Industry sign banking new jersey ppt now
Hello and welcome. In today's video we will be briefly reviewing our recent Seeking Alpha article regarding a potential merger between the gas utilities New Jersey Resources ("NJR") and South Jersey Industries ("SJI"). As their names suggest, both of these gas utilities are
located in the state of New Jersey. This merger analysis was first
published on the Seeking Alpha website back in April of 2017. The written article can be accessed
for free from the Seeking Alpha website using the first link under the video
description and the PowerPoint slides can also be downloaded using the second link under the video
description. We chose this potential merger as a
case study for highlighting some of the
real life challenges of negotiating merger
("M&A") premiums. These challenges go well beyond simple merger accretion / (dilution) analysis and pro forma leverage. At the time of the article's
publication we considered the odds of a
successful merger between these two companies to be
relatively low. For reasons we will discuss in
this video, we could not definitively rule out
the possibility of an NJR / SJI merger announcement, but it certainly was
not the slam dunk portrayed by some media
commentators. A merger between NJR and SJI makes for an interesting
case study because these two (2)
companies possess a unique set of attributes and we're going to focus on a number
of those attributes in today's video. For example, corporate governance
structuring and the sharing of control are often
overlooked aspects of merger arbitrage
analysis. Yet, they are really critical to the
size of the eventual merger premium
payment. Secondly, SJI possesses a number of unique tax attributes which will have an important bearing on our
merger analysis. And, lastly, the US utility sector is somewhat unique, compared to other industries, in terms of its treatment of merger
synergies. This potential deal provides a convenient example for
illustrating the impact of merger synergy sharing on our utility merger premiums. On April 4th 2017, the Wall Street Journal was
reporting that the US gas LDCs New Jersey Resources and South Jersey Industries were
engaged in merger discussions. It is not clear whether the NJR & SJI merger discussions have progressed beyond initial negotiations to
comprehensive due diligence or even contract negotiations. We should probably caution that, for all the reasons we are
going to discuss in this video, that the stock price upside for SJI shareholders might not be that
great. There's the risk that the deal
doesn't happen and then we're going to go into all
the reasons why, if a deal does happen, there's a reasonable likelihood that
it could be a low premium merger. The similarities between these two
companies goes beyond their geographic
location. They are comparable on several
metrics, including their equity market cap, their leverage ratios, their trading multiples and even their proportion of
unregulated operations. The initial equity market reaction to the rumors of a takeover were surprisingly aggressive. Both stocks rallied over 5 percent on the release of that Wall Street Journal blog article. However, the market quickly retraced its steps and both stocks ended up only
closing around 2 percent higher on the day. This suggests to us that maybe the market is pricing in a Merger Of Equals ("MOE"): a low premium
deal where both sets of company
shareholders will end up owning around 50 percent
of the new company. If the market was expecting, say, a 30 percent premium, where NJR would buy-out all the SJI shareholders, you would expect the probability weighted stock price of SJI to jump
a lot more than 2 percent at the end of the day. In this section we are going to look
at the relative pricing of New Jersey Resources and South Jersey Industries and what is driving valuations in the US utility sector. Despite a significant U.S. utility sector equity rally over the last couple of years, South Jersey Industries stock price declined 20 percent in nominal terms during 2014 and 2015. However, starting in early 2016, the SJI stock price outperformed both its utility peers and the NJR stock price. While the NJR stock price has
aggressively outperformed its utility peers for most of the period starting in early 2014. Which brings us to the exchange
ratio between NJR and SJI. You can think of this as the amount
of NJR shares that South Jersey Industries shareholders would be
issued in a 100 percent stock merger. Based on their relative stock price performance of recent years, you would naturally expect the
exchange ratio between these two companies to have improved quite markedly since early 2016. Although, it could be argued that
SJI's stock price is still "cheap" relative to where it was in early 2014. So where does this place the two
stocks relative to their comparable
companies? Well, if we look at just US gas LDCs, you can see that both NJR and SJI appear to be priced pretty fully. Their Enterprise Value ("EV") to
EBITDA multiples are higher than for any other
company in the sector. Admittedly, it's a small sample of only eight
(8) companies. At the same time, their P/E multiples are at the high end of the range. So this might initially make you
think that SJI is fully valued and if you add a merger premium to that trading multiple then the
stock could appear quite expensive
relative to its peers. In a merger context you would often perform quite detailed trading multiples and transaction multiples and discounted cash flow analysis etc etc. We wanted to save the reader from this so we're going to use a rather simplified form of this analysis
which is to take the P/E multiples for the US utility sector; this includes both gas and electric utilities. And we're going to look at how they're all priced as of late March 2017. This will give us forty four (44)
companies. The sample is going to exclude the
Canadian utilities and any utility that's currently engaged in announced merger and acquisition
("M&A") activity. We are also going to exclude
yield-oriented renewable generation companies because their source of stability comes from long-term contracts as
opposed to, generally speaking, regulator mandated pricing. When we perform this regression
analysis, we can simplify our model to just four (4) variables and this will explain roughly two thirds (~66%) of all the
variation in forward P/E multiples in the US
utility sector. Those variables are whether the utility has a relatively high amount of gas operations and we are calling that variable
"Gassy". That would include everything from, obviously, a gas LDC which just distributes and transmits gas. It would also include an electric
utility that owns relatively large amounts of gas transmission
pipelines. The second variable is "Genco" which represents whether a utility has a high degree of unregulated generation. The third variable is net debt to firm value or you can think of that as debt to the combined value of your equity market cap and your debt. And the final variable, payout ratio, which is the amount of dividends
paid out as a percentage of book (G.A.A.P.)
