EVALUATING MERGERS IN THE ELECTRIC AND
NATURAL GAS INDUSTRIES
BY
ARTHUR ANDERSEN ECONOMIC CONSULTING
CHARLES J. CICCHETTI, PH.D.
COLIN M. LONG
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EXECUTIVE SUMMARY
Competition is driving the nation's electric utilities to pursue two strategies:
1) consolidate or merge; and 2) process redesign or re-engineer. Monroe has
hired Arthur Andersen Economic Consulting (AAEC) to evaluate and analyze
strategic options based on these two strategies.
The Company could merge, concentrate on process redesign/cost cutting, or do
both, either at the same time or in tandem. If the in tandem option is
selected, either strategy could take place first, I.E., merge and then re-
engineer, or vice versa. These various alternatives have been analyzed both
economically and strategically. The good news is that there do not appear to be
any bad choices. There is, however, a fair degree of mutual exclusivity which
requires the Board to make some specific decisions about merger selection and
the priority and timing of process redesign VIS A VIS merging.
There are differences in the numbers or underlying financial factors associated
with the various choices. Nevertheless, one principal conclusion is that
strategic and qualitative differences are more important than the numbers
attached to each choice. There are three reasons for this conclusion.
1) The quantitative analyses were performed using publicly-available data and
various industry-wide benchmarking statistics. These data are good enough
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to screen out bad choices, identify good ones and reasonably, but not
definitively, rank alternatives.
2) There is simply no bad alternative in the options AAEC has been asked by
the Board Liaison Committee to analyze. There is a degree of uncertainty
in the specific deals or options that might be pursued, as well as some
uncertainty related to how regulators and the market might react to
specific options. Accordingly, the economic and financial data cannot be
exclusively relied upon to choose without considering an array of
qualitative factors and differences. This introduces an element of
subjectivity into the analysis.
3) Strategy and vision matter. They are not simply tie-breakers. Strategy
and vision represent important differences for your employees, communities,
customers, regulators, the market and shareholders. Relative success in
economic terms will undoubtedly be affected by the marriage of the
financial and strategic aspects of each choice.
In the AAEC analysis, four merger alternatives are compared using both economic
and strategic factors. A similar analysis of the so-called standalone option is
also performed. The standalone case is based upon deferring all mergers until
the cost savings related to process redesign are either achieved or
significantly underway.
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The data for merger savings were prepared in a manner consistent with all other
utility mergers and FERC filing requirements. Specifically, the savings are
stated in nominal annual savings (with a specified inflation escalator) for ten
years. This presentation format is not how economists and financial analysts
would normally state the results because there is no attempt to discount future
values to present value terms. More important, there is also no attempt to
identify how regulators might actually split the savings between shareholders
and ratepayers. We address these matters now.
We repeat: NUMBERS DO NOT TELL THE WHOLE STORY!
OPTION 1
Although the numbers do not tell everything, they do suggest that a "three-way"
merger between Monroe, Washington and Amber has the potential to yield the most
economic synergy. The ten-year undiscounted synergy estimate for this case is
about $670 million with about $325 million in the categories most likely to be
claimed by shareholders: Labor, Administrative and General (A&G) and Operations
and Maintenance (O&M).
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OPTIONS 2 AND 3
Two-way mergers between Monroe and Washington or between Monroe and Lincoln are
fairly close from an economic synergy perspective. We estimate them to yield,
respectively, $502 million and $442 million in nominal undiscounted synergy
savings. The Lincoln merger represents a merger with a larger two-way partner.
This would normally provide a greater opportunity for synergy. However, this
potential advantage is effectively offset by the fact that Lincoln is in the
midst of completing a major merger, which will squeeze a significant amount out
of what could have been achieved by Monroe merging with Lincoln if Lincoln had
been previously formed some time ago.
A major synergy difference for these somewhat equivalent savings represents a
major advantage for Washington. About half the synergy savings, $253 million in
the Washington case, come from the categories most likely to be claimed by
shareholders, I.E., labor, A&G and O&M. The comparable synergy savings for the
Monroe/Lincoln case are about $137 million. Using other mergers as a guide,
each dollar saved in these categories might reasonably be expected to be split
50/50 between shareholders and ratepayers. This means that this approximate
$120 million difference over ten years equates to about a $12 million per-year
difference in pre-tax earnings for the Washington/Monroe merger as compared to
Lincoln/Monroe.
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OPTION 4
The fourth merger option is Monroe and Indigo. This merger would most likely
achieve less system integration benefits because the Indigo system is
geographically dispersed. Indigo is also different than the other utilities
because it has disproportionately more natural gas than electricity. This makes
Indigo a mirror image of the other utilities analyzed. This difference would
also contribute to reduced synergy benefits.
Notwithstanding the difference between Indigo and the others, we based the
Indigo synergy analysis on assumptions which tended to at least partially ignore
some of these differences. We did this to avoid any bias against Indigo and to
be consistent. The result is that Indigo savings are less conservative.
The Indigo ten-year nominal undiscounted synergy savings are estimated to be
about $355 million. However, this savings gap which puts Indigo in last place
is minimized when savings in the categories most likely to be claimed by
shareholders are examined. In this comparison, Indigo actually moves ahead of
Lincoln with savings in Labor, A&G and O&M, estimated to be about $213 million.
This conclusion needs to be somewhat discounted by the fact that adopting
consistency in analyzing Indigo savings caused the savings to be increased
relative to the more conservative position we took in the other categories.
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Nevertheless, in all cases, each merger represents opportunities for increasing
earnings per share.
STRATEGIC CONSIDERATIONS
[REDACTED LANGUAGE]
The real issue in the merger option comparison comes down to a choice between
the Washington and Indigo strategies. We did not seek to find differences when
there are no material distinctions. We emphasize this approach because,
although we perceive differences in the two company's intermediate strategic
positioning, we tend to think that Washington and Indigo's long-term strategies
may not be quite so different. This would mean that the differences may have
more to do with the "means" than the "ends."
However, this difference we find is not without significance for current
shareholders, employees and current customers. But this puts us ahead of
ourselves. Stepping back, some of the strategic differences between Washington
and Indigo can be explained by noting that Washington seems to have a customer
focus, while Indigo seems to have a commodity focus. In ten years this
distinction may have less meaning than it does today.
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Another difference is that Washington expects, at least for the intermediate
term, to be as much a manufacturer (producer) as a merchant (marketer). Indigo
seems much more ready to become a "branded" energy merchant, I.E., buying and
re-selling electricity and natural gas. While noting this difference, we
concede: (1) that Washington has been an industry leader in diversifying into
energy and pollution rights marketing; and (2) that Indigo has not sold off its
generation assets; we nevertheless think this is an important distinction.
Accepting these distinctions means you might assign different values to the
Washington and Indigo options. A Washington/Monroe/Amber regional consolidation
and system integration should be valued if you think the next decade will still
be dominated by traditional entities; albeit ones that meet competition
aggressively. An Indigo/Monroe merger should be valued if you think it is
important to form complements (in a gas/electric mix sense), for the purpose of
gaining, at least partially, Indigo's vision of achieving a national market
share through a brand-name strategy.
In a regional consolidation, vertically-integrated systems are combined to
consolidate a customer base, reduce costs and to prepare to meet the
competition. Production continues to be emphasized as the regional
consolidation attempts to capture the value of existing fixed-generation and
transmission assets. This favors Washington.
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A merchant/commodity consolidation means that price reductions for standardized
products are emphasized as premium products for niche markets and services are
identified and brought into the market. Production and current fixed assets are
de-emphasized. This favors Indigo.
These are differences which matter in several ways. First, the Board,
management and employees are likely to find that the more traditional utility
approach of Washington as it responds to the urgency of competition is more
familiar and more similar than the Indigo strategy. Second, there may be some
who like the end-game of competition and see little reason to delay getting
there. These confident souls probably think Indigo sees the future relatively
clearly and prefer this strategy because it is based more certainly on this
competitive future.
No analyst is equipped with sufficient knowledge and experience to make this
choice for Monroe. But, this choice is exactly what the Monroe Board has before
it. We find these distinctions real and the choice has strategic significance.
One factor not yet mentioned might help make the choice. Strategy can only be
made from scratch in a business school classroom. In the real business world
with shareholders, assets and employees, strategy needs to reflect the starting
point, as well as the destination. Washington's strategic positioning matches
up nicely with Monroe. This fact alone will suffice for some.
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For others, Indigo's vision seems clearer. Indigo may even be right. Much can
be gained by being early to the new game. And, much could be lost. For those
that prefer caution in the face of uncertainty, there is nothing that would seem
to preclude pursuing both a strong regional utility consolidation, especially
one with a proven record of innovation, process redesign and diversification,
and then adopting the Indigo-type strategy sooner, just not so soon, rather than
later.
THE STANDALONE OPTION
A different set of strategic issues are related to what might be called the
standalone strategy where mergers are deferred until Monroe's process redesign
efforts are completed or at least largely underway. Put positively, the
standalone alternative would yield ten-year undiscounted nominal dollar savings
of about $582 million. This would put standalone savings at levels second only
to a Washington/Monroe/Amber three-way merger. Even more importantly, the
standalone or process redesign initiative would yield about $432 million in the
labor, A&G and O&M categories, with about $351 million in labor savings alone.
There are certain differences in how the projected savings were calculated for
the mergers and the process redesign which tend to make such comparisons
misleading. First and foremost, the process redesign projections are quite
aggressive. The opposite is true for the merger savings, which are
intentionally quite conservative. This can be best illustrated by considering
labor savings.
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The process redesign contemplates eliminating 400 positions, approximately 14.5%
of Monroe's total workforce. By contrast, the merger analysis takes, at most,
5% of the COMBINED workforce. Additionally, before combining the workforces, we
eliminated from Monroe's workforce the 400 positions slated to be eliminated by
process redesign, 650 nuclear employees and 200 employees associated with
non-utility operations. Had the merger analysis projected savings using the
same aggressive 14.5% workforce reduction assumption utilized in the process
redesign, savings for the labor category would have increased dramatically. For
example, even after eliminating the 1,250 positions referenced above,
Washington's and Monroe's projected labor savings would have increased from $140
million to approximately $263 million.
Two conclusions need to be emphasized. First, we repeat it's not just numbers.
Second, standalone and merger options are not fundamentally mutually exclusive.
Since the merger and restructuring options are not mutually exclusive, this
important difference in estimation criteria should NOT matter. To the extent
that standalone and merger operations are viewed as alternatives, this
difference is basic and assumptions would need to be reconciled. As a general
matter, most of the mergers' savings would just about double or even triple if
they were based upon the data derived from the upper quartile savings for the
various mergers in the data base used for this report.
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It is also correct that the timing of the two strategies must be analyzed
carefully. It is just as true, however, that competition is forcing every U.S.
utility to pursue both the merger and process redesign strategies. Monroe would
be virtually alone if it chose one over the other. It is simply unnecessary to
place all your strategic eggs in one basket.
The most important thought to remember is that the process redesign and merger
savings are NOT mutually exclusive. In certain circumstances, the savings
categories are similar in both process redesign and mergers. Thus, it can be
difficult to distinguish, when process redesign and a merger are proceeding
simultaneously, whether it is the process redesign or the merger synergy which
is driving the savings. There will likely be some overlap. Nevertheless, most
of the savings attributable to both the process redesign and the merger savings
should be recoverable. There are, however, some pros and cons to putting
process redesign first. We repeat what we say in the main study.
Both process redesign and merging can create a difficult and stressful
transition for management and employees alike. It can be argued that to do both
simultaneously would introduce unmanageable uncertainty into the workplace.
Thus, it may be more efficient, from a personnel standpoint, to take each
activity in turn. This would allow management to concentrate on the process
redesign. Different merger candidates could have varying affects on the
employer angst associated with change from either process redesign or merger.
For example, a
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merger with Washington or Lincoln may offer some comfort to employees because
the core, traditional utility business would remain unchanged. On the other
hand, a merger with Indigo could leave Monroe as the flagship utility, firmly
anchored in its community. Removing uncertainties associated with relocation,
retraining or job loss might reduce employee stress.
Further, the primary benefit to completing process redesign is to drive up
earnings per share so as to create a more valuable entity by enhancing earnings
prior to merging. This would increase your shareholders' value. This benefit
depends upon regulators allowing shareholders to keep at least some of the
savings created by the process redesign. It is conceivable that more process
redesign savings can be kept by shareholders under a voluntary no rate case
strategy if there is no concomitant merger. Thus, by completing your process
redesign before merger, stress is reduced in the workplace, management can
better focus on the process redesign and you can potentially increase Monroe's
value in the market, giving Monroe more value in a future merger.
There are, however, risks involved in waiting until the completion of the
process redesign. FIRST, the regulatory plan for a standalone plan is riskier
than it is for a merger. Thus, it could be more difficult to retain the savings
attained in the process redesign than it will be to retain the savings in a
merger, unless the voluntary rate case strategy works better for process
redesign. Increasing share value is dependent on regulators allowing
shareholders to retain some
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significant proportion of these savings. Unless regulators allow shareholders
to keep the savings, any potential growth in market value will be, for the most
part, illusory. Additionally, with a simultaneous merger some process redesign
savings could be rolled into the merger savings. This would increase the
likelihood that regulators would allow shareholders to keep more of these
savings because mergers immediately flow some synergy savings to ratepayers.
