Industry merger and acquisition activity yesterday was astartling confirmation of two major trends: the convergence of gasand electricity operations, and consolidation. Two more of thenation’s largest diversified gas pipeline companies were snatchedup by two major energy distributors. Sempra Energy (SRE) bought KNEnergy (KNE) in a stock-and-cash transaction valued in theaggregate at $6 billion, a 24% premium to KNE’s recent stock price,and Dominion Resources bought Consolidated Natural Gas Co. (CNG)for about $6.3 billion in stock, a 25% premium.

“You’ve got fragmented businesses. You’ve got tremendous economyof scale. You’ve got electric companies with very little if anyfuture. You have got to reinvent yourself. And natural gas is anice growth platform on which to do that,” said Merrill Lynchenergy analyst Donato Eassey. “We’ve seen example after exampleafter example. It worked for Houston Industries and NorAm, TXU andEnserch, Duke and Panhandle Eastern, and CMS with Panhandle andTrunkline. 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 EnovaCorp., parent of San Diego Gas & Electric, and PacificEnterprises, parent of Southern California Gas. And only sevenmonths prior, KNE purchased MidCon Corp. from Occidental Petroleumfor $3.49 billion in cash and the assumption of $500 million inliabilities.

The SRE-KNE combination will create an energy conglomerate witha combined $20 billion in assets. Sempra contributes $10 billion inassets and operations, a strong balance sheet and the largestretail customer base in the industry (more than 6 million metersserving 21 million customers), while KNE adds the nation’ssecond-largest gas pipeline and storage operator, and thesixth-largest integrated natural gas company. Capitalization of thecombined company will be $14.3 billion ($7.1 billion in marketvalue of equity; $7.2 billion in debt). Based on 1998 results, thecombined company would have revenues of $9.9 billion and more than15,000 employees.

Under terms of the merger agreement, SRE will acquire all of theshares of KNE for a fixed exchange ratio of 1.115 shares of SREcommon stock, or $25 in cash/share. In total, 70% of the KNE sharesoutstanding will be converted into SRE stock and 30% of the KNEshares will be converted into cash.

It’s a steal for Sempra, according to several energy analystswho point out the 52-week high for KNE stock is $40, while Semprais paying only $25. “It was one of the more attractive lowerpremiums, lower prices in the group,” said Eassey. “The question iscan they hold it. Look at Southern Union today with Southwest Gas,they have a hostile bid on that,” he noted (see related story thisissue).

“I think Sempra is getting a good deal,” said Zach Wagner ofEdward Jones. “If you look at where KN’s stock price has been, itwas up in the $40 range. Their low is $18 so $25 is a greatbargain.”

The combined company will retain the Sempra Energy name and SanDiego headquarters. The merger is conditioned upon various federaland state regulatory approvals and is expected to be completed insix to eight months.

“This combination creates value for the shareholders of bothcompanies,” said Sempra’s Chairman Richard D. Farman. “Ourstrategic objectives, assets and activities are complementary andwill allow the combined company to aggressively pursue theconsiderable opportunities of the energy services marketplace andthe convergence of natural gas and electricity. The strongcash-flow generation from our combined operations can be investedin the growth opportunities in natural gas and electricitygeneration..

“Not only does KN Energy’s extensive pipeline system complementour portfolio of energy related assets, this transaction allows usto increase our penetration in the energy market triangle thatstretches from the Gulf Coast to Chicago and across the Rockies toCalifornia,” he said. “As the energy markets continue opening tocompetition, customer connectivity and economies of scale will bethe critical factors in determining which companies will be theultimate winners.”

Wagner noted Sempra has the financial resources KN lacked totake advantage of the opportunities along the NGPL pipeline system.”Being a bigger company they do have a stronger balance sheet. KNhad a lot of debt on their books which kind of restricted theirflexibility when it came to spending money. Sempra brings a prettygood checkbook. I’m not sure that they could run the assets anybetter, but if you look at where we are in the commodity cycle Ithink we’re probably near the bottom. By virtue of a small recoveryin liquids prices, I think you’ll see a nice rebound in what KNEcan earn. I think Sempra is buying them for a good price at thebottom of the cycle.”

