Merger Mania Resurfaces with Sempra-KNE, Dominion-CNG Combos
Industry merger and acquisition activity last week was a wholesale confirmation
of two major trends: the convergence of gas and electricity operations,
and consolidation. Two more of the nation's largest diversified gas pipeline
companies were snatched up by two major energy distributors. Sempra Energy
(SRE) announced it is buying KN Energy (KNE) in a stock-and-cash transaction
valued in the aggregate at $6 billion, a 24% premium to KNE's recent stock
price, and Dominion Resources said it is buying Consolidated Natural Gas
Co. (CNG) for about $6.3 billion in stock, a 25% premium (see
related story this issue).
That took care of the East and West Coasts. In the middle of the U.S.,
Southern Union threw another $100 million into the pot and bought a place
at the table in what had been an almost-done acquisition deal by ONEOK
to take over of Southwest Gas (see another related
story). And in a potential coast-to-coast and international merger
transaction, Southern Co. and El Paso Energy were rumored to have broken
off their possible engagement, which would have formed a company with $44.5
billion in assets (see yet another related story).
"You've got fragmented businesses. You've got tremendous economy
of scale. You've got electric companies with very little if any future.
You have got to reinvent yourself. And natural gas is a nice growth platform
on which to do that," said Merrill Lynch &Co. energy analyst Donato
Eassey. "We've seen example after example after example. It worked
for Houston Industries and NorAm, TXU and Enserch, Duke and Panhandle Eastern,
and CMS with Panhandle and Trunkline. It's not going to slow down."
SRE and KNE are all too familiar with these industry trends. Last June,
Sempra was formed by a $6.2 billion merger of Enova Corp., parent of San
Diego Gas &Electric, and Pacific Enterprises, parent of Southern California
Gas. And only seven months prior, KNE purchased MidCon Corp. from Occidental
Petroleum for $3.49 billion in cash and the assumption of $500 million
The SRE-KNE combination will create an energy conglomerate with a combined
$20 billion in assets. San Diego-based Sempra contributes $10 billion in
assets and operations, 12,000 employees, a strong balance sheet and the
largest retail customer base in the industry (more than 6 million meters
serving 21 million customers), while Lakewood, CO-based KNE bestows the
nation's second-largest gas pipeline and storage operation with 25,000
miles of pipe, operations in 16 states and 3,300 employees. Capitalization
of the combined company will be $14.3 billion ($7.1 billion in market value
of equity; $7.2 billion in debt). Based on 1998 results, the combined company
would have revenues of $9.9 billion and more than 15,000 employees.
Under terms of the merger agreement, SRE will acquire all of the shares
of KNE for a fixed exchange ratio of 1.115 shares of SRE common stock,
or $25 in cash/share. In total, 70% of the KNE shares outstanding will
be converted into SRE stock and 30% of the KNE shares will be converted
It's a steal for Sempra, according to several energy analysts who point
out the 52-week high for KNE stock is $40, while Sempra is paying only
$25. "It was one of the more attractive lower premiums, lower prices
in the group," said Eassey. "The question is can they hold it.
Look at Southern Union with Southwest Gas, they have a hostile bid on that,"
he noted, referring to Southern's announcement last week.
"I think Sempra is getting a good deal," said Zach Wagner
of Edward Jones. "If you look at where KN's stock price has been,
it was up in the $40 range. Their low is $18 so $25 is a great bargain."
The combined company will retain the Sempra Energy name and San Diego
headquarters. The merger is conditioned upon various federal and state
regulatory approvals and is expected to be completed in six to eight months.
"This combination creates value for the shareholders of both companies,"
said Sempra's Chairman Richard D. Farman, who will be chairman and CEO
of the combined company.
"Not only does KN Energy's extensive pipeline system complement
our portfolio of energy-related assets, this transaction allows us to increase
our penetration in the energy market triangle that stretches from the Gulf
Coast to Chicago and across the Rockies to California," he said. "As
the energy markets continue opening to competition, customer connectivity
and economies of scale will be the critical factors in determining which
companies will be the ultimate winners."
