In the United States, the National Basketball Association and the utility industry
may not have much in common fundamentally, but what they do share is the nature
of the development of what is required to be a “star player.” In the NBA, the
dominant players were almost always the most physically imposing through the
1950s, 1960s, and 1970s. The physical giants of the league were the performance
leaders, starting with George Mikan and Bill Russell and continuing to Wilt
Chamberlain and Kareem Abdul-Jabbar. Similarly, in the utility industry, bigger
was indeed better — the economies of scale in an industry characterized
by such high levels of fixed costs dictated that the larger utilities would
be more likely to have better financial performance, because their costs were
spread across a larger sales base.

In the 1980s and 1990s, Larry Bird, Magic Johnson, and Michael Jordan ushered
in two new ways of thinking that changed the sport forever: (1) a player did
not have to be the largest on the court to be the most dominant, and (2) a wider
base of skills and an ability to adapt to the changing style of play as the
game ebbed and flowed was far more important than pure size. That is not to
say that size completely ceased to be relevant — 5′ 3″ Tyrone “Muggsy”
Bogues was capable of being a very good niche player, but stood virtually no
chance of rising to the highest echelon of his peers — but it was no longer
the primary factor in separating the stars from the role players. Were that
not true, 7′ 7″ centers Manute Bol and Gheorge Muresan would have been among
the great names of the last part of the 20th Century in the NBA. Since many
readers have not heard of them, suffice it to say they did not achieve greatness.

Can this not be said of today’s utility industry as well? While economies of
scale certainly still exist, their magnitude is often exaggerated and the effort
and expertise required to achieve them is downplayed. A big reason for the exaggeration
is that executives often overlook the fact that economies of scale are generally
found at the plant or operating company level rather than at the holding company
level. Two utilities may merge, but if each owns a 750 MW generator, they do
not suddenly enhance the profitability of each by taking advantage of the economies
of scale of a 1500 MW plant. This type of logic holds true for many (though
not all) utility functions.

Furthermore, “scale” implies lowering costs. If cost-cutting from mergers were
the key to success, then this should be evident in a positive reaction by the
investment community to mergers from which scale-based cost reductions were
expected. This has generally not occurred. The keys to success in the 21st Century
appear to be: the number of different segments of the industry in which an integrated
energy company can successfully compete, how well the overall business model
ties these activities together, and how these translate into sustainable revenue
growth.

There are many reasons given for utility mergers and acquisitions, but nonetheless
large utility mergers generally take one of two forms:

• The more traditional are “scale-based” mergers, in which one vertically
integrated utility acquires another (or a substantial portion of its assets)
in order to achieve cost efficiencies, expand service territory, or increasingly,
defend against becoming a merger target itself. Scale-based mergers usually
reflect a desire to expand an existing business model with a company operating
under a similar model. This would be the case when one vertically integrated
utility acquires another vertically integrated utility, or when one wires company
acquires another wires company.

• The other type of merger is a “transformational” merger. This type is
characterized by a company acquiring or transferring a skill-set, physical asset,
or presence in a market that one of the merger partners did not have prior to
the merger. Transformational mergers reflect an attempt to apply a successful
business model to a company not currently operating under such a model. The
two are as different in execution and effectiveness as a fast-break and a half-court
offense are in basketball.

The Impact of the “New Style of Play” on Merger and Acquisition Effectiveness

From the perspective of stock performance, executives will have the greatest
interest in two reactions: the immediate reaction of Wall Street to the announcement
of the merger, and the market value increase of the equity over a longer period
of time. These will represent the ultimate impact of the merger. For our purposes,
we define these two periods in the following ways:

• Immediate-term: The increase or decrease of the stock’s value between
14 days before and 14 days after the announcement of the merger. The two-week
period before the merger removes the effect of any speculative buying or selling
that may result from information leaks or rumors. The post-announcement period
gives time for the merging entities to publicly state the goals of the merger
and for Wall Street to absorb and value those goals.

• Longer-term: The increase or decrease in the stock’s value during the
period from fourteen days before merger announcement to one year after the deal
is closed. The one-year period after the merger allows time for the market to
observe and value the performance of the merged entity against stated goals
or strategies, while not being so long that other actions taken by the merged
firm are likely to affect the performance.

Figure 1 shows both the immediate-term and longer-term stock price performance
of the 50 most recently completed mergers. The remainder of this paper should
be read largely in the context of this chart.