net income. Using those four (4) variables in our sample of
forty-four (44) utilities, we estimated that New Jersey Resources' forward P/E - based on its leverage, based on its dividend payout ratio, based on the fact that it's got a
lot of gas assets - it's forward P/E multiple could be in the range of
twenty four (24) times forward earnings and
it is currently trading at twenty one point seven (21.7)
times forward earnings. And that means that New Jersey
Industries is arguably undervalued to the extent of two point three (2.3) times forward earnings. South Jersey Industries, on the other hand, given its
leverage and the other factors we discussed, it has an implied forward P/E ratio of twenty three point five (23.5)
times whereas it's currently trading at a
consensus of twenty four point three (24.3)
times forward earnings. So it is mildly overvalued relative to its peers. What are the implications of this relative valuation analysis for the merger discussions? Well, firstly, the Board of Directors of NJR may be reluctant to issue too much stock to SJI shareholders if they feel that their stock - NJR
- is currently undervalued. Two point three (2.3) turns of forward earnings is not a huge under-valuation and there is some forecasting inaccuracy. Our model can only predict about sixty-five (65)
percent of the variation in forward P/E
multiples. We could potentially say two point three (2.3) times forward
earnings is just close to rounding error. Nevertheless, if you go into more
detailed analysis of relative evaluation, the NJR Board may be reluctant to pay a large premium to
the South Jersey Industry shareholders if you combine the NJR under-valuation with the SJI relative over-valuation. All things being equal, these relative value considerations may act as a type of an indirect constraint on the stock price premium that NJR would be willing to pay to SJI shareholders. Relative value considerations may also limit the proportion of equity that NJR is willing to use in the merger structure. Which is to say that relative value considerations may cause NJR to lean towards issuing some cash, or a higher percentage of cash consideration, than would otherwise be the case. On the other hand, if the NJR Board of Directors looks at its own stock price
multiples relative to its historical trading multiples, it may form the view that it's current trading multiples are
materially higher than the historic average range. And this may prompt the NJR Board to prefer to use more of its own
stock in the merger funding structure. There are several mergers
structuring considerations that can provide us with some guidance on outcomes to the speculated merger negotiations. An often overlooked aspect in merger negotiations is the corporate governance
arrangements. You'll often hear the press or analysts talk about merger
funding structures, earnings accretion / (dilution), pro forma leverage and we'll look at all of that. However, some of the key issues that get overlooked are the proposed
governance arrangements. For example, how many of the Board seats are
going to be allocated to each company? Who is going to be the CEO of the merged entity? Who is going to be the Chairman of
the Board ("COB")? If you have a one hundred (100)
percent cash takeover then SJI shareholders take their cash and walk away. So all of the
governance will be assigned to NJR; or at least they will get to decide who has the governing control. They may decide unilaterally to, for example, appoint the SJR CFO as the CFO of Newco, or they may give some Board seats to
the SJI Board but it's not really a negotiation. They (i.e. NJR) will control one hundred (100)
percent of the merged entity and they can, within limits, do whatever they
want. However, depending on the relative size of the two entities and the amount of stock issued, a one hundred (100) per cent stock
merger and/or a fifty (50) percent stock merger
can result in a number of different
outcomes. If NJR has clear control of NewCo after the merger, for example, the NJR shareholders hold, say, sixty (60) or seventy (70) percent
of the stock of NewCo, then it will usually only offer a limited number of Board seats to the SJI Board of Directors and they will generally retain the existing NJR senior management team. This is important because for the SJI Board of Directors to sign up for that kind of
governance arrangement they are going to
require a high merger premium. They - they being SJI's Directors - are not going to give up their
jobs in exchange for a relatively low merger premium. This gets even
more complicated when you are looking at a "Merger Of Equals" - where each company will gain
around fifty (50) percent of the control of NewCo - you would normally expect a similar number of Directors from
both companies on the merged company's Board and that may be the structure in an
NJR/SJI merger discussion. However, there is some complexity here because the average age of the NJR Directors is sixty-seven (67). While for the SJI Directors it is almost sixty (60) and that may point towards merger discussions where the SJI Board would be reluctant to give up their current
roles. Many, if not most, of the Directors on the SJI Board are probably not thinking
about retirement at this early stage in their career as a company
Director. This has implications for a fifty (50) percent stock / fifty
(50) percent cash merger because in that
scenario NJR would control roughly sixty-five (65) percent of the pro forma shareholder registry. And then when it comes to allocating
senior management positions in a Merger Of Equals it gets even more complicated. The CEO of SJI is only forty-eight (48) years of age and has only been the CEO for around two years. So he is probably not ready to hand over the keys to his new toy just yet. On the other hand, the CEO and Chairman of the Board of
