in Mergers: An Analysis of Stock and Product Prices in the Utility Industry published byAn Analysis of Stock and Product Prices in the Utility Industry, published by Wharton Financial Institutions Center

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