Figure 1 – Stock Performance for Companies Announcing Mergers (48 Mergers)

Scale-Based Mergers: A Series of Airballs?

The benefits of scale mergers have been touted over and over again in merger
announcements over the past five years. Typical expectations include:
• Improvement in competitive position and financial resources
• Strengthening of regional position
• Exploitation of economies of scale and/or purchasing power
• Reduction in costs through elimination of functional or geographical
overlap
These have been almost sacred tenets in utility M&A. The following quotes from
utility CEOs just prior to or during mergers in which they were involved give
some sense of how deeply rooted these expectations have become:

“[We] have both felt the force of competitive pressures that have characterized
our industry over the past few years and both have been successful in aggressively
reducing operating costs and keeping … customers’ energy bills among the lowest
in the nation. Together we are convinced we can do more, better, cheaper and
faster on all those fronts than either of us could do alone.”

“As competition intensifies within the industry, scale will increasingly contribute
to overall business success.”

These statements do not seem unreasonable, nor do the expectations that achievement
of these goals will increase shareholder value. But the market reaction has
not reflected this; all three mergers represented by the quotes above appear
in the lower left-hand quadrant of the chart. In other words, these mergers
underperformed the industry index immediately after the announcement (indicative
of market skepticism), and also underperformed it in the long run (failure to
overcome the skepticism).

Figure 2 – Performance versus Expectations: Scale Doesn’t Always Lower Costs
See Larger Image

So why the lack of faith? Perhaps the two graphs can provide some perspective.
For the two mergers represented by these graphs, announcements of significant
cost savings were made at the beginning (1996 and 1997, respectively), but they
never materialized. In fact, the second graph represents the performance of
the companies involved in the merger about which the first quote was made! This
performance, typical of the results of scale-based mergers, would help explain
why scale-based mergers generally receive a negative reaction from investors
in the period just after the announcement. In fact, in the first chart, about
two-thirds of those mergers for which the short-term returns were negative were
entirely or primarily scale-based.

Transformational Mergers:
Taking the Early Lead and Never Looking Back

Unfortunately, there is no scripted playbook for laying out a successful transformational
merger. However, we can say that any such merger must take as its starting point
a company’s vision, an understanding of the key success factors required for
the execution of that vision, and perhaps most importantly, a candid identification
of existing skill gaps that are excessively difficult or expensive to develop
internally. While scale-based mergers primarily provide the promise of one-time
cost reductions, transformational mergers provide a foundation for sustainable
growth. Here are synopses a few recent successful transformational mergers:

• Dynegy’s acquisition of Illinova: This July 2000 deal serves as a good
example of a company applying unique skills to a target company. Dynegy’s acquisition
enabled it to enter the midwest market in the United States by bringing its
knowledge of gas and electric prices and its trading and arbitrage skills to
bear on Illinova’s underutilized generation assets.

• Public Service Company of Colorado’s merger with Southwestern Public
Service: In this merger that closed in August 1997, the companies were able
to exploit tangible economies of scope, as opposed to more elusive economies
of scale. PSC Colorado’s strength in information technology and SPS’ proficiency
in unregulated operations allowed each company to apply underutilized skills
across both companies, improving operations in ways each could not have on its
own.

• Scottish Power’s acquisition of PacifiCorp: In this case, the acquirer
was seen as a company with skill and success in bringing regulated utilities
into a deregulated environment, having done this overseas. Furthermore, the
company being acquired had recently been through a merger that in many respects
had not met investor expectations. The market thus greeted this merger announcement
with the same expectations sportswriters have when a poorly-performing NBA team
grabs a high-profile #1 draft pick, and the short-term results reflected those
heightened expectations.

The companies that are likely to be successful are those companies developing
and executing new business models that have increased focus on higher growth.
These three mergers are examples of how this can be done. The increased growth
in the Dynegy/Illinova merger stems from increased production from a fixed asset
base; in the PSC/SPS merger, from adding business capability on each side that
can be translated into new revenue; and in Scottish Power’s case, from bringing
a model that had increased revenues under one deregulated regime and applying
it to stabilize and grow a stagnating enterprise. In light of this and other
evidence, we believe transformational mergers are now fundamentally more compelling
than scale-based mergers, although scale will remain important in certain respects.
Scale may be important, for example, in increasing the geographic scope of a
utility in such a way that its load profile and customer base become more diverse,
or in a way that allows for profitable arbitrage across dispersed geographic
regions. The use of scale as a defensive tactic will be another theme that will
not soon disappear. Overall, however, these reasons will be an element that
improves an already attractive deal; the main driver will be growth opportunities
that the merger makes possible.