This fact encourages regulators to approve a reasonable ratepayer/shareholder
sharing plan. At the very least, you need to know this is the prevailing
strategy driving several recent mergers.
SECOND, both competition and the potential risk of stranded cost recovery loom
on the horizon. Although stranded cost estimates are subject to debate, it is
clear that Washington has no stranded costs while Monroe and the other merger
candidates all have some stranded costs. If shareholders are held responsible
for stranded costs (or substantial portions of stranded costs) utility market
value will go down. Thus, the growth of market value engendered by process
redesign could be undermined if regulators are unable to follow through on their
promises to allow utilities to recover their stranded costs. And, competition
could cause further market value loss. If you believe that this is what the
future holds, waiting will cause your market value to erode, reducing your
ability to complete a merger. Some of your potential merger partners could fair
better. Others could fair worse. The relative effects will establish the role
you may play in any future merger.
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THIRD, waiting exposes you to the threat of a hostile take-over attempt. This
may be especially true if process redesign has created enhanced value which the
market has not yet recognized. Needless to say, this would severely affect your
ability to control Monroe's destiny.
FOURTH, the most attractive potential merger partners may not be available if
merger is delayed. Increasingly, the STATUS QUO is being abandoned. Options
most likely will be fewer and control over your destiny could be reduced. If
you wait, there are no guarantees that your opportunities will wait for you.
FIFTH, process redesign benefits can be gained through a merger. For example,
if a merger partner is also undergoing process redesign, Monroe would share in
those savings. Likewise, if the merger candidate had not started process
redesign effects, Monroe could benefit from applying its process redesign
efforts to this fatted calf. Finally, if the merger candidate had completed its
merger redesign efforts, Monroe might be able to leverage off the merger
candidate's knowledge. Additionally, costs associated with process redesign
(for example new information systems) might be saved if the merger candidate, in
its process redesign, had implemented a change which could be used by Monroe.
There is no certain answer to the merits of these pro and con arguments. The
only unambiguous case would be to make Monroe's process redesign part of
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any argument to establish an improved exchange value, if Monroe decides to merge
at this time. Such an outcome would be a way for Monroe shareholders to attempt
to gain the benefits of both alternatives. It would also most likely improve
the regulatory chances for the shareholders to gain a somewhat larger share of
the gains because ratepayers would also share in the synergy gains.
SHAREHOLDER VALUE AND CHOICES
Mergers are all about improving earnings in the near and intermediate term and
finding a partner that shares one's longer run strategic view and for which
there is a reasonable chance of market acceptance. Shareholders buy stock
because they want to earn dividends and receive the benefit of any price
appreciation in their shares. In a merger there are five sources of shareholder
value creation. These are:
1) The premium paid, if any, by one company to the other at the commencement
of the merger. Typically, this premium is "paid" in terms of a company's
ownership interest in the new merged company relative to its current market
value.
2) A second source of shareholder value comes from the market's acceptance (or
rejection) of the premium paid and/or the strategic and management synergy
created (or diluted). This second "kick" forward or "slide" back comes
from the manner in which the market treats the companies' combined
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P/E ratios. For example, mergers may bring together, (as in the case of
Washington and Monroe), two somewhat similarly sized and performing
utilities where one company has a significantly higher P/E ratio. To the
extent the merger pulls up the resulting P/E ratio, both groups of
pre-existing shareholders would gain, and vice versa.
3) Mergers are about reducing costs, selling more and avoiding capital
outlays. Some of these gains are passed on to shareholders in the merger's
regulatory plan. These savings are taxed and the remainder increases
earnings per share. Coupled with the P/E ratio assigned by the market,
these shareholder savings increase the merged company's share price.
(Similar effects could come from process redesign efforts.)
4) Mergers are long-term commitments. Matching strategic purposes and finding
compatible partners is also about long-term earnings growth potential. The
market will set a reward or penalty based upon which strategic alliances
make sense and which do not. Short- and long-term P/E ratios are a
reasonable indication of how a merger is valued by the market.
5) Dividends are also a source of value for shareholders. Mergers are often
evaluated, in part, based upon the agreement reached concerning expected
dividends, payout philosophy and market acceptance of the reasonableness of
the above.
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Mergers are also about intangibles such as management succession, board
representation, employee acceptance and social consequences. These matters can
directly influence market acceptance and, therefore, P/E ratios. They can also
affect the likelihood of achieving any synergy savings, as well as what
proportion regulators might approve for shareholders.
This Board needs to sort out the financial and strategic virtues of the merger
choices. Secondly, the Board needs to determine whether it should "wait" to
merge while pursuing process redesign; or, alternatively, get on with a merger
so it can do what most utility companies are attempting to do simultaneously:
seek to merge and to pursue process redesign.
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INTRODUCTION
Arthur Andersen Economic Consulting ("AAEC") prepared this report at the request
of the Board Liason Committee. There were several initial assignments which the
Board Liason Committee gave to AAEC. These included: (1) report on the changes
affecting the electric industry; (2) discuss the strategic considerations and
options for utilities in this changing industry and review what other utilities
are doing; (3) evaluate four potential merger candidates and Monroe; and
report to the full Board at its meeting on August 30, 1995. After the Board
Meeting, the Board expanded AAEC's assignment to include the following: (1)
converting the oral presentation into a written report by September 22, 1995;
(2) take the company's data and analysis for process redesign and prepare
comparable ten year savings data to that prepared for the four merger studies;
(3) work with company personnel to refine and recalculate synergy savings for
the four merger candidates; and (4) expand the strategic qualitative and
quantitative merger analysis taking into account information on stranded costs,
financial strength and regulatory assets and liabilities.
In our Report to the Board entitled "Strategic Considerations and Options for
Utilities in a Changing Electricity Market", which will be distributed to the
Board prior to its next Board meeting, we discuss the various strategies being
pursued by electric utilities in the face of burgeoning wholesale and retail
competitiors. In essence, there are two strategies that effectively
characterize the approach currently taken by most electric utilities.
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A declining number have adopted a wait and see approach. These utilities seek
to slow down the regulatory reform effort. However, at the same time, these
utilities must still be primed to respond to the competitive threat knocking on
their doors. But the key to this approach is to delay taking any definitive
action until such time as it becomes clear what the legislative and regulatory
efforts will render in their respective regions and at the national level.
The second approach is the one being currently adopted by a significant number
of the electric utilities across the nation. These utilities are taking a more
proactive or opportunistic approach. These companies are driving the regulatory
debate and preparing for competition. At the same time, they are attempting to
reduce their potentially stranded assets through regulatory means. They attempt
to write down these assets as quickly as possible before they are at the
market's mercy with respect to recovering their transition costs. Of course,
they are also taking action to ensure, as best they can, that transition costs
will be recovered. And, finally, these companies are actively seeking out
like-minded utilities with which to merge, strengthening their respective
organizations and positioning themselves in the market place.
Naturally, the various approaches adopted by utilities are not always at either
of the two extremes we have described here. Often, the companies will adopt an
approach that effectively blends elements from each approach. Thus, it is not
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uncommon for a company to seek to blunt the competitive reform effort while
still reacting aggressively to competitive threats.
An alternative approach adopted by some companies is to diversify into other
countries and businesses. Some utilities are considering selling off principal
portions of their business, including all of their generating assets. However,
the mainstream adopts either the wait and see approach or the
proactive/opportunistic approach.
The balance of this Report will discuss the potential merger candidates
identified by the Board. To that end, this Report is organized as follows.
First, we review the merger candidates. We identify what service territories
would look like after a merger with each candidate. Then we compare each
company utilizing various financial data and corporate intangibles.
Second we discuss the three methods utilized in this Report to estimate synergy
savings. We used publicly available information in the principal approach.
These results are checked using both the "back-in" method which utilizes key
ratios and the statistical estimating technique. In this section, the central
assumptions regarding potential savings are detailed and discussed in each
category utilized to project savings. In this section, we present our findings
for the four merger alternatives.
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Third, we review Monroe's current process redesign program and present the
savings, over ten years, which are estimated through this program's
implementation. We then discuss the potential cumulative benefits available
from pursuing both process redesign and a merger. Next, we discuss the pros and
cons of pursuing a stand-alone approach during the process redesign.
Fourth, we analyze the manner in which savings are likely to be shared between
shareholders and ratepayers. These shareholder savings are used to demonstrate
the effect savings, exchange ratios and P/E ratios have on shareholder value.
Finally, we present our conclusions.
THE CANDIDATES
The four prospective merger partners identified by the Board for consideration
in this Report are Washington, Washington in conjunction with Amber, Indigo and
Lincoln. The following section discusses the characteristics of these various
companies. A map showing the Monroe system as it exists currently is appended
to this Report as Exhibit 1.
Washington is similar to Monroe in that both companies represent fairly large
service areas in their respective states. However, although an interconnection
could be constructed relatively inexpensively, the companies are currently not
directly interconnected. Therefore, certain system integration benefits
attainable
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with certain of the other potential merger candidates are not attainable with
Washington without investing in transmission or entering into transmission
agreements with neighboring utilities. A map showing the combined system is
appended to this Report as Exhibit 2.
This minor issue leads to an intriguing possibility. If Monroe combines with
Washington and Amber simultaneously, the direct interconnection problem is
resolved. Additionally, the addition of Amber's large regional system to the
combination of Monroe and Washington creates a regional utility with significant
size and power. In fact, it would be sufficiently significant to potentially
dominate respective reliability councils. A map showing the combined system is
appended to this Report as Exhibit 3.
The third option, Indigo, presents an altogether different situation. Indigo
has operations across several states and countries. Many of its operations are
geographically distant from Monroe's headquarters. Additionally, unlike the
other three merger candidates, Indigo is predominantly a gas company. A map
showing the combined system (incorporating only Indigo's electric operations) is
appended to this Report as Exhibit 4.
The fourth option, Lincoln, is similar to the first two options in that this
company is primarily an electric utility with some gas operations.
Additionally, like the Monroe/Washington/Amber combination, this company is
contiguous to Monroe.
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Two factors set this potential merger candidate apart from the others. First,
Lincoln is a company that was formed by the just completed merger of two
electric and gas utilities. Second, the combination would create virtually an
all-Iowa company. The only other Iowa utility which would exist after such a
merger would be the relatively small Amber. A map showing the combined system
is appended to this Report as Exhibit 5.
Reviewing the maps which represent the possible combined systems highlights some
apparent differences between the companies and raises some intriguing
possibilities.
FINANCIAL COMPARISON
In analyzing the merger options, a useful starting point is a financial
comparison of these different alternatives. Set forth below is a table which
lists information taken from the Wall Street Journal.(1) This data is based on
1994 earnings.
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FINANCIAL COMPARISON (9/26/95)
Dividend Yield P/E Price
Washington $1.94 6.8% 16 $28 3/8
Amber 2.08 7.8 12 26 1/2
Indigo 1.72 6.1 15 28 1/4
Lincoln 1.20 7.9 12(2) 15 1/4
Monroe 2.10 8.2 12 25 3/4
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(1) Wall Street Journal, September 27, 1995.
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There are some similarities and some differences with respect to dividends,
yield, and price/earnings (P/E) ratios. Washington has a current dividend of
$1.94. Its yield is 6.8%. Its P/E ratio is 16, which is quite high. This high
P/E ratio suggests both strong investor confidence and strong market confidence
in Washington's long-term strategy and its ability to continue earning at its
current level.
Amber has a current dividend of $2.08. Its yield is 7.8%. However, its P/E
ratio of 12 is lower than Washington's. This suggests that investor and market
confidence in Amber's long-term strategy and ability to continue earning at its
present level is not as strong as it is for Washington.
Indigo has a current dividend of $1.72. Its yield is 6.1%. And, its P/E ratio
is 15. This relatively high P/E ratio, as it did with Washington, suggests
strong market and investor confidence in Indigo's long-term strategy and ability
to continue growing at its present level.
Lincoln has a current dividend of $2.10. Its yield is 7.9%. There is no posted
P/E ratio because Lincoln is a recently formed company. It is the third of
three mergers that have formed Lincoln. A pro forma P/E based on the individual
predecessor utilities yields a P/E ratio of 12.
- --------------------------------------------------------------------------------
(2) Based on a pro forma from the P/E ratios of the two prior companies
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By way of comparison, Monroe has a dividend of $2.10, a yield of 8.2% and a P/E
ratio of 12. As with Amber, this suggests that neither the market nor the
investors feel the same confidence level with Monroe's long-term strategy as
they do with Washington and Indigo.
RETURN TO SHAREHOLDER
An additional source of financial information is the company's return to
shareholder measure. A table showing this information is set forth below.
- --------------------------------------------------------------------------------
COMPARISON OF CUMULATIVE TOTAL SHAREHOLDER RETURN
- --------------------------------------------------------------------------------
UTILITIES 1989 1990 1991 1992 1993 1994 % Decline
from 1993
- --------------------------------------------------------------------------------
WASHINGTON 100 109 155 170 174 155 11
AMBER 100 108 154 151 157 135 14
INDIGO 100 100 148 152 184 168 9
LINCOLN A 100 100 133 120 144 126 13
LINCOLN B 100 106 125 107 129 106 18
MONROE 100 109 128 149 168 147 13
- --------------------------------------------------------------------------------
Average 100 105 141 141 159 139 13
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
INDICES 1989 1990 1991 1992 1993 1994 % Decline
from 1993
- --------------------------------------------------------------------------------
S&P 500 100 97 127 136 150 148 1
S&P Utility 100 97 112 121 138 127 8
Wilshire Utility 100 91 110 123 134 123 8
EEI 100 100 101 131 141 156 138 12
- --------------------------------------------------------------------------------
Average 100 97 120 130 144 134 7
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
On average, the potential merger candidates, except for Lincoln's predecessor
entities, outperformed the indices' average. Lincoln's two predecessor
utilities showed shareholder return which was the lowest of the merger
candidates,
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Monroe, Indigo and Washington (and Amber to a lesser extent) showed strong,
steady growth through 1993. All merger candidates and every index took a
reduction in 1994, as is shown in the table above. Indigo and Washington were,
however, the strongest performers.