Merge Assets &Investment
Wagner noted Sempra has the financial resources KN lacked to take advantage
of the opportunities along the NGPL pipeline system. "Being a bigger
company they do have a stronger balance sheet. KN had a lot of debt on
their books which kind of restricted their flexibility when it came to
spending money. Sempra brings a pretty good checkbook. I'm not sure that
they could run the assets any better, but if you look at where we are in
the commodity cycle I think we're probably near the bottom. By virtue of
a small recovery in liquids prices, I think you'll see a nice rebound in
what KNE can earn. I think Sempra is buying them for a good price at the
bottom of the cycle."
After integrating MidCon into its operations and reducing expenses by
about $100 million/year primarily by cutting its work force 18%, KN earnings
still were down about 23% last year. After considering a $27.8 million
fourth quarter charge, net income slipped to $60 million, or $0.92/share,
from $77.5 million, or $1.63/share in 1997.
Sempra, primarily a retail energy company, is buying primarily a wholesale
operation in KNE, Wagner noted. "They are getting into new markets
with greater growth potential. KN has the potential to reach 15% growth
so the blended growth for the combined company could be 7-8%."
Sempra also is eyeing gas-fired generation projects along side KNE's
pipeline assets. NGPL uses most of its 3 Bcf/d capacity to serve winter
peaking needs in Chicago, but during the summer about 80% of its capacity
goes unused, said Warren Mitchell, group president of Sempra's regulated
operations. With electricity demand growing rapidly in the Midwest, Sempra
sees "real opportunities to use this unused capacity during the off-peak
months for new electric generation. This is an opportunity for additional
earnings because the rate design on [KN's pipelines] is straight-fixed
variable so the pipeline is fully contracted for at a fixed cost. Any additional
capacity utilization off-peak is frosting on the cake," he noted.
Builds Unregulated Side
The merger sharply raises the percentage of revenues and profits coming
from Sempra's unregulated operations, noted Sempra President Stephen L.
Baum, who will be vice chairman, president and COO of the new combined
company. Baum said the deal is a "breakout strategy that overnight
strengthens our business profile..." Unregulated operations will account
for 29% of operating cash flow rather than only 2% as it had before at
Sempra. "We believe that Sempra Energy's earnings growth rate is likely
to be significantly higher following this transaction due to the development
potential of KN Energy's assets," said Baum.
Sempra anticipates the transaction will be "non-dilutive"
to earnings next year, which is expected to be the first full year of operations,
and accretive to earnings in 2001. Sempra officials see the potential to
reduce costs but also are counting on a turn-around in the gas liquids
market to help boost earnings.
"We think there will be some modest increase in gas liquids prices,"
said Mitchell. "And we believe there will be synergies created as
we put the two companies together [and savings] of between $30 million
and $50 million primarily from the corporate center costs. We have duplications
in finance and accounting, human resources, investor relations, procurement,
legal, all of those types of support services. We think [staff will be
reduced by] between 200 and 300 people."
Sempra has struggled to meet Wall Street expectations recently and its
stock price has suffered as a result, hovering near $21/share from a 52-week
high of $29/share. Mitchell said the company's $1.60/share earnings for
1998 were below Wall Street's expectations of $1.65-$1.67. "I think
the Street is taking a wait and see attitude relative to nonregulated operations
and I think this transaction will help that considerably." Sempra
share prices fell $0.75 Monday following the announcement to close at $21.56
and were flat to down through the rest of the week. KNE's shares jumped
$2 during the day Monday but then fell back to end the day up $0.125 at
$21.63/share. KNE's high for the week was $23.56/share.
Both KNE and CNG stock surged on Friday, Feb.19, prior to the public
announcements Monday regarding their mergers, triggering some speculation
about possible insider trading activity. The Wall Street Journal (WSJ)
ran a story noting KNE shares jumped 5% between noon Friday (Feb. 19) and
12:30 p.m. that day while CNG share prices soared nearly 7% to close the
day at $56.25. CNG volume doubled on Friday from the previous day. KNE
volume jumped more than 300% Friday from Thursday's level. The WSJ reported
the New York Stock Exchange contacted the companies on Friday to get explanations
of the unusual trading activity, but officials declined to comment.
An SEC spokesman said, "Any number of things could trigger an insider
trading [investigation] from tips from witnesses to unusual trading on
the exchanges, which the exchanges monitor, to unusual trading in options
which the options exchanges monitor." However, the SEC does not comment
on current investigations.