What we believe, however, means little unless the financial markets believe
it as well. Fortunately, there is evidence this is happening. The market appears
to be doing an increasingly good job of either recognizing the benefits of the
merger right away, with that recognition directly reflected in short-term share
performance, or picking up on this value creation as the merger integration
gains steam, and rewarding the merged company appropriately.

Conversely, there is quite a bit of evidence that the markets are not shy about
meting out punishment when they hear a merger announcement that does not have
clear transformational elements (or if the transformational elements do not
bear fruit). Looking at past mergers in four distinct groups bears this out.

Market Reaction: The Oddsmakers Lay Their Bets

A glance at the short-term vs. long-term performance chart introduced earlier
(Figure 1) shows that there are four very distinct overall market reactions
to mergers (described clockwise from upper-left):

• Mergers initially given poor grades by the market but showing long-term
positive returns (upper left-hand quadrant): All of the mergers with total values
exceeding $10 billion have had initial negative returns relative to the market
index. This may reflect market skepticism that such large companies can be transformed.
However, for these and other smaller mergers, the primary cause of poor short-term
performance may be simply an initial inadequate identification of the transformational
benefits. Note that in the end, however, all of the mergers resulted in positive
shareholder return as the transformational benefits became more clear (e.g.,
Exelon’s nuclear asset-based strategy, which was increasingly viewed positively
once the ramifications of the California power crunch became evident).

• Mergers which won immediate market approval and fulfilled that initial
promise (upper right-hand quadrant): These were the mergers on which the market
picked up as clear winners from the start. Often, these were mergers that were
led by companies outside the regulated domestic utility industry, including
those from industries (e.g, Kinder Morgan) or countries (e.g., PowerGen) that
had experience with deregulation that could be brought profitably to the transaction.
In other cases, the mergers were led by an unregulated company with a successful
business model (e.g., Enron, CalEnergy) that the market correctly foresaw as
transferable.

• Mergers which were seen as positive early on but failed to sustain market
confidence (lower right-hand quadrant): This seems to be a mixed group, with
a specific story for each case about why the originally well-thought-of strategy
went sour. The failure of these mergers to meet expectations resulted in harsh
treatment by Wall Street: the average decline in stock price from pre-merger
announcement levels was 26.4 percent — the worst of any of the four categories
— and the decline from post-merger announcement levels was more than 30
percent.

• Mergers never accepted as positive by the market, neither in the short
nor long term (lower left-hand quadrant): This is the largest group, which provides
strong indication that when the market does not see a good growth story, above-market
returns are not likely even in the long run. Of the 18 mergers in this group,
only three had a clear growth story. Regardless of the merged company’s eventual
evolution, it appears difficult to overcome this stigma in the long run. Of
the 30 companies initially given below-market returns after a merger announcement,
more than half had long-term returns of 10 percent or lower below the market
index.

The Message to Utilities That Are Seeking to Merge

The critical message to utilities for mergers in the first decade of this new
millennium — and the first decade in which deregulation will take a real
foothold — is to be sure there is a growth story in the merger rationale.
While size-related performance excellence is neither dead on the basketball
court nor in the utility industry — ask Shaquille O’Neal (nicely) or Exelon
— it is no longer the exclusive means to dominance. In fact, “recovering”
from the impact of an initial scale-based story requires working hard to bring
the story out during the merger and not later; it may be easier to simply ensure
some compelling growth story is part of the initial presentation of the merger
to the public. Those who explicitly include this as a part of the early story
generally have positive returns; those who fail to do this are working out of
a hole. And while scale-based mergers had a shot at ultimately producing positive
returns in the early days of the M&A wave (as the likes of Cinergy and First
Energy proved), since 1998 it has been virtually impossible for a scale-only
merger to produce long-term above-market results. Careful consideration must
be given to how new revenue can be generated through the combination, not merely
how costs can be cut. The latter used to be a sufficient story to interest Wall
Street in the merits of a merger. But being a seven-footer with offensive basketball
skill used to be sufficient to guarantee you stardom in the NBA, too. As one
former athlete once succinctly put it, “it ain’t the same yesterday today.”