BOND RATINGS
In addition to this type of financial information, the companies' bond ratings
are a good information source to understand the market's perception of the
companies. The table below sets out the respective bond ratings for Monroe and
each of its prospective partners.
--------------------------------------------------------
MOODY'S BOND RATING
Washington Aa(2)
Amber A(1)
Indigo Baa(3)
Lincoln A(3)
Monroe A(2)
--------------------------------------------------------
Monroe has a bond rating of A(2). By comparison, Washington's bond rating is
Aa(2). The other companies in our comparison don't fare quite so well. Indigo
does not even list its bond rating in its annual report, a very unusual
omission.
- ----------------------------
(3) August, 1995.
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However, Indigo's debt is unsecured and their bond rating of Baa(3) is one step
above a junk bond. Amber has a bond rating of A(1) and Lincoln is rated at
A(3).
DEBT EQUITY RATIOS
A related financial statistic that warrants comparison is the debt equity ratios
of the respective companies. The table below, which includes only long-term
debt and common equity, sets forth this information.
--------------------------------------------------------
CAPITALIZATION RATIOS
Long-Term Debt Common Equity
Washington 36% 58%
Amber 45% 46%
Indigo 51% 47%
Lincoln 51% 44%
Monroe 48% 50%
--------------------------------------------------------
Washington has 58% equity and 36% debt. This undoubtedly contributes to its
high P/E ratio. Indigo, on the other hand, is 47% equity and 51% debt. Amber
has 46% equity and 45% debt, while Lincoln has 44% equity and 51% debt.
Because Washington has relatively little debt, it would allow Monroe to gain
some financial leverage. Indigo, because it is already highly leveraged (and
thus has a lower bond rating), would not allow Monroe to gain any additional
advantage. Thus, in this sense, Washington offers certain financial benefits
not
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possessed by Indigo, Amber or Lincoln. This "benefit" is in the eye of the
beholder. No merger has ever attempted to quantify the potential savings
attributable to such a benefit and we do not attempt such an effort in the
Report.
STRANDED COSTS
There is one additional financial statistic that is extremely relevant to
electric utilities. We discuss stranded costs extensively in the Report to the
Board entitled "Strategic Considerations and Options for Utilities In a Changing
Electricity Industry" which is appended to this Report as Exhibit 1. The Board
should be wary of merging with any company that has large potentially stranded
assets. The table shown below shows, by company, Moody's estimated stranded
costs which each company has at risk and shows the ratio of stranded costs to
equity. This data has not been independently checked in preparing this Report.
Regardless, the data receives much investor attention.
--------------------------------------------------------
STRANDED INVESTMENT
Total Stranded Cost % of Equity
Washington 0 0
Amber $48,000,000 25.3%
Indigo $379,000,000 44.5%
Lincoln $172,000,000 34.5%
Monroe $293,000,000 58.5%
SOURCE: Moody's Investor Service, "Stranded Costs
Will Threaten Credit Quality of U.S. Electrics",
(August 1995). Estimates are based on stranded
generating capacity investments; specifically,
fixed costs associated with production and energy
contracts.
--------------------------------------------------------
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By way of comparison, Monroe has $293 million in stranded investment exposure.
This represents 58.5% of its equity. Washington is in the enviable position of
having no potentially stranded investment. Amber has $48 million in stranded
investment, representing 25.3% of its equity. Indigo has $379 million in
potentially stranded investment, representing 44.5% of its equity. Finally,
Lincoln has $172 million in stranded investment, representing 34.5% of its
equity.
There are decided advantages in spreading out any potentially stranded
investment liability. A merger with each potential candidate will dilute
Monroe's liability somewhat. Amber has only $48,000,000 in potential stranded
investment. However, due to its relatively small size, this amount still
represents 25.3% of its total equity. Lincoln also has substantial stranded
investment totaling $172,000,000 representing 34.5% of its total equity. Indigo
also has a substantial stranded investment liability totaling $379,000,000, or
44.5% of its equity. Washington, with no potentially stranded investments is
the clear winner when only this financial statistic is viewed. Washington
offers the opportunity to substantially dilute the stranded investment
liability.
It must be noted that there is controversy surrounding the manner in which the
Moody's Report, from which these stranded cost numbers were derived, calculates
the stranded costs. There are those that believe the totals stated in that
Report are overstated. Also, the Moody's Report includes Purchased Power
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Contracts in their stranded asset assessment. Many of these contracts could end
in the relatively near term, reducing the projected stranded assets. Without
question, the assumptions used in that Report are such that reasonable minds
could differ. It is not our purpose to endorse the stranded cost estimates put
forth by Moody's. We seek only to highlight the potential problem stranded
costs could present in the future. And, by any measure, Washington, with no
stranded costs, is most attractive.
OTHER INTANGIBLE FACTORS
REVENUE SOURCES
The numbers presented above and below do not tell the entire story. There are
complementary business relationships which are not readily apparent from the
numbers. For example, consider the table set forth below listing the revenue
sources for the five companies.
-------------------------------------------------------
REVENUE SOURCES
Electric Gas Diversified
Washington 65% 17% 18%
Amber 85% 15% NA
Indigo 37% 63% NA
Lincoln 60% 30% 10%
Monroe 68% 21% 11%
-------------------------------------------------------
As can readily be seen, Monroe and Washington have very similar businesses.
Washington derives 65% of its revenues from electricity, 17% from gas and 18%
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from diversified activities. Monroe derives 68% of its revenues from
electricity, 21% from gas and 11% from diversified activities. Amber, on the
other hand has no diversified businesses and derives 85% of its revenues from
electricity and 15% from gas. Lincoln derives 60% of its revenues from
electricity, 30% from gas, and 10% from diversified activities. These three
companies are all quite similar to Monroe, with Washington and Lincoln looking
like sister companies.
Indigo, on the other hand, is quite the outlier. It derives only 37% of its
revenue from electricity, 41% from selling gas and 22% from other gas related
activities, primarily gas production and transportation. In essence, Indigo is
Monroe's mirror image.
Thus, a merger with Washington, Washington/Amber or Lincoln would merge
similarly structured companies which share a similar product or activity focus.
Alternatively, a merger with Indigo would merge companies with mirror images to
create a new company which is nearly equally balanced between electric and gas
revenues.
It must be stressed that these differences are not necessarily negative in any
way. We simply wish to stress that there are substantial difference between the
companies.
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AVERAGE PRICE FOR ELECTRICITY
It is also useful to compare the average price for electricity charged by these
potential partners. To accomplish this, and to account for the different manner
in which revenues were reported by the various companies, we took the total
revenue associated with both on-system and off-system sales and divided that
number by the total kWh sold both on-system and off-system. This calculation
yields the average price for both retail and wholesale transactions. The table
below sets forth this analysis.
-------------------------------------------------------
AVERAGE KWH PRICE
Washington 4.9 CENTS
Amber 4.9 CENTS
Indigo 5.1 CENTS
Lincoln 5.5 CENTS
Monroe 5.2 CENTS
-------------------------------------------------------
All these prices are well below the national average. A quick analysis reveals
that a merger with Washington might drop Monroe's average price while a merger
with Lincoln might cause a slight price increase. Of course, comparing
different specific tariffs could change these rankings. For example, the
average residential price for Washington is higher than it is for Indigo. This
is related to the fact that Washington's commercial and industrial rates are
somewhat lower than Indigo's and there might be differences in the mix of
residential customers, E.G. heating and non-heating.
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Additionally, different rankings are also obtained if only on system sales are
considered. These are shown in the table set forth below.
-------------------------------------------------------
AVERAGE KWH PRICE - - ON SYSTEM
Washington 6.0 CENTS
Amber 5.0 CENTS
Indigo 6.0 CENTS
Lincoln 6.2 CENTS
Monroe 5.7 CENTS
-------------------------------------------------------
The differences in the two tables points out potential differences in the
strategies pursued by the merger candidates for recovering their full costs.
Those companies with the largest off-system sales find their average kWh price
driven down in relation to their average on-system price. Thus, Amber's prices
change imperceptibly, largely reflecting the lack of off-system sales.
Washington, with the largest differential, reflects both the largest off-system
sales and the second highest on-system price. Thus, it has the highest price
differential between average and on-system average kWh prices.
VISION OF THE FUTURE
The differences in these companies becomes more apparent when their visions of
the future (as set forth in their annual reports) are examined. Much can be
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learned from the strategies stated in these mission statements. The table below
sets these forth.
- --------------------------------------------------------------------------------
COMPARISON OF UTILITY STRATEGIES
MISSION STATEMENTS
Monroe Monroe will be the supplier of choice for its products and
services through outstanding performance and responsible
Corporate Citizenship.
Washington Working hard to understand what customers want; high reliability
and low prices are givens. Committed to offering value-added
customer services.
Amber Earnings have experienced peaks and valleys. Filed rate increase
requests essential to guarantee strong earnings, and continue
their commitment to be a well-managed, dedicated, focused
company.
Lincoln To succeed in an increasingly competitive environment, Lincoln is
committed to a performance level to equal or exceed that of the
best companies in the industry.
Indigo Goal is to become the first national U.S. utility, and to provide
choice and lower cost to customers. Committed to leading the
process of redefining the electric utility industry and setting
competitive standards.
- --------------------------------------------------------------------------------
Monroe states that it wants to be the supplier of choice for products and
services by providing outstanding performance and responsible corporate
citizenship. The key here is winning the customer at the retail level.
Washington is working hard to gain a clear understanding as to their customers
requirements and desires. They strive to provide high reliability in
conjunction with low prices. They seek to add services which will enhance value
to their customers.
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Amber is strikingly different in that they simply list a litany of their
complaints and note that they have filed a rate case in an effort to guarantee
strong earnings. They strive to continue to be a well-managed, dedicated and
focused company. Amber seems determined to play by the old rules and look for
someone to blame if new rules harm their earnings ability.
Indigo has a very clear and strong strategy. Its goal is to become the first
national U.S. utility. It wants to provide choice and lower cost to its
customers. Indigo is committed to leading the process which is redefining the
electric utility industry. It wants to be the one to set competitive standards.
There is a strong proactive position voiced. It wants to establish its branded
product and win market share.
[REDACTED LANGUAGE]
The two strongly stated strategies belong to Washington and Indigo. Washington
leans towards a customer focus. It wants to build its base by focusing on
customer relationships with its existing customer base. They want to do it the
"old-fashioned" way, from the bottom up and will continue to stress production,
I.E. generation.
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Indigo wants to develop a branded product and achieve market share from that
brand. Indigo seeks to go aggressively into the market and acquire market
share.
In the long-run, both companies want to be successful, low-cost energy
providers. The difference is the focus on the means to achieve that end. No
one can predict which is the superior strategy. Indeed, both may be extremely
successful. The difference lies in the focus. Washington focuses on customers
and Indigo focuses on commodities.
Currently, Monroe's strategy would appear to more closely aligned with
Washington's strategy. However, to the extent the Board prefers the branded
notion of the electric industry's future, and to the extent that the Board
wishes to aggressively take an early position in forming a national energy
utility, the Indigo strategy is the appropriate focus.
Again, we wish to stress that no one can predict which, if either, strategy will
prove to be the most successful. However, the Board must decide which merger
candidates' vision of the future is most closely aligned with their own. That
company should then be carefully considered for merger.
COMPARISON OF UTILITY STRATEGIES
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A subjective way to look at these alternatives is to look at several key
characteristics. Although the comparisons are subjective, we believe them to be
significant. The table set forth below shows these comparisons.
- -------------------------------------------------------------------------------------------------------------------
COMPARISON OF UTILITY STRATEGIES
- --------------------------------
UTILITY Similar Nuclear Contiguous Similar Regional Regulatory Control of
- ------- Product Mix Commitment Electric Strategy Strength Diversity Future
Monroe Plus Operations Vision Synergy
Washington Y Y N Y Y Y Y
Washington/Amber Y Y Y Y Y Y Y
Lincoln Y Y Y ? Y N Uncertain
Indigo N N N ? or N N Y Dilution?
- -------------------------------------------------------------------------------------------------------------------
CUSTOMER MIX
Combining Monroe with Washington results in a similar product mix. The same
holds true for both the Monroe/Washington/Amber and Monroe/Lincoln combination.
However, Indigo with its 2/3 natural gas, 1/3 electric makeup, results in a
different product mix. This is essentially due to the first three choices
having a similar electric and gas composition, while Indigo is a mirror image of
Monroe.
