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Sempra-KNE Merger is Dead

Sempra-KNE Merger is Dead

In what one observer described as one of the first "blunders" among energy mergers, Sempra Energy and KN Energy said yesterday they have mutually agreed to call off their $6 billion marriage, which was first announced in February. The two companies said that as they were studying the integration process they discovered the combined company "would not be able to realize the business objectives they originally anticipated."

Sempra has agreed to reimburse KN $5.95 million for expenses incurred in connection with the proposed deal and the two companies have entered into a confidential termination and release agreement that requires each to refrain from soliciting the employees of the other for a two-year period and to refrain from acquiring any stock or making any proposals to acquire the other party for a three-year period.

"When it became clear that the transaction with KN Energy could not be completed to both companies' mutual satisfaction, we determined that it was time to close this chapter and focus on our own business strategy," said Sempra Energy CEO Richard D. Farman. Sempra had intended to pay $1.8 billion in cash and stock for KN and to assume $4.2 billion of KN's debt.

Most observers speculated Sempra just couldn't stomach KN's poor financial performance and large debt given its own financial woes. KN CEO Larry Hall revealed that the company's earnings will be significantly below analysts expectations. KN is expected to experience a loss of $0.20-$0.25 per share in the second quarter of 1999 and likely will break even or post a modest gain of $0.10 per share for the year. That compares with analyst's forecasts of $1.07/share. KN estimates earnings for the year 2000 are expected to be in the range of $0.70 to $0.90 per share but officials said it could be six months to 12 months before performance begins to reflect improving market conditions.

Hall blamed KN's woes a variety of accidental factors, including the warm winter, poor basis differentials between producing and market areas on KN's pipelines, greater competition for markets in the Midwest, and lower production from the Rocky Mountain and Gulf regions to serve its pipeline assets. KN officials said about 14% of Natural Gas Pipeline Co.'s firm capacity was not under contract in the first quarter and 12% was not under contract in the second quarter. KN expects a $20 million income decline during the second quarter from the uncontracted capacity and noted a significant number of contracts are terminating in 2000. High storage levels also have not helped.

Some observers see KN's problems dating back to its acquisition of MidCon in December 1997, which was followed by deep staff reductions and large financial and operational hurdles. During a conference call with analysts yesterday, KN CEO Larry Hall said the company has cut about $95 million in costs related to the KN-MidCon integration, but "..we've got some challenges to replace" the personnel that left following the KN-MidCon merger. He indicated the KN-MidCon integration was a small part of KN's difficulties.

KN intends to heal its wounds by selling off up to $300 million non-strategic and unprofitable assets, but it has not disclosed which assets have been targeted. KN officials said pipeline assets other than NGPL will be included in the sales.

Merrill Lynch analyst Rebecca Followill said KN's earnings projections came as a shock to everyone and were probably to blame for the merger's failure. "Even the people who study the company and have studied the company for a long time weren't looking for this."

Followill, however, said KN shouldn't entirely take the blame. "Not every marriage works, you know. It's like blaming a divorce on one party. You know markets change during due diligence, and these people just walked away. It was mutually agreeable. I don't want to call it a spat."

Analysts called the Sempra-KNE deal a steal when it was first announced because Sempra was paying $25/share when KNE's 52-week high was $40. Some were expecting a bidding war for KNE with other energy companies jumping in. But since then KN's stock price has cascaded downward. Before the announcement yesterday, its stock price had been hovering slightly less than $20/share. Afterward it fell nearly 30% to close the day down $5.13 at $13/share. SRE was down $1.13, or 5%, to $22.81/share.

"Ultimately this industry is about scale and scope and the merger gave Sempra scale and scope, just what they were looking for," said Followill. "It gave them a more diversified asset base, pushed them out of California where they were so heavily dependent, gave them more pipeline assets to play off from a power generation standpoint. We liked it for those reasons," she said. "I think any merger Sempra gets in after this may be more conservative. KN had a lot of nonregulated assets which provide a lot of advantages but also are a much higher risk as you can see with what KN announced on earnings."

KN's Hall stressed the positive in saying the company is "engag[ing] in some capital reallocation planning, which will serve us well moving forward as we focus on improving operations efficiencies, managing capital expenses and investing in projects that will position KN for long-term earnings growth."

Farman said Sempra intends to expand its "geographic footprint," work on retail energy services, build wholesale trading, and grow an asset base that supports those operations.

Sempra, based in San Diego, has two regulated utilitity subsidiaries-- Southern California Gas and San Diego Gas & Electric. KN Energy is the sixth-largest integrated gas company in the U.S.

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