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Merger Mania Resurfaces with Sempra-KNE, Dominion-CNG Combos

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 in liabilities.

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 into cash.

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.

Rocco Canonica

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