NUCLEAR COMMITMENT
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Monroe is the only nuclear operator. However, Washington and Lincoln both have
contractual relations with nuclear operators and meet a least part of their
power requirements through nuclear power. Amber and Indigo have neither nuclear
power nor any contractual obligations related to nuclear power. Thus, a
combination with Indigo would spread the risks associated with nuclear power
over a larger asset base. Regulators in the states in which Indigo operates
could block some of this risk spreading. To a lesser extent, this is also true
for Amber. However, given Indigo's expansion plans and philosophy, there is no
guarantee that Indigo would not seek to merge or acquire a utility with a large
nuclear component in the future. But at the present, Indigo offers the
opportunity to dilute the nuclear risk.
CONTIGUOUS ELECTRIC OPERATIONS
Contiguous electric operations were an important factor in earlier mergers.
Many of the gains achieved in those mergers resulted from integrated systems
savings. Because their systems are not contiguous, a Monroe merger with
Washington would achieve some of those types of savings only if an inter-tie
were built or wheeling charges were paid. Consequently, the three way merger
with Washington and Amber looks attractive because this merger results in a
large, integrated, contiguous service territory.
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Similarly, a combination with Lincoln also offers a contiguous and integrated
system and the concomitant opportunity to achieve savings similar to those which
are possible with the Monroe/Washington/Amber combination.
Indigo, on the other hand, represents a much different kind of opportunity.
There are few integrated savings benefits which can be obtained from merging
with Indigo. Such savings as are available, could not be achieved by simply
building a transmission tie or by contracting for transmission. This merger
would represent a different merger strategy. In this type of merger, savings
from system integration, while desirable if available, are not the central
reason to merge. Rather, the driving force behind this merger would be to gain
market advantages from having the brand name and from the centralized electric
and natural gas operations.
[REDACTED LANGUAGE]
REGIONAL STRENGTH
In terms of regional strength, a Monroe/Washington, Monroe/Washington/Amber or
Monroe/Lincoln combination all result in regionally strong players. All would
create strong, integrated systems with major control over transmission in their
region. Indigo, with its national branded and international focus does not
provide this regional strength. Again, this brings us back to what the future
will hold. Regional strength is important if there is value in transmission and
building long-term customer relationships. And, it is important if
manufacturing
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and low cost generation are to be emphasized. However, if the future holds that
the electric business will be primarily a branded product-based business in
which the merchant, not manufacturing, is emphasized, this regional strength is
not important.
REGULATORY DIVERSITY
Regulatory diversity refers to the differences in the regulatory structures of
the companies that the Board is considering for merger partners. Washington
possesses a completely different regulatory experience than Monroe. Thus, a
combination with Washington or Washington and Amber will provide access to the
regulatory diversity of Wisconsin. The same is not true for Lincoln. This
merger would create, in essence, an all-Iowa utility. No regulatory diversity
is achieved. Indigo hits the jackpot in this category. Located throughput the
country, it provides the benefits associated with a national company that is not
under the control of any one particular regulatory body.
CONTROL OF THE FUTURE
[REDACTED LANGUAGE]
Both Washington and Indigo have expressed their respective desires to "do"
another merger after Monroe has been consummated. It is likely that Indigo will
pursue this strategy more aggressively than will Washington. However, with
initial equal board representation, at least initially, Monroe will have a voice
in
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Indigo's plans. One advantage to a Monroe/Indigo consolidation is a resulting
size and merger strategy which would make a hostile takeover bid unlikely.
Once again, we want to stress that we are not saying that one company's strategy
and vision of the future is better than another's. Neither are we saying that
one company will guarantee you a strong voice in the future. Our objective is
simply to point out the differences between the various companies and highlight
where those company's objectives and strategies might differ from Monroe's
objectives.
METHODS USED TO ESTIMATE SYNERGY SAVINGS
In estimating the synergy benefits which are potentially achievable from these
various mergers, we utilized three different methods. First, we used publicly
available information such as FERC Forms 1 and 2, annual reports, and SEC
documents, to accumulate information. This information was buttressed by our
experience in previous electric and gas mergers and information provided to us
by Monroe. This combined set of information and knowledge was used to develop
the assumptions from which we estimated the potential savings.
The second approach was used as a check on the principal approach. We backed
into savings estimates utilizing key ratios. These ratios include kWh sales,
operating expenses, revenue, customers and assets.
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The third approach is a statistical estimating technique which we have developed
to estimate potential merger savings. Its R squared is 92, indicating high
predictive success. This approach was also used to serve as a check on the
primary approach.
EXPECTED MEDIAN SYNERGY SAVINGS FROM USING PUBLICLY AVAILABLE DATA
The merger of Monroe with one or more neighboring utilities would create
substantial opportunities for cost savings and revenue enhancements. These
would increase shareholder value and allow utility rates to be lower than
otherwise. The following analysis quantifies these potential gains utilizing
publicly available data from FERC Forms 1 and 2, annual reports, and SEC
filings. In addition, we have utilized information provided by Monroe to refine
some data and assumptions used in this analysis. There was however, no direct
communication with any person from any of the potential merger targets for which
this analysis was completed.
This analysis includes several options:
1. Monroe combined with Washington;
2. Monroe combined with Washington and Amber;
3. Monroe combined with Indigo; and
4. Monroe combined with Lincoln.
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We begin with an analysis of the potential merger partners. All the potential
combinations consider the same general savings categories, with different
assumptions, where appropriate, used to reflect more accurately the varying
underlying situations and explicit strategies related to specific alternatives.
The general categories in recent merger cases are related to specific categories
of savings and revenue enhancement which cannot be attained other than merger.
Thus, savings available through re-engineering processes are not included. The
general categories we included in the initial analysis include:
1. Labor, both corporate and operations;
2. Administrative and general;
3. Operations and maintenance;
4. Fuel supply and purchased power;
5. Gas supply; and
6. Integrated generation system (either savings or potential new sales);
This analysis of the savings attributable to the various potential mergers was
limited because we had no direct intervention with the various companies, other
than Monroe. This limited our direct analysis of actual costs and changes which
would be attributable to merger related activities. Consequently, we relied
only upon publicly available information and information provided by Monroe to
estimate potential savings. We complemented this with both direct and
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statistical comparisons for other completed and proposed mergers. We
specifically relied upon savings attained and used these as proxies for
anticipated savings in the options we analyzed in this Report.
In order to complete a more detailed assessment of all the potential merger
benefits, we would need to work, on a day-to-day basis with members of working
groups from each prospective merger team. In this way, the knowledge and
experience of individuals intimately familiar with each respective company's
operations would be coupled with the merger related experience of AAEC personnel
to compile a more detailed analysis. Nevertheless, the analysis herein has been
subject to detailed scrutiny by study teams both in AAEC and Monroe.
Savings and revenue enhancement were quantified on a nominal basis over a ten-
year period because that is the way in which regulatory Commissions typically
analyze the savings attributable to a merger. Elsewhere in this Report, we
discuss how these savings might be allocated between shareholders and ratepayers
and look at the cumulative savings from both the process redesign effort and the
merger. However, in the following section, the savings and revenue enhancement
are presented on a nominal basis over ten years, and no attempt is made to
estimate the percentages which would go to shareholders and ratepayers.
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With these limiting caveats in mind, the following sections discuss the various
savings categories analyzed, the assumptions which were utilized, those
instances where differing assumptions were used for the various merger
combination possibilities, the estimated achievable savings and, where relevant,
revenue growth associated with each potential combination.
LABOR
Merging two utilities presents opportunities to eliminate positions made
redundant, primarily in the corporate, administrative and technical support
areas. Redundant positions in operations are much more difficult to achieve,
unless service areas overlap substantially. This can occur when gas operations
of one company overlap electric operations of another. However, for the most
part, redundancies in operations are often insignificant unless a service
company can outsource these activities. Conversely, a merger provides an
opportunity to consolidate administrative functions especially when payroll
functions do not tend to vary much with an increase in customers. Labor
categories where such savings can be expected are the following:
- Executives
- Treasury
- Investor relations
- Tax
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- Accounting
- Internal audit
- Public relations
- Public affairs
- Information systems
- Personnel
- Industrial relations
- Division safety
- General services and purchasing (net of fuel)
- Customers services
- Industrial services
- Rates and research
- Corporate planning
- Marketing
- Legal
In each of these categories, redundancies are determined, ideally, through a
detailed, time intensive analysis performed with teams from each of the merging
utilities very familiar with the departmental operations. In this way, related
tasks can be assigned to a specific function and redundancies identified. For
this Report, such detailed work was not possible. Therefore, we utilized very
conservative assumptions based upon other specific merger studies in which we
have been directly involved or with which we are otherwise familiar.
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There was no other way to determine definitively the number of redundant
positions in each category. Therefore, we used a percentage of the total
workforce to estimate potential redundancy. To calculate the gross savings
achievable from eliminating these positions, a weighted average annual salary
was computed for the combined workforce and an assumed loading factor of 42.5%
(to account for fringe benefits) was applied. This was multiplied by the total
positions eliminated. An escalation rate of 4% was then applied to the annual
savings to account for wage and benefits inflation.
To accomplish the elimination of redundant positions as rapidly as possible, we
further assumed that, in addition to an annual attrition rate of 2%(4), many
positions could be eliminated through offering an early retirement program.
These programs can take many different forms, varying widely with respect to
which employees are eligible and how much the program will cost per employee.
For our purposes we utilize Washington as a base case and assume that
approximately 7% of the combined Monroe/Washington workforce would be eligible
(E.G. over 55 years of age) and that one-half (3.5%) of those eligible would
accept the early retirement offer, at a per-employee cost of $40,000. To be
consistent, we utilize the same early retirement parameters for all merger
possibilities analyzed here.
- --------------------
(4) A 4% attrition rate was used for Indigo. The 2% rate reflects the recent
early retirement programs instituted at Monroe, Lincoln and Washington. For the
Amber/Washington/Monroe combination, 2.4% was used, reflecting a weighted
average.
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Certain executive positions are also considered redundant. We used an annual
executive compensation (in all situations) of $150,000 and a severance pay
totaling 2.0 times annual salary will be required to eliminate the redundant
positions.
Each potential merger requires some relocation. As a base case in each merger
we assume that 200 employees will have to be relocated at a cost of about $3,000
per employee. This assumes that the merged companies will centralize specific
functions in one location rather than maintaining separate locations.
Additionally, retraining costs have been calculated. It is not realistic to
assume that early retirement and attrition will simply occur in those positions
identified as redundant. Some retraining will be necessary. During retraining,
employee efficiency will likely suffer. To quantify this reduction in
efficiency, we have assumed that for every two people who leave, either through
attrition or early retirement, one person will require retraining. It is
further assumed that retraining will result in a one third loss in efficiency
over a six month retraining period. We quantify this loss in terms of average
annual employee salary. This is accomplished by dividing the average fully-
loaded annual salary in half (to represent a six month efficiency reduction) and
then multiplying the result by .33 (to represent a one-third loss in
efficiency).
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This analysis can readily be recalibrated by varying the explicit assumptions.
For example, the redundant positions can be changed by increasing or decreasing
the percentage of the combined workforce which is eliminated. We have in fact,
completed analysis of the merger combinations at redundancies at 4%, 5% and 6%.
Similarly, redundant positions can be eliminated solely through attrition. This
Report presents only the results of the median detailed above (5% workforce
reduction). Based on recent mergers this is a rather conservative estimate of
the achievable savings.
MONROE/WASHINGTON
The Monroe/Washington consolidation utilizes these basic parameters just
reviewed. The combined workforce for the two companies totals 3,904 (Monroe
with 1,513 and Washington with 2,391). The employee totals for Monroe reflect
the 400 person reduction contemplated by the company's current re-engineering
plan. Therefore, only redundancies associated with the merger are considered in
this Report. Additionally 650 positions associated with nuclear operations and
200 employees associated with diversified operations were excluded. In our
analysis, only those employees in non-nuclear electric and gas operations were
considered. Applying the 5% employee reduction assumption results in an
estimate of 195 redundant positions. The weighted average annual salary for the
combined workforce is $40,249 (Monroe with $36,960/39% and Washington
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with $42,353/61%). This analysis also includes the elimination of four
executive level positions.
These assumptions result in total gross labor related savings of $156,339,000
over ten years. Subtracting the $16,064,000 in early retirement and retraining
costs required to achieve the labor savings leaves net labor savings, over ten
years of $140,275,000. The yearly totals are detailed in Exhibit 6 which is
appended to this Report.
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MONROE/WASHINGTON/AMBER
The three way consolidation between Monroe, Washington and Amber utilizes the
same general parameters as those utilized in the Monroe/Washington
consolidation. The combined companies have 4,844 employees (Monroe with 1,513,
Washington with 2,391 and Amber with 940). Applying a 5% employee reduction
results in an estimated 242 redundant positions. The weighted average salary is
$40,219 (Monroe with $36,690/31%, Washington with $42,353/49% and Amber with
$40,042/20%).
These assumptions result in total gross savings of $195,088,000 over ten years.
Subtracting the $16,960,000 in costs required to achieve the savings would yield
a net labor savings, over ten years of $178,128,000. The yearly totals are
detailed in Exhibit 7 which is appended to this Report.
MONROE/INDIGO
The Monroe/Indigo consolidation was slightly more problematic. The Indigo
system is very widespread and is not integrated. A Monroe/Indigo combination
will not result in an integrated system. Additionally, Indigo is the only
system where natural gas, not electricity, predominates. Consequently, we
determined that these differences would make redundant positions more difficult
to identify. However, we assumed (simply to avoid any notion of bias and for
consistency) that consolidating company headquarters and operations would allow
5% labor force reductions. Thus, we used the 5% figure. The combined company
would
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have 4,643 employees (Monroe with 1,513 and Indigo with 3,130)(5). Applying the
5% labor reduction assumption results in 282 redundant positions. The weighted
average annual salary is $29,028 (Monroe at $36,960/27% and Indigo at
$26,095/72%).