After integrating MidCon into its operations and reducing costby about $100 million primarily by cutting its work force 18%, KNearnings still were down about 23% last year. After considering a$27.8 million fourth quarter charge, net income slipped to $60million, or $0.92/share, from $77.5 million, or $1.63/share in1997.

Sempra, primarily a retail energy company, is buying primarily awholesale operation in KNE, Wagner noted. “They are getting intonew markets with greater growth potential. KN has to potential toreach 15% growth so the blended growth for the combined companycould be 7-8%.”

In an interview with NGI, Warren Mitchell, group president ofSempra’s regulated operations, said one immediate benefit of thecombination will be the synergies in marketing and trading. Sempramaintains trading operations in Greenwich, CT, while KN has officesin Houston. “I think there are some very good opportunities thereboth in terms of streamlining the operations [and] giving us accessto new customers in the Midwest because we haven’t done a lotthere,” he said.

Sempra also is eyeing gas-fired generation projects along sideKNE’s pipeline assets. NGPL uses most of its 3 Bcf/d capacity toserve winter peaking needs in Chicago, but during the summer about80% of its capacity goes unused, said Mitchell. With electricdemand growing in the Midwest, Sempra sees “real opportunities touse this unused capacity during the off-peak months for newelectric generation. This is an opportunity for additional earningsbecause the rate design on [KN’s pipelines] is straight-fixedvariable so the pipeline is fully contracted for at a fixed cost.Any additional capacity utilization off-peak is frosting on thecake,” he noted.

KNE CEO Larry Hall said, “coupled with Sempra Energy’s powerdevelopment projects, KN Energy’s asset base positions the combinedcompany for a national presence in gas-fired generation. The addedbenefits of marketing, gathering and processing, as well asinvestments in telecommunications, will create further value andearnings growth opportunities. In addition, combining the twocompanies’ wholesale trading operations creates a top-ranked energycommodity and services provider.” Combined, the company will be No.3 in gas marketing with 9.9 Bcf/d based on fourth quarter 1998volumes.

“I like the combination,” said Merrill Lynch’s Eassey. “I thinkSempra has a very solid balance sheet, and it is an excellentopportunity to spring forward-[KNE] is a growth platform that theydidn’t have-and really truly exploit their trading arrangements andtheir ability to site some plants and take advantage of theunderutilized capacity on MidCon.”

Stephen L. Baum, president and COO of Sempra Energy, said, thedeal is a “breakout strategy that overnight strengthens ourbusiness profile, while dramatically increasing the percentage ofrevenues and profits derived from non-state-regulated businesses.”Unregulated operations will account for 29% of operating cash flowrather than only 2% as it had before at Sempra. “We believe thatSempra Energy’s earnings growth rate is likely to be significantlyhigher following this transaction due to the development potentialof KN Energy’s assets,” said Baum.

Sempra anticipates the transaction will be “non-dilutive” toearnings next year, which is expected to be the first full year ofoperations, and accretive to earnings in 2001.

“We think there will be some modest increase in gas liquidsprices,” said Mitchell. “And we believe there will be synergiescreated as we put the two companies together [and savings] ofbetween $30 million and $50 million primarily from the corporatecenter costs. We have duplications in finance and accounting, humanresources, investor relations, procurement, legal, all of thosetypes of support services. We think [staff will be reduced by]between 200 and 300 people.”

Sempra’s stock price has suffered recently, hovering near$21/share from a 52-week high of $29/share. Mitchell said thecompany’s $1.60/share earnings for 1998 were below Wall Street’sexpectations of $1.65-$1.67. “I think the Street is taking a waitand see attitude relative to nonregulated operations and I thinkthis transaction will help that considerably.” Sempra share pricesfell $0.75 yesterday to close at $21.56. KNE’s shares jumped $2during the day but then fell back to end the day up $0.125 at$21.63/share.

Richard D. Farman will be chairman and CEO of the combinedcompany and Stephen L. Baum will be vice chairman, president andCOO. Three members of KN Energy’s board of directors, includingLarry Hall, will join the board of directors of Sempra Energy. Hallwill be a senior advisor to the office of the chairman.

KNE, based in Lakewood, CO, operates more than 25,000 miles ofpipeline, has 3,300 employees and operations in 16 states. Semprahas 12,000 employees and revenues of $5.5.

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