In what one observer described as one of the first “blunders”among energy mergers, Sempra Energy and KN Energy last weekmutually agreed to call off their $6 billion marriage, which wasfirst announced in February.

The combination would have created an energy conglomerate with acombined $20 billion in assets, a $14.3 billion marketcapitalization, revenues of $9.9 billion and more than 15,000employees. But the two companies said that as they were studyingthe integration process they discovered the combined company “wouldnot be able to realize the business objectives they originallyanticipated.”

Sempra has agreed to reimburse KN $5.95 million for expensesincurred in connection with the proposed deal and the two companieshave entered into a confidential termination and release agreementthat requires each to refrain from soliciting the employees of theother for a two-year period and to refrain from acquiring any stockor making any proposals to acquire the other party for a three-yearperiod.

“When it became clear that the transaction with KN Energy couldnot be completed to both companies’ mutual satisfaction, wedetermined that it was time to close this chapter and focus on ourown business strategy,” said Sempra Energy CEO Richard D. Farman.Sempra had intended to pay $1.8 billion in cash and stock for KNand to assume $4.2 billion of KN’s debt.

Although the companies provided few details, most observersspeculated Sempra just couldn’t stomach KN’s poor financialperformance and large debt given its own financial woes. KN CEOLarry Hall revealed last week that his company’s earnings will besignificantly below analysts’ expectations. KN is expected toexperience a loss of $0.20-$0.25 per share in the second quarter of1999 and likely will break even or post a modest gain of $0.10 pershare for the year, said Hall. That compares with analyst’sforecasts of $1.07/share.

KN estimates earnings for the year 2000 are expected to be inthe range of $0.70 to $0.90 per share but officials said it couldbe six months to 12 months before performance begins to reflectimproving market conditions.

Hall blamed KN’s woes a variety of accidental factors, includingthe warm winter, poor basis differentials between producing andmarket areas on KN’s pipelines, greater competition for markets inthe Midwest, and lower production from the Rocky Mountain and Gulfregions to serve its pipeline assets. During a conference call, KNofficials said about 14% of Natural Gas Pipeline Co.’s firmcapacity was not under contract in the first quarter and 12% wasnot under contract in the second quarter. KN expects a $20 millionincome decline during the second quarter from the uncontractedcapacity and noted a significant number of contracts areterminating in 2000. High storage levels also have not helped.

Some observers see KN’s problems dating back to its acquisitionof MidCon in December 1997, which was followed by deep staffreductions and large financial and operational hurdles. Hall saidthe company has cut about $95 million in costs related to theKN-MidCon integration, but “…we’ve got some challenges toreplace” the personnel that left following the KN-MidCon merger. Heindicated the KN-MidCon integration was a small part of KN’sdifficulties.

Analysts Shocked

Although the announcement had been expected by many close to thedeal, most analysts were shocked by the news. Analysts called theSempra-KNE deal a steal when it was first announced because Semprawas paying $25/share when KNE’s 52-week high was $40. Some wereexpecting a bidding war for KNE with other energy companies jumpingin. But since then KN’s stock price has cascaded downward. Beforethe announcement last week, its stock price had been hoveringslightly less than $20/share. Afterward it fell nearly 30% to closethe day (Monday) down $5.13 at $13/share. SRE was down Monday$1.13, or 5%, to $22.81/share.

“Ultimately this industry is about scale and scope and themerger gave Sempra scale and scope, just what they were lookingfor,” said Merrill Lynch analyst Rebecca Followill. “It gave them amore diversified asset base, pushed them out of California wherethey were so heavily dependent, gave them more pipeline assets toplay off from a power generation standpoint. We liked it for thosereasons,” she said.

Followill said KN’s earnings projections startled everyone andwere probably to blame for the merger’s failure. “Even the peoplewho study the company and have studied the company for a long timeweren’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 onone party. You know markets change during due diligence, and thesepeople just walked away. It was mutually agreeable. I don’t want tocall it a spat.”

KN’s Hall stressed the positive in saying the company is”engag[ing] in some capital reallocation planning, which will serveus well moving forward as we focus on improving operationsefficiencies, managing capital expenses and investing in projectsthat will position KN for long-term earnings growth.”

Hall vowed to take drastic action. He said the company’sobjective is to reduce its debt ratio to 55 to 60%, from thepresent level of 72%, over the next three or four years.Significant ground will be gained by selling off up to $300 millionnon-strategic and unprofitable assets. KN did not disclose whichassets have been targeted for sale, but Hall indicated pipelineassets other than NGPL will be included. About $100 million inasset sales are slated for this year.

Farman said Sempra intends to expand its “geographic footprint,”work on retail energy services, build wholesale trading, and growan asset base that supports those operations. Sempra, based in SanDiego, has two regulated utility subsidiaries-Southern CaliforniaGas and San Diego Gas & Electric. It has $10 billion in assetsand operations, 12,000 employees, a strong balance sheet and thelargest retail customer base in the industry (more than 6 millionmeters serving 21 million customers). It has had increasingsuccess in expanding into neighboring Mexico. (See NGI, May 3 &31, 1999)

“I think any merger Sempra gets in after this may be moreconservative. KN had a lot of nonregulated assets which provide alot of advantages but also are a much higher risk as you can seewith what KN announced on earnings.”

Rocco Canonica

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