These combine to yield ten year gross savings of $135,723,000. The costs to
attain the savings total $11,053,000. Net savings over ten years amount to
$124,671,000. Without further analyzing the manner in which the corporate and
administrative functions would be structured in a Monroe/Indigo merger, it is
not possible to know the extent to which the 5% rate is too aggressive.
However, to be consistent, we use the 5% rate. The yearly totals are detailed
in Exhibit 8 which is appended to this Report.(6)
MONROE/LINCOLN
A Monroe/Lincoln merger also presents a rather unique situation. Lincoln, in
its current form, resulted from a series of very recent mergers, the last of
which has just recently been completed. The initial difficulty in assessing the
potential merger savings is that there is, as of yet, a paucity of data
available for the newly merged company. Therefore, the two companies which
comprise Lincoln must be first analyzed individually, put together, and then
combined once more
- --------------------
(5) The Indigo labor force totals include only those employees involved in U.S.
electric and gas utility operations.
(6) This exhibit does not reflect a one-time $25 million tax benefit which is
unique to the Monroe/Indigo combination.
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with Monroe. These extra steps necessitate manipulating the base rate, as
detailed below.
This recently completed merger which resulted in the formation of Lincoln was
approached as follows. We first attempted to account for this merger by
calculating what the projected 10-year savings would have resulted for just this
completed merger. We used a 7.4% labor redundancy rate because this higher rate
is what the company has reported.(7) This results in 250 redundant positions.
The weighted average annual salary is $36,153 (Company A at $33,036/40% and
Company B at $38,232/60%), which formed Lincoln. These assumptions result in
total gross savings of $177,852,000. Subtracting the $14,596,000 in costs
required to achieve the savings leaves net labor savings over ten years of
$163,256,000. These yearly totals for Lincoln standing alone are detailed in
Exhibit 10 which is appended in this Report. The results for the 10 year
analysis total $494,905,000. The yearly totals can be seen in Exhibit 9 which
is appended to this Report. Lincoln currently estimates that the ten year
savings from the merger will be approximately $500,000,000.
We then took the combined Lincoln and combined it with Monroe. The newly formed
Lincoln entity would have a combined workforce of 2,732 (representing 250
redundant positions eliminated plus an additional 400 reduced through re-
- --------------------
(7) "A Merger of Equals: The Making of 'Lincoln'" PUBLIC UTILITIES FORTNIGHTLY,
page 33, July 15, 1995.
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engineering). Consequently, the combined workforce totals 4,255 (Monroe with
1,513 and Lincoln with 2,732). We then took a 2.5% workforce reduction
reasoning that it will be more difficult to gain additional redundancies in
subsequent mergers. This resulted in 106 redundant positions. The weighted
average annual salary is $36,711 (Monroe at $36,960/36% and Lincoln at
$36,570/64%).
These assumptions result in total gross savings of $83,111,000 over ten years.
Subtracting the $13,933,000 in costs required to achieve the savings leaves net
labor savings, over ten years of $69,177,000. The yearly totals can be seen in
Exhibit 10 which is appended to this Report.
Thus, although the Monroe/Lincoln merger results in a large company, net labor
savings are only $69,178,000. This reflects that the recently completed merger
would, by itself, generate $163,256,000 in labor savings.
ADMINISTRATIVE AND GENERAL
Certain administrative and corporate functions which, prior to the merger, were
performed by employees of each company can often be integrated. Substantial
merger related savings can be realized from consolidating and eliminating
duplicate programs and expenditures. Additionally, certain purchasing economies
are created due to the merged company's increased size. In the following
section, administrative and general functions and expenses are
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identified where potential merger related savings may be found. Again, it must
be emphasized that this information is not based on an in-depth analysis
performed with merger teams from the various companies analyzed. Rather, the
information was gleaned exclusively from publicly available information such as
FERC Forms 1 and 2, annual reports and SEC reports. To this raw data, we
applied certain savings rates, which are detailed below, and which are based on
our previous experience in analyzing other merger related savings. These
initial reductions were further refined in discussions with Monroe's management
so that the rates used were validated to the highest degree possible without
consulting with merger teams from the respective targets.
We have identified and quantified merger related savings in the following
administrative and general expenses categories:
- Advertising;
- Bank credit lines and fees;
- Directors fees;
- Employee overhead;
- Insurance;
- Investor relations;
- Regulatory costs;
- Material management;
- New York Stock Exchange fees;
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- Tax and SEC publications;
- Tree trimming;
- Professional services (including Audit, Benefit Plan
Administrator, Engineering, Financial and Accounting, Legal, Personnel
Consulting, and Rating Agencies).
Other potential savings areas were not quantified as it was not possible to
venture even an educated guess as to the potential savings without discussions
with both companies (which was not possible at this juncture). These include
redundant information systems expenses(8), redundant nuclear administration and
management, redundant demand side management administration, duplicative
association fees, lobbying costs and political contributions.
The general approaches which were made in these categories listed above are set
forth below. Unless specifically noted, the same parameters were applied to
each potential merger candidate. Only opportunities for savings which would
result from the merger have been categorized and quantified. An escalator of 4%
annually has been applied to the ten year savings projections to account for
inflation.
- --------------------
(8) This category includes the elimination of any outsourced contracts, parallel
development plans, elimination of mainframe computer or personal computer
purchases, software and hardware licensing fees, upgrades, and maintenance
costs.
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ADVERTISING: Although the general level of advertising is not expected to
decline following the merger, there will be opportunities to reduce the spending
levels associated with advertising. Each potential merger has slightly
different geographical implications. For example, Monroe/Lincoln provides for
overlapping media coverage in Iowa. To a lesser degree, this is also true for
the Monroe/Washington/Amber combination. The overlap for a Monroe/Washington
combination is less clear because the companies are in different states.
Similarly, a Monroe/Indigo combination has an even more tenuous geographic
overlap. Nevertheless, cost savings can be attained through eliminating
duplicate internal fixed production costs related to supporting the outside
advertising. In all cases, we have used a reduction of 50% in the smaller
utility's advertising budget.
BANK CREDIT LINES AND FEES: By combining the companies, savings can be attained
by consolidating banking activities. We have assumed that each company spends
approximately $50,000 per year in these costs and that that 50% of one company's
expenditures could be saved.
DIRECTORS' FEES: The fees and expenses paid to two boards can be reduced when
the boards of the respective companies are combined. We assumed that the board
of the merged company will be larger than either of the existing boards.
Therefore, 50% of the smaller company's (or 50% of the smaller board
expenditure) was assumed to be saved.
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EMPLOYEE OVERHEAD: This category assumes that there will be savings in employee
overhead associated with workforce reductions. Included are savings associated
with a reduced need for personal computers, telephone charges, copy charges and
office supplies. It is assumed that the overhead cost averages $2000 per
employee. Thus, this amount is multiplied by the number of redundant employees
to arrive at the employee overhead savings figure.
INSURANCE: Cost savings are attainable in property insurance, excess general
liability insurance, officers and directors' liability and other insurance due
to the combined company's increased size and concomitant reduced risk profile.
In this analysis, we have assumed that 10% of the combined insurance costs could
be saved. However, for Monroe/Lincoln, we assumed that the recent merger which
formed Lincoln has already captured substantial savings in this category.
Therefore, we applied the 10% savings for only Monroe's costs.
INVESTOR RELATIONS: Combining the companies will mean that, ultimately, only
one annual report, one set of quarterly reports, one proxy statement and one set
of shareholder communications would be required. These savings cannot all be
realized during the first year due to increased reporting and disclosure
obligations during the initial year following the merger. We assume, therefore,
that 75% of the smaller company's expenditures can be ultimately saved. Only
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70% of this amount is likely to accrue during the first year, but 100% should be
fully recoverable by the second year following the merger.
REGULATORY COSTS: For certain combinations, regulatory savings are available at
either the state or federal level, or both. For example, some minor federal
regulatory savings can be expected with a consolidation of Monroe and
Washington. However, the two utilities will operate as stand-alone facilities
in two different states. Thus, state regulatory savings are minimal. The same
holds true for a Monroe/Indigo consolidation which might allow some federal
regulatory savings and some minor gas related regulatory savings. A
Monroe/Washington/Amber combination allows for more state regulatory savings
because Amber and Monroe are located in the same state, allowing 100% of the
smaller companies' regulatory expenses to be saved. The same holds true for a
Monroe/Lincoln merger. However, many of these savings have likely been already
attained in the recent merger which formed Lincoln. Therefore, we assumed that
only 50% of Monroe's costs could be saved.
MATERIAL MANAGEMENT: The projected savings in this category are created by the
combined company's increased purchasing power. Savings can be achieved through
centralizing the combined company's purchasing and inventory functions. Savings
can be achieved through standardizing both commodity items and equipment.
Larger purchases can often be equated with deeper discounts. These savings can
be more difficult to capture than other identified
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categories because it is necessary for the company to develop and implement a
coordinated purchasing effort, including commodity-specific action plans.
Consequently, we assume that 25% of the savings could be captured in the first
year, 50% in the second year and 100% in the third year and each year
thereafter. We very conservatively assumed that savings would amount to 2% of
total combined materials purchases.
However, the non-integrated and predominantly natural gas nature of the
Monroe/Indigo combination would make achieving the savings more difficult.
Therefore, we assumed that savings would amount to 1% of total combined
purchases, not 2%.
Similarly, for Monroe/Lincoln, it was assumed that certain economies of scale
had already been achieved in their recent, still being completed, merger.
Therefore, to avoid double-counting, we applied the 2% to Monroe's purchases
alone.
Within this category, substantial savings are also attainable by reducing
inventory. The increased size of the combined companies will offer
opportunities to standardize parts and components. This in turn would be likely
to yield a one-time reduction in the size of inventory. This Report has not
quantified potential savings associated with inventory reduction due to a lack
of information concerning the policies of the potential merger partners.
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NEW YORK STOCK EXCHANGE FEES: A combined company will need only one listing,
thereby saving this annual registration fee. The exception is the
Monroe/Washington/Amber combination which would save two such annual
registration fees.
TAX AND SEC PUBLICATIONS: We assumed that only one financial library will be
needed after the companies consolidate. These savings reflect the annual costs
associated with eliminating one library. For the Monroe/Washington/Amber
consolidation, two libraries were assumed eliminated.
TREE TRIMMING: Due to the increased purchasing power of the companies and
economies of scale, 10% of the combined companies' tree trimming costs were
assumed saved. However, only 5% of the combined Monroe/Indigo tree trimming
costs were assumed saved because Indigo's far flung system will make it more
difficult to capitalize on the increased purchasing power and economies of
scale. Also, for a Monroe/Lincoln combination, we assumed that many of these
costs had been already recovered in the recent merger which formed Lincoln.
Therefore, we applied the 10% only to Monroe's expenditures.
PROFESSIONAL SERVICES: This category consists of outside services which are not
specifically broken out in the FERC Forms 1 and 2. These include Audit, Benefit
Plan Administrator, Engineering, Financial and Accounting, Legal, Personnel
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Consulting, and Rating Agencies. We assumed that eliminating duplicate services
would result in annual savings totaling 50% of the smaller company's
expenditures. Again, due to the recent Lincoln merger, we applied the 50% only
to Monroe's expenditures.
The estimated ten-year Administrative and General savings are as follows:
- Monroe/Washington: $63,857,000;
- Monroe/Washington/Amber: $89,763,000;
- Monroe/Indigo: $56,878,000; and
- Monroe/Lincoln: $43,432,000.
The yearly detail for each combination is in Exhibits 7,8,9 and 11,
respectively, which are appended to this Report. By way of comparison, we
estimated that the merger which formed Lincoln would have resulted in 10-year
A&G savings of $57,489,000. The yearly detail is shown in Exhibit 10 which is
appended to this Report.
OPERATIONS AND MAINTENANCE
The savings achievable in the O&M category represent the elimination of
redundancies in O&M expenses.(9) These do not include labor, fuel purchases or
purchased power expenses. A 4.5% escalator was applied to the ten-year savings
totals to account for inflation. We used this slightly higher escalator to
- --------------------
(9) Some of these savings are likely achievable through Monroe's ongoing
re-engineering program. Thus, when we consider the results of a merger and a
re-engineering program, we assume that 1/3 of the O&M merger savings could be
achieved through re-engineering.
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account for inflationary effects which are likely to be greater than for Labor
and A&G. To calculate savings, the companies' combined O&M expenses were taken
from FERC Forms 1 and 2. For the Monroe/Washington and Monroe/Washington/Amber
consolidations, the economies of scale were based on a savings rate of 3% of
total O&M expenditures. For Monroe/Indigo, the non-contiguous, far-flung nature
of the Indigo system makes attaining these savings more difficult.
Consequently, the savings rate used was 1.5% of the combined expenditures. The
3.0% savings rate was also used for Monroe/Lincoln, recognizing that although
savings have likely been already achieved in the merger which formed Lincoln,
the Lincoln system is so integrated with Monroe that additional savings are
likely. However, to avoid double counting, the 3% was applied only to Monroe's
O&M purchases. In this way the savings already attained (or to be attained)
because of the merger which formed Lincoln will not be attributed to a
Monroe/Lincoln merger. The ten year totals are as follows (with the alternate
3% calculations listed in parentheses):
- Monroe/Washington: $48,651,000;
- Monroe/Washington/Amber: $57,063,000;
- Monroe/Indigo: $30,990,000; and
- Monroe/Lincoln: $24,641,000.
The annual savings totals are detailed in Exhibits 6,7,8 and 10, respectively,
which are appended to this Report.
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FUEL SUPPLY AND PURCHASED POWER
This savings category represents savings which are achievable in fuel purchases
and purchased power expenses. There are two savings sub-categories represented
here. The first is the ability to negotiate more favorable terms with suppliers
due to increased size and purchasing power. The second relates to savings
representing the ability to dispatch the electric system in a more efficient
manner. To estimate the savings, total fuel purchases and purchased power
expenses for the combined companies were first totaled. Based on these
assumptions the combined companies are assumed to save 3% for the total expenses
in this category. As with O&M costs, we used a 4.5% escalator to account for a
slightly higher inflation rate.
Monroe/Indigo was treated differently. Due to the far-flung, non-contiguous
nature of the Indigo system, it is difficult to identify savings that could be
achieved in this category. However, because Indigo has recently announced a
"one-stop" shopping source for its fuel needs, we assumed that the savings which
would be attributable to Indigo's purchases have already been achieved. Thus,
we applied the 3% to only Monroe's purchases.
Monroe/Lincoln was also treated differently. We assumed that substantial
savings had already been achieved in the merger which formed Lincoln.
Therefore, to avoid double counting, the 3% was applied to only Monroe's total
purchases.
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The projected savings are summarized below:
- Monroe/Washington: $109,831,000;
- Monroe/Washington/Amber: $144,330,000;
- Monroe/Indigo: $50,198,000; and
- Monroe/Lincoln: $50,198,000.
The yearly savings totals are detailed in Exhibits 6,7,8 and 10, respectively,
which are appended to this Report.
GAS SUPPLY
This savings category represents savings in the purchased and delivered cost of
gas. This category has two sub-categories. These include the ability of the
combined companies to use their increased size and purchasing power to obtain
more favorable terms with suppliers. The second sub-category is classified as
savings attributable to routing or transportation. This represents the
increased ability to exploit displacement opportunities available with a larger
system with a greater number of nodes. To calculate savings, the total amount
paid by the merging companies for natural gas was reduced by a percentage. For
the same reasons used for fuel, we applied the savings percentages to only
Monroe's purchases when analyzing the Monroe/Lincoln and Monroe/Indigo mergers.
As with O&M and Fuel Purchases, we applied a 4.5% escalator to account for
inflation.
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The ten-year savings for the various merger combinations are as follow:
- Monroe/Washington: $22,157,000(10);
- Monroe/Washington/Amber: $41,455,000(11);
- Monroe/Indigo: $22,883,000; and
- Monroe/Lincoln: $22,883,000.
The annual savings are detailed in Exhibits 6,7,8 and 10, respectively, which
are appended to this Report.
GENERATION SYSTEM
This savings category represents the benefits from integrating the power
systems. There are three sub-categories. The first is COINCIDENT PEAK, which
represents the savings associated with combining systems with distinct peak
timings. To calculate the ten-year savings, the combined capacity of the merged
companies is multiplied by the cost of peaking capacity (assumed to be $300/KW).
This is then multiplied by an annual carrying cost of 18%. This is multiplied
by 1% to represent either savings or off-system sales revenue potential. The
same conservative percentage is applied to all merger candidates. However, due
to Indigo's far flung system, only one of Indigo's electric subsidiaries could
be interconnected through constructing an interconnection or contracting for
transmission. Thus, only the capacity of this
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(10) No savings are allocated for routing or transportation because the systems
are not connected and share no common carrier.
(11) Savings reflect the lack of a Washington interconnect noted in the previous
footnote.
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subsidiary is utilized for Indigo. Once again, we applied a 4.5% escalator to
account for inflation.
The ten-year benefits (with the second Monroe/Indigo computation in parenthesis)
are as follows:
- Monroe/Washington: $25,255,000;
- Monroe/Washington/Amber: $31,911,000;
- Monroe/Indigo: $16,329,000; and
- Monroe/Lincoln: $40,922,000.
The annual total effects are detailed in Exhibits 6,7,8 and 10, respectively,
which are appended to this Report.
The second sub-category under generation is benefit from the REDUCED RESERVE
REQUIREMENT associated with a larger system. The estimated benefits in this
category are also set at 1% in the base case for each merger option. Thus the
savings totals are the same for reduced reserve requirement and coincident peak.
They are as follows:
- Monroe/Washington: $25,255,000;
- Monroe/Washington/Amber: $31,911,000;
- Monroe/Indigo: $16,329,000; and
- Monroe/Lincoln: $40,922,000.
The annual savings totals are seen in Exhibits 6,7,8 and 10, respectively, which
are appended to this Report.
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The third sub-category under generation is based on the savings achievable by
moving the newly integrated system towards the Monroe risk taking strategy which
relies on a higher percentage of peaking versus base-load capacity (MARKET
POTENTIAL). The calculation used is slightly different than for the previous
subcategories. For this sub-category, the merger partner's capacity is
multiplied by the difference in the cost of baseload capacity (assumed to be
$1100/KW) and the cost of peaking capacity (again assumed to be $300/KW). The
resulting number is then multiplied by the annual carrying cost of 18%. This is
then multiplied by an assumed 2% benefits in all potential combinations. The
ten-year savings totals are as follows:
- Monroe/Washington: $66,746,000;
- Monroe/Washington/Amber: $102,242,000;
- Monroe/Indigo: $37,053,000; and
- Monroe/Lincoln: $150,302,000.
The annual savings totals are detailed in Exhibits 6,7,8 and 10, respectively,
which are appended to this Report.
AVERAGE PRELIMINARY COMPARISON TO OTHER MERGERS
To serve as a check on the above analysis, we also backed into potential savings
totals for each of the merger candidates. We analyzed the savings claimed in
previous electric and natural gas mergers. We then analyzed these claimed
savings as percentages of the various operating categories identified
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above (kWh sales, operating expenses, revenues, customers and assets). Thus,
average annual claimed savings on a per 1000 kWh sold and per customer basis
were calculated. Average annual savings were also measured as a percent of
total annual operating expenses and revenue. Total claimed savings over a ten
year period were also measured as a percent of the total assets of the combined
companies. From this analysis, we developed mean ratios for each of these
categories. These means were then utilized to calculate the savings, for each
key ratio, that each of these merger candidates would need to attain to achieve
the mean. Those results are contained in the table below.
- --------------------------------------------------------------------------------
PRELIMINARY COMPARISON TO OTHER
- -------------------------------
(in millions) WASHINGTON WASHINGTON/AMBER INDIGO LINCOLN
kWh 462 572 461 655
Expenses 339 420 312 444
Revenue 257 320 258 374
Customers 381 469 411 521
AVERAGE 360 445 361 499
Assets 277 339 266 424
- --------------------------------------------------------------------------------
The circumstances in every merger of electric and gas utilities is unique.
There are as many possible scenarios as there are mergers. Some are mergers of
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equals(12), some are large companies taking over smaller ones(13), some are
financially troubled utilities, on the verge or in bankruptcy, being acquired by
a financially healthier company(14), some are hostile takeovers(15), and some
are friendly takeovers fending off a hostile suitor(16). Merger benefits are
typically claimed over periods of ten years. However, some mergers have
analyzed claimed benefits over a period as long as fifteen years(17) or as short
as five years(18). In regulatory hearings, some companies have attempted to
calculate savings for periods as long as forty years(19). However, the typical
savings period is the ten year period which we have utilized here and which the
FERC considers.
This method loses the distinction between the differences in contiguousness.
Thus, the analysis projects virtually the same savings from Washington and
Indigo. Including Amber into the Washington mix substantially increases the
projected savings. Also, because the combination with Lincoln results in the
largest electric utility in terms of kWh sales, this analysis produces the
largest predicted savings in this comparison category. This method simply looks
at various characteristics and does not take into account real world
differences.
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(12) CG&E/PSI; CEI/TE
(13) Southern/Savannah
(14) NEU/PSNH
(15) SCE/SDG&E
(16) KPL/KG&E
(17) CEI/TE
(18) PacifiCorp/Utah P&L
(19) KPL/KG&E
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Therefore, the results of this analysis should be used simply to validate the
more detailed study that we completed using publicly available information.
REGRESSION ANALYSIS
The regression analysis is a statistical analysis which is driven by similar key
factors as the ones utilized in the "Back-in" analysis described above.
Utilizing data from previous merges, the regression analysis predicts, using key
variables for each of the merger candidates, what the merger savings would be in
each case. The regression has a very high R square, suggesting that it is a
strong predicative tool. To demonstrate the accurateness of this tool, we used
the model to "predict" the savings claimed in recent mergers. The table below
demonstrates the model's high success level, showing the claimed savings in one
column and the savings predicted in another column.
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REGRESSION ANALYSIS
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SIZE AS TOTAL CLAIMED SAVINGS PREDICTED
MERGER MEASURED BY 10 YEAR SAVINGS BY REGRESSION
ANNUAL kWh (THOUSANDS)
SALES
(THOUSANDS)
NEU 38,000,000 $791,000 778,000
PSNH
KP&L 18,000,000 $280,000 408,000
KG&E
IOWA POWER 9,000,000 $109,000 190,000
IOWA PS
PACIFICORP 46,000,000 $1,010,000 1,040,000
UTAH P&L
CLEVELAND 26,000,000 $900,000 665,000
TOLEDO
GULF STATES 85,000,000 $1,695,000 1,970,000
ENTERGY
SCE 86,000,000 $1,700,000 1,583,000
SDG&E
CG&E 48,000,000 $1,500,000 1,231,000
PSI
WASHINGTON WATER 17,000,000 $450,000 452,000
SIERRA PACIFIC
IOWA-ILLINOIS G&E 20,000,000 $400,000 453,000
MIDWEST RESOURCE
IOWA SOUTHERN 8,000,000 $170,000 233,000
IOWA ELECTRIC
NORTHERN STATES PWR 60,000,000 $1,000,000 1,396,000
WISCONSIN ENERGY
- --------------------------------------------------------------------------------
The predicted savings for each potential merger candidate, using the regression
analysis, are set forth in the table below.
- --------------------------------------------------------------------------------
REGRESSION RESULTS
- ------------------
WASHINGTON WASHINGTON/ INDIGO LINCOLN
AMBER
Regression Estimate
From 545 664 429 685
Recent Mergers
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The regression analysis also ignores real world differences. Here, though, we
see a difference between Washington and Indigo. Because Indigo is primarily a
gas utility, it is penalized by the regression model. Again, because it would
form a large electric utility, the Monroe/Lincoln combination produces the
largest benefits. The regression ignores the fact that Lincoln is still coming
together. Thus, like the "back-in" method, the regression method should be used
as a check on the numbers generated by the more sophisticated analysis performed
with publicly available information.
SUMMARY OF FINANCIAL COMPARISONS
The table set forth below summarizes the savings which are predicted by each
savings category.
- --------------------------------------------------------------------------------
SUMMARY OF FINANCIAL COMPARISONS
- --------------------------------
THE DETAILED ANALYSIS
---------------------
Washington Washinton/ Indigo Lincoln
Amber
Expected Median
Using Publicly 502 677 355 442
Available Data
CHECKS ON THE ANALYSIS
----------------------
Average Preliminary
Comparison to Other 360 449 361 499
Mergers (Ratios)
Regression Estimate
From 545 664 429 685
Recent Mergers
- --------------------------------------------------------------------------------
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MONROE STAND-ALONE
Monroe is currently embarking on an ambitious and aggressive process redesign
effort which is projected to result in average annual net savings approaching
$58 million. This process redesign will affect almost every aspect of Monroe's
business. These steps are based upon achieving the "best practices" of both the
utility and non-utility businesses in the United States. The savings,
particularly in labor, are very aggressive. They are likely to be achievable if
Monroe continues to dedicate management time and commitment and Monroe spends
the considerable money required on training, consultants and new information
technology.
Most of the savings are based upon the goal of achieving a top quartile, or even
a top decile performance in each targeted cost reduction/performance enhancement
category. This approach is significantly different than the manner in which
this Report calculates potential synergy gains for mergers. In nearly every
merger case, the assumptions used are very conservative and were based upon
targets established using data from other mergers either at the mean or median
or even below such benchmarks. This would put the analysis of the mergers
considered in this Report in the third quartile, while standalone savings are in
the first quartile.
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Since the merger and restructuring options are not mutually exclusive, this
important difference in estimation criteria should NOT matter. To the extent
that standalone and merger operations are viewed as alternatives, this
difference in basic approach, and assumptions would need to be reconciled. As a
general matter, most of the mergers' savings would just about double or even
triple if they were based upon the data derived from the upper quartile savings
for the various mergers in the data base used for this Report.
We have taken the savings projections for this redesign effort and converted
them into a format which is comparable to the one we used to estimate the merger
savings detailed in the previous section. Thus, we project savings on a nominal
basis(20) over a ten year period. Conceptually, it would be more appropriate to
calculate a net present value for the savings rather than to simply escalate the
savings total over ten years. However, this introduces the requirement that the
appropriate discount rate be chosen, a choice often subject to debate.
Additionally, conceptual niceties aside, all mergers quantify savings on this
escalated, nominal basis. Consequently, that is the manner in which we
approached the merger analysis. And to be consistent, we used the same approach
for the process redesign numbers. This reformatting used Monroe's own numbers.
We have not prepared these estimates nor have we made an attempt to audit or
assess how likely it is that these savings can be attained. We
- --------------------
(20) To be as consistent as possible, the process redesign numbers were
escalated at 4% annually for Labor, A&G, Capital Recovery and Costs. A 4.5%
escalator was applied to O&M and fuel savings.
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undertook this approach to put the savings attainable through process redesign
and merger on a comparable basis. The projected savings for ten years are set
forth in Exhibit 11 which is appended to this Report.
In considering the process redesign projected savings, it is crucial to keep in
mind that the process redesign effort will proceed regardless of the Board's
decision to merge with one (or more) candidate or, conversely, a decision to
forego merger at this time. Care should be taken to avoid the temptation to
compare the savings to be gained from merging with the savings to be gained
through process redesign. These savings do not represent an "either or"
situation. For the most part, both the savings from the process redesign effort
and the merger can be attained. Later in this Report, we discuss this concept
in greater detail.
It must be noted that Monroe has spent considerable time, effort and money to
develop its process redesign plan. Similarly, the savings which are projected
for the process redesign have undergone the same scrutiny. The high cost
associated with implementing the plan give us confidence that Monroe is
extremely motivated towards attaining the goals set forth in the process
redesign plan. Our merger analysis, because we were not permitted to contact
merger candidates, does not contain the same level of detail as the process
redesign plan.
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Additionally, there are certain differences between the projected savings for
the mergers and the projected savings for the process redesign which make direct
comparisons misleading. The process redesign plan does not simply utilize
companies in the top quartile or, in some instances, the top decile as
benchmarks. Rather, the best practices of each of these top performing
companies is used to benchmark the goals to be achieved in various functions
throughout the company. Just the opposite is true for our merger analysis.
Because we were not able to perform the same type of detailed analysis which was
performed for the process redesign, we used savings in the third and fourth
quartiles for recently completed mergers. This dichotomy between the aggressive
process redesign estimated savings and the conservative merger savings can be
best illustrated by considering labor savings. The process redesign
contemplates eliminating 400 positions, approximately 14.5% of Monroe's total
workforce. By contrast, the merger analysis takes, at most, 5% of the COMBINED
workforce. Additionally, before combining the workforces, we eliminated from
Monroe's workforce the 400 positions slated to be eliminated by process
redesign, 650 nuclear employees and 200 employees associated with non-utility
operations. Had the merger analysis projected savings using the same aggressive
14.5% workforce reduction assumption utilized in the process redesign, savings
for the labor category would have increased dramatically. For example, even
after eliminating the 1,250 positions referenced above,
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Washington/Monroe projected labor savings would have increased from $140 million
to approximately $263 million.
The A&G estimates are similarly aggressive. For example, on a stand-alone
basis, the process redesign effort produces almost $42 million in ten-year
savings. The Washington merger predicts savings for the combined company of
approximately $64 million for this same ten year analysis. Assuming these
savings are equally distributed between the two companies, Monroe's share would
be $32 million. Thus, the process redesign predictions are 24% more aggressive
than the merger analysis numbers.
However, the predicted O&M and Fuel savings are quite comparable. This can be
seen by comparing the Monroe Stand-Alone and Washington Median Case.
Although these savings categories look at similar things, the Merger analyses
contain categories which are achievable solely through merger. These categories
include Gas Purchases, Peak Saving, Reserve Requirement, and Market Potential.
Consequently, those savings categories do not appear in the Monroe Stand-Alone
table. Similarly, the Monroe Stand-Alone table contains a category called
Capital Recovery Factor which represents savings from the carrying costs
associated with reducing the capital budget $20 million annually. These savings
are achievable only through the process redesign efforts and are thus not
quantified in the Merger Savings.
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As mentioned earlier, there are substantial costs required to achieve the
process redesign savings. The process redesign includes ongoing training,
educational costs and amortized costs for capital improvements related to
information technology centers. These high costs, however, are consistent with
the aggressive nature of the predicted savings. Additionally, the realistic
attitude towards these costs further indicates how seriously committed Monroe's
management is to achieving these goals.
However, even though these savings estimates result from substantial work and
effort, Monroe has set the bar extremely high. While it is admirable to
challenge management and employees and to strive to be the best in each
measurement category, the final results are not clear. Thus, although Monroe
projected savings from the process redesign may be better grounded in fact than
are the merger estimates, Monroe's ability to achieve ALL the savings from
process redesign is somewhat uncertain.
By the same token, the merger savings also have some risk and uncertainty. Not
all companies achieve the merger savings which they initially predict. However,
our merger analysis acts as a screen. A detailed study involving teams from the
respective merging companies would be required to achieve a higher degree of
certainty.
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However, the most important thought to remember is that the process redesign and
merger savings are NOT mutually exclusive. In certain circumstances, the
savings categories are similar in both process redesign and mergers. Thus, it
can be difficult to distinguish, when process redesign and a merger are
proceeding simultaneously, whether it is the process redesign or the merger
synergy which is driving the savings. There will likely be some overlap.
Nevertheless, most of the savings attributable to both the process redesign and
the merger savings should be recoverable. The table below shows our estimate
for the savings, for each potential merger candidate, where the process redesign
proceeds during the merger procedure.
- --------------------------------------------------------------------------------
Merger Process Redesign 1/3 Merger Combination
(millions) (millions) O/M Savings
-----------------------------------------------------------
Washington 502 581 (16) 1,067
Washington/ 677 581 (19) 1,239
Amber
Indigo 355 581 (10) 926
Lincoln 442 581 (8) 1,015
- --------------------------------------------------------------------------------
The O&M reductions represent our best estimate as to the amount of merger
savings which are redundant to the process redesign savings.
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Thus, it is clear that there are distinct savings to be attained through both
process redesign and merger. In fact, as noted above, certain merger candidates
may offer certain synergies which could reduce process redesign costs, increase
process redesign savings, or both. Both should be pursued. The question to be
resolved by this Board of Directors is whether process redesign and merger
should be pursued simultaneously or whether merger should be pursued after
process redesign has been implemented. There are advantages and disadvantages
associated with each choice.
Both process redesign and merger can create a difficult and stressful transition
for management and employees alike. It can be argued that to do both
simultaneously would introduce unmanageable uncertainty into the workplace.
Thus, it may be more efficient, from a personnel standpoint, to take each
activity in turn. This would allow management to concentrate on the process
redesign. Different merger candidates could have varying affects on the
employee angst associated with change from either process redesign or merger.
For example, a merger with Washington or Lincoln may offer some comfort to
employees because the core, traditional utility business would remain unchanged.
On the other hand, a merger with Indigo could leave Monroe as the flagship
utility, firmly anchored in its community. Removing uncertainties associated
with relocation, retraining or job loss might reduce employee stress.
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Further, the primary benefit to completing process redesign is to drive up
earnings per share so as to create a more valuable entity by enhancing earnings
prior to merging. This would increase your shareholders' value. This benefit
depends upon regulators allowing shareholders to keep at least some of the
savings created by the process redesign. It is conceivable that more process
redesign savings can be kept by shareholders under a voluntary no rate case
strategy if there is no concomitant merger. Thus, by completing your process
redesign before merger, stress is reduced in the workplace, management can
better focus on the process redesign and you can potentially increase Monroe's
value in the market, giving Monroe more value in a future merger.
There are, however, risks involved in waiting until the completion of the
process redesign. FIRST, the regulatory plan for a stand-alone plan is riskier
than it is for a merger. Thus, it could be more difficult to retain the savings
attained in the process redesign than it will be to retain the savings in a
merger, unless the voluntary no rate case strategy works better for process
redesign. Increasing share value is dependent on regulators allowing
shareholders to retain these savings. Unless regulators allow shareholders to
keep the savings, any potential growth in market value will be, for the most
part, illusory. Additionally, with a simultaneous merger some process redesign
savings could be rolled into the merger savings. This would increase the
likelihood that regulators would allow shareholders to keep more of these
savings because mergers immediately
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flow some synergy savings to ratepayers. This fact encourages regulators to
approve a reasonable ratepayer/shareholder sharing plan. At the very least, you
need to know that this is the prevailing strategy driving several recent
mergers.
SECOND, both competition and the potential stranded cost issue loom on the
horizon. If shareholders are held responsible for stranded costs (or
substantial portions of stranded costs) utility market value will go down.
Thus, the growth of market value engendered by the process redesign could be
undermined if regulators are unable to follow through on their promises to allow
utilities to recover their stranded costs. And, competition could cause further
market value loss. If you believe that this is what the future holds, waiting
will cause your market value to erode reducing your ability to complete a
merger. Some of your potential merger partners could fair better. Others could
fair worse. The relative effects will establish the role you may play in any
future merger.
THIRD, waiting exposes you to the threat of a hostile take-over attempt.
Needless to say, this would severely affect your ability to control Monroe's
destiny. Also, the most attractive potential merger partners may not be
available if merger is delayed. Options may be fewer and control over your
destiny could be reduced. Waiting to merge may have a significant price
However, the argument holding the least validity for waiting is to ensure that
Monroe's shareholders do not have to share the process redesign savings. This
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conclusion overlooks the process redesign benefits which can be gained through a
merger. For example, if a merger partner is also undergoing process redesign,
Monroe would share in those savings. Likewise, if the merger candidate had not
started process redesign efforts, Monroe could benefit from applying its process
redesign efforts to this fatted calf. Finally, if the merger candidate had
completed its merger redesign efforts, Monroe might be able to leverage off the
merger candidate's knowledge. Additionally, costs associated with process
redesign, such as information systems, might be saved if the merger candidate,
in its process redesign, had implemented a change which could be used by Monroe.
There is no certain answer to the merits of these pro and con arguments. The
only unambiguous case would be to make Monroe's process redesign part of any
argument to establish an improved exchange value, if Monroe decides to merge at
this time. Such an outcome would be a way for Monroe shareholders to gain the
benefits of both alternatives. It would also most likely improve the regulatory
chances for the shareholders to gain a somewhat larger share of the gains
because ratepayers would also share in the synergy gains.
UNDERSTANDING THE SHARE VALUE CONSEQUENCES OF MERGERS
A merger of equals takes place by exchanging the shares of each merging company
for the shares of a new combined entity. Shareholder value may be enhanced by
three somewhat different steps. First, a premium representing a
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greater share of the initial market value might be paid to the shareholders of
one company by the shareholders of the other company. For example, let's assume
that Company A has a share price of $10 per share and that there are 100 shares
outstanding. Thus, the market value of A equals $1,000. Let's also assume that
the second company (B) has a share price of $20 per share and also has 100
shares outstanding. Thus, the market value of Company B is $2,000.
The combined market value of A and B would equal $3,000. If the shareholders in
each company retained their current market values, shareholders in Company A
would own 33 1/3 percent of the combined company and the shareholders in
Company B would own 66 2/3 percent of the combined company.
Now let's assume that at the time of the merger, Company B was willing to pay
Company A a premium to merge. For example, A and B might agree that, after
combining the two companies, the initial shareholders in Company A would own 40
percent of the new shares (not 33 1/3 percent) and the initial shareholders in
Company B would own 60 percent (not 66 2/3 percent). Such an agreement means
that Company A shareholders would receive new stock worth $1,200 (or 40 percent
of $3,000) and Company B shareholders would receive new stock worth $1,800 (or
60 percent of $3,000).
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Such an agreement would represent a 20 percent premium for the shareholders of
Company A, or an increase from $1,000 of market value to $1,200 in market value.
Shareholders in Company B, who pay the $200 premium, would accept a dilution in
market value of 10 percent because their market value declines from $2,000 to
$1,800.
In addition to a premium payment, a second step could affect the market value of
the initial shares of both companies. As standalone companies, the market
evaluates each company's dividend history, growth prospects, earnings prospects,
risk, strategic plan, and perhaps more. The financial statistic which comes
closest to representing the combination of these distinguishing factors is the
Price/Earnings ("P/E") ratio. When two companies are merged, the market will
evaluate the various factors listed above and assign a new P/E ratio to the
combined entity.
Market value might be increased or decreased, relative to the initial share
values of each company, based upon the relationship of the new combined P/E
ratio to the weighted average P/E ratio, using as weights the initial market
values of the two companies which merge. For example, suppose Company B has a
P/E ratio of 12 and company A has a P/E ratio of 9. Now, suppose there is a
merger of these two companies which possess the same standalone market values as
used in the previous discussion, I.E., $1,000 for Company A and $2,000 for
Company B.
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If there was no premium paid and the market set a new P/E ratio based upon the
weighted average of the pre-existing P/E ratios, this would mean that the new
company's P/E ratio is 11. (This is 2/3 of 12 plus 1/3 of 9.) However, if
Company B's risk, strategy, dividend policy, etc. were positively regarded by
the market, the market would give its performance a greater weight. In this
situation, both groups of shareholders would receive a premium.
In this scenario if a premium had also been paid to one company, the
shareholders in the company receiving the premium would receive a
disproportionate share of any such P/E-related gain, and vice versa.
Nevertheless, both groups of shareholders would receive some gain. This holds
true unless the market sets the new P/E ratio for the merged entities at the
lessor of the two initial company's P/E ratio.
The third step in determining the market value consequence for the shareholders
in the two companies is related to the expected annual increase in net income
(or earnings) attributable to the synergy achieved by the merger. Under the
hypothetical merger between Company A and B, there would be a new company with a
combined market value of $3,000 ($1,000 plus $2,000). Assume the combination
was achieved by exchanging two shares of Company A for one share of Company B.
This means there would be 150 shares in the new company worth $20 per share for
a market value of $3,000.
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Using the weighted P/E ratio based upon initial market values, the merged
company's P/E ratio would be 11. The earnings per share (EPS) would be about
$1.82 ($20 per share divided by 11).
Suppose the synergy savings available to shareholders (after passing on benefits
to customers, paying the costs to achieve the combination and paying taxes)
equaled $27 per year or 18 CENTS per share ($27 divided by 150 shares). The new
EPS would be $2.00 (or $1.82 + 18 CENTS). Applying the same P/E ratio of 11
results in a new share price of $22.00. The new combined company market value
would be $3,300.
In this scenario, both groups of shareholders, due to the synergy achieved,
would gain from the increased earnings. The proportionate shares would be based
upon the market values used to merge the two companies. Specifically, any
premium paid which changed the effective market values of the two companies,
would affect the allocation of synergy gains for relative shares of both groups
of shareholders.
SOME SPECIFIC MONROE ANALYSIS
In Exhibit 12 which is appended to this Report, sensitivity analyses are
performed using the concepts just described for a potential combination of
Monroe and Washington. And, Exhibit 13 contains similar sensitivity analyses
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for a three way merger between Monroe, Washington and Amber. The companies have
1995 financial data as detailed in Table I, which follows, for the pre-exchange
conditions. Based upon this current information, Washington has a market value
of about $874.1 million and Monroe has a market value of about $728.3 million,
for a combined $1,602.4 million. These respective initial shares are about 54.5
percent and 45.5 percent. The initial P/E ratios are 12.91 for Washington and
11.26 for Monroe. The P/E ratios are based on estimated 1995 earnings. The
weighted average P/E ratio is about 12.16. Similar statistics for a three way
merger are also shown.
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TABLE I
SHAREHOLDER VALUE SENSITIVITY ANALYSIS
TWO-WAY
------------------------------------------------------------------------
INITIAL VALUE PERCENT SHARE P/E RATIOS INITIAL
($ Million) STOCK PRICE
- --------------------------------------------------------------------------------------------
WASHINGTON $874.10 54.5% 12.91 $28.50
MONROE $728.28 45.4% 11.26 $25.50
- --------------------------------------------------------------------------------------------
TOTALS $1,602.38 100.0% 12.16* NA
- --------------------------------------------------------------------------------------------
THREE-WAY
------------------------------------------------------------------------
INITIAL VALUE PERCENT SHARE P/E RATIOS INITIAL
($ Million) STOCK PRICE
- --------------------------------------------------------------------------------------------
WASHINGTON $874.10 47.2% 12.91 $28.50
MONROE $728.28 39.3% 11.26 $25.50
AMBER $251.06 13.5% 12.62 $26.25
- --------------------------------------------------------------------------------------------
TOTALS $1,853.44 100.0% 12.22* NA
- --------------------------------------------------------------------------------------------
*Weighted average
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A total of 12 separate sensitivity analyses were run for the potential two way
mergers. Each analysis varies the key variables identified above. Thus,
Exhibit 12 utilizes both an exchange ratio of 1.034 (representing 53% for
Washington and 47% for Monroe) and an exchange ratio of 1.000 (representing the
current 54.5% for Washington and 45.5% for Monroe). Then, the P/E ratios and
savings totals are varied to complete the analysis. Thus, each case represents
a separate scenario with a different exchange ratio, P/E ratio and savings
total.
To summarize, the assumptions contained in Exhibit 12 are as follows:
- -------------------------------------------------------------------------------------
Exchange Ratio P/E Ratio Savings
--------------------------------------------------------
Exhibit 12, page 1-2 1.000 12.16 7.6
Exhibit 12, page 3-4 1.000 11.26 7.6
Exhibit 12, page 5-6 1.000 12.91 7.6
Exhibit 12, page 7-8 1.000 12.16 15.2
Exhibit 12, page 9-10 1.000 11.26 15.2
Exhibit 12, page 11-12 1.000 12.91 15.2
Exhibit 12, page 13-14 1.034 12.16 7.6
Exhibit 12, page 15-16 1.034 11.26 7.6
Exhibit 12, page 17-18 1.034 12.91 7.6
Exhibit 12, page 19-20 1.034 12.16 15.2
Exhibit 12, page 21-22 1.034 11.26 15.2
Exhibit 12, page 23-24 1.034 12.91 15.2
- ------------------------------------------------------------------------------------
Thus in the sensitivity analyses, two different exchange values for Monroe and
Washington are compared. Also, three ratios are compared. These are
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respectively 11.26, 12.16 and 12.91. The low P/E ratio is a current estimate
for Monroe based on 1995 estimated earnings. The high P/E ratio is a similar
statistic for Washington. The middle P/E ratio is a weighted average using
current pre-merger market valuations for weights. And two different cases for
sharing the synergy benefits between shareholders and customers are compared.
Recall that for a Monroe/Washington merger, the average annual savings will
total approximately $50 million or about $500 million for ten years. Please
refer to Exhibit 7, appended to this Report, for a detailed breakdown. In the
conservative case, the customers receive all the fuel, gas purchase and
generation savings. The remainder is split 50/50 between shareholders and
customers. The government also takes about 40 percent of the shareholder share
in taxes. The result is about $7.6 million per year average increase in net
income for shareholders.
In a more aggressive case, we double the synergy savings which go to
shareholders and deduct the government's 40 percent in taxes. The result is
about a $15.2 million per year average increase in net income for shareholders.
The results of these various sensitivity analyses are shown in Table II. As the
conceptual discussion suggests, these various factors affect shareholders' value
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for the merged companies. The most likely outcome, based upon our experience
with other mergers and the conservative nature of most of this analysis, would
probably be represented by the cases shown in results columns (3) and (5).
These correspond to increases in share prices or values of about 12.0% to 12.8%
for each company if no premium is paid to Monroe. And, for comparison, if
Monroe were to receive a 47/53 split, Monroe's gain would be about 15.8% to
16.6%.
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TABLE II
PERCENT CHANGE IN MARKET VALUE
- --------------------------------------------------------------------------------------------------------------
INCREASED NET INCOME
COMPANY PRE-MERGER FINAL Conservative Synergy More Optimistic Synergy
MARKET VALUE OWNERSHIP $7.6 million/year $15.2 million/year
$MILLIONS SHARE (1) (2) (3) (4) (5) (6)
P/E= 11.26 12.16 12.91 11.26 12.16 12.91
- --------------------------------------------------------------------------------------------------------------
Washington $874.10 54.5% (1.6)% 6.2% 12.8% 3.7% 12.0% 18.9%
Monroe $728.28 45.5% (1.6)% 6.2% 12.8% 3.7% 12.0% 18.9%
TOTALS $1,602.38 100.0%
- --------------------------------------------------------------------------------------------------------------
Washington $874.10 53.0% (4.4)% 3.2% 9.6% 0.8% 8.8% 15.6%
Monroe $728.28 47.0% 1.7% 9.9% 16.6% 7.3% 15.8% 23.0%
TOTALS $1,602.38 100.0%
- --------------------------------------------------------------------------------------------------------------
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Another alternative has also been discussed. This would involve a three-way
merger with Amber. One option would be for the two principal merger candidates
to pay an initial premium of ten percent to Amber. The current market value of
Amber is about $251 million, or $26.25 per share for 9,564,287 shares. A ten
percent premium for Amber is about $25 million. This would reduce the value for
Monroe and Washington in the synergy calculations discussed in the previous
sensitivity analysis.
However, offsetting these reductions is the fact a three-way saving would
produce about $676,802,000 in synergy gains as compared to a two-way merger
which would produce about $502,027,000. Using the conservative split between
shareholders, ratepayers and tax collectors, this merger would yield an
additional $2.3 million over the $7.6 million from the two-company merger.
Using a P/E ratio of 12 would yield about $28 million in additional market
value. This yields about $233 million in increased market value for the three
shareholder groups when compared to the two-way merger. For the more aggressive
case, the increment in market value would be about twice this amount and thus
would effectively cancel much of the premium paid for Amber.
The consequence for each group of initial shareholders would depend upon the
allocation of new shares, I.E., ownership in the combined company. The split of
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ownership between the three firms would depend upon how any premium paid for
Amber was split between Monroe and Washington. Table III shows some potential
options.
Table III presents three exchange scenarios for the three way merger between
Monroe, Washington and Amber. In the first case, Monroe and Washington share
the cost of a 10% premium paid to Amber in proportion to their pre-merger market
values; 45.5% for Monroe and 54.5% for Washington. In the second case, the
Monroe/Washington merger is formed on a 53/47 basis. Here, the cost of Amber's
premium is shared on the basis of this 53/47 split. In the third case
Washington pays a 10% premium to Amber and a 3.4% premium to Monroe. Table III
is presented below.
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TABLE III
COMPARING A TWO-WAY AND THREE-WAY MERGER
TWO-WAY RESULTING IN A 53/47 SPLIT
--------------------------------------------------------------------------------
INITIAL MARKET OWNERSHIP NEW MARKET NEW SHARE PERCENT
VALUE SHARE VALUE CHANGE
- ----------------------------------------------------------------------------------------------------
WASHINGTON $874.10 54.5% $ 849.33 53 (2.8)%
MONROE $728.28 45.5% $ 753.04 47 +3.4 %
- ----------------------------------------------------------------------------------------------------
TOTALS $1,602.38 100.0% $1,602.37 100 NA
- ----------------------------------------------------------------------------------------------------
THREE-WAY UNDER THREE APPROACHES
---------------------------------------------------------------------------------------------------------
PAY 10% TO AMBER AND SPLIT 54.5/45.5 SPLIT 53/47 AND PAY 10% TO AMBER PAY AMBER 10%, PAY MONROE 3.4%
------------------------------------ -------------------------------- ------------------------------
NEW MARKET OWNERSHIP NEW MARKET OWNERSHIP NEW MARKET OWNERSHIP
VALUE SHARE VALUE SHARE VALUE SHARE
- ------------------------------------------------------------------------------------------------------------------------
WASHINGTON $716.87 38.7% $741.24 40.0% $753.04 40.6%
AMBER $276.17 14.9% $276.17 14.9% $276.17 14.9%
MONROE $860.40 46.4% $836.03 45.1% $824.23 44.5%
- ------------------------------------------------------------------------------------------------------------------------
TOTALS $1,853.44 100.0% $1,853.44 100.0% $1,853.44 100.0%
- ------------------------------------------------------------------------------------------------------------------------
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In Table IV, the three way mergers are compared for the more likely cases as
described in the two way analysis. These results are based upon the detailed
cases found in Exhibit 13. Under these cases, Monroe could expect gains in the
11.8% to 14.4% range.
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TABLE IV
PERCENT CHANGE IN MARKET VALUE
- --------------------------------------------------------------------------------------------------------------
COMPANY PRE-MERGER FINAL Conservative Synergy More Optimistic Synergy
MARKET VALUE OWNERSHIP $9.9 million/year $19.8 million/year
$MILLIONS SHARE (1) (2)
P/E= 12.91 12.22
- --------------------------------------------------------------------------------------------------------------
Washington $874.10 47.2% 13.0% 13.5%
Monroe $728.28 39.3% 13.0% 13.5%
Amber $251.06 13.5% 13.0% 13.5%
TOTALS $1,853.44 100.0%
- --------------------------------------------------------------------------------------------------------------
Washington $874.10 45.1% 8.1% 8.5%
Monroe $728.28 40.0% 15.0% 15.5%
Amber $251.06 14.9% 24.3% 24.8%
TOTALS $1,853.44 100.0%
- --------------------------------------------------------------------------------------------------------------
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Similar analysis can be performed for different exchange rates, synergy saving
calculations and market acceptance. Other merger alternatives may be similarly
compared. A standalone case based upon similar shareholder/ratepayer splits and
differences in timing of various options can also be made. We conclude that
analyzing shareholder consequence has a number of important steps.
CONCLUSION
The Board finds itself in a position that is both difficult and enviable. It
has before it a menu which includes both a process redesign effort which will
likely realize average annual savings of $59 million per year and a slate of
worthy merger candidates. Each of these mergers will likely result in
additional average annual savings of between $35 and $67 million dollars per
year.
The Board's easiest decision is allowing the process redesign effort to proceed.
The more difficult decision is whether to proceed with a merger during the
process redesign or to wait until the redesign effort has been fully
implemented. This Report has discussed the pros and cons associated with
waiting. This Board's vision of the electric industry's future will largely
shape this decision.
Then, if the Board decides to pursue a merger candidate, it will face its most
difficult decision; choosing its merger partner. As we have discussed at
length,
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all the prospective partners analyzed here are attractive. All the potential
mergers should attain substantial savings which might enhance shareholder value.
Similarly, all merger candidates will create a much larger company which attains
or gets closer to the critical mass which will be required to survive in future
competitive markets. However, there are substantial differences between the
potential candidates that transcend the total savings which might be attained
through the respective mergers. Thus, the Board must decide which of the
potential partners possesses a strategic vision that is the most closely aligned
with their own vision of the electric industry's future. This analysis may be
just as important as analyzing the dollars to be saved.
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