NJR is also quite young at fifty-nine
(59). One way to resolve this issue would be for one of the CEOs to become CEO of NewCo and the other CEO could become the
Chairman of NewCo. However, that then depends on what the
current Chairman of the Board of SJI plans to do. Alternatively, the companies could
look at a multi-year transition period where they would share the CEO role. We see that quite a lot. The ability to find a resolution to these kind of governance
arrangements will play a key role in determining whether a low premium merger is even a realistic possibility. And its often overlooked when people perform their merger analysis. Our base case assumption is that NJR can control the NewCo Board if it pays a high (> 30%) merger premium or it can pay a low merger premium but expect to share control with SJI shareholders and the SJI Board. The key tax consideration for the SJI shareholders will be, not surprisingly, to pay as little tax as possible to achieve a tax-free sale; which really means a tax deferred
sale. The SJI Shareholders would prefer a 100 percent stock deal or potentially a 50 percent stock deal. (A 100 percent cash deal, as far as we are aware, will never work for a tax-free
sale.) If you are an SJI shareholder you would probably want a higher merger premium under the 100 percent cash deal to compensate you for the fact that you have to
pay the taxes today (or 12 to 18 months from now when the merger is
approved). As opposed to a one hundred percent
stock deal where, with some structuring, it may be possible to defer those
taxes until you sell the NJR shares many years from now. NJR's key focus in the merger tax arena will be the fact that SJI carries seven hundred million dollars in Net Operating Loss ("NOL") carry
forwards as well as an additional 200 million dollars in investment tax credit
carry forwards. It is these tax attributes that initially made us wonder
whether NJR and SJI were rushing to implement a merger before the Trump administration reduced the federal corporate income tax rate. Obviously, the lower tax rate would reduce the value of any NOLs. However, a typical US utility merger can take anywhere from 12 to 18 months - sometimes even longer - to secure the necessary State utility regulatory approvals. It is quite possible that the Trump administration will reduce corporate income tax rates before that time. Which is kind of fatal to our
tax-motivated merger theory. More importantly, when we run a quick
back-of-the-envelope analysis, applying the Section 382 limitation on post-merger annual NOL utilization, we estimate that it may
be possible to utilize all of SJI's NOL carryforwards, before they expire, at the current corporate income tax rate. This conservatively assumes that after an NJR merger the current long-term tax exempt rate under Section 1274 remains constant into the future. Historically, U.S. gas LDCs have achieved merger synergies in the ballpark of about 10 percent of their combined pre-tax, non-fuel operating and maintenance expense (or their
"OpEx"). Unfortunately for utility companies, the utility regulators will often require the merging gas LDCs to "share" a portion of any merger synergies with their utility customers. And while the sharing portion does
vary radically over time and across jurisdictions, a reasonable base case assumption is that 50 percent of the merger synergies will be retained by the
utility shareholders and 50 percent will be "shared" with utility customers in the form
of lower gas distribution rates. The analysis of merger synergies
gets even more complicated because both NJR and SJI, as we mentioned previously, have relatively large unregulated businesses. And while the unregulated businesses
do not need to share their merger
synergies with the utility customers, in reality the situation is far more complex and... shall we say... fluid. There are various reasons for this. Some of the main ones include that
the utility regulators use their own form of accounting which isn't the same as G.A.A.P. accounting. Nor is it the same as cash tax accounting that the IRS uses. So there will be different
depreciation rates, there will be different definitions
of whether items can be depreciated or not, there are different
treatments of tax credits & tax losses, the list of differences goes on and on. In practice there is often a debate - and often it a one sided debate -
where the utility regulator treats unregulated business OpEx items as
part of the regulated utility operations. While the unregulated operations of NewCo are not required to "share" their merger synergies with the regulated utility
customers, there is a lot less certainty regarding the level and durability of the merger
synergies for an unregulated business. As a result of these various considerations, we are going to assume in our base case that the combined company can achieve merger synergies equal to about 5 percent of the combined non-fuel, pre-tax operation and maintenance expense. This amount represents the combined regulated and unregulated non-fuel OpEx of the merged entity. However, we will also run upside and downside sensitivities on this 5 percent assumption later in the
analysis. Based on our discussion up until
this point on corporate governance
arrangements, tax structuring and merger synergies, we now are going to make a number of
base case assumptions for the various merger
funding alternatives. This is the more traditional merger analysis that you will see in most articles about merger arbitrage. The key earnings drivers in our analysis are going to be (1)
the acquisition debt interest rate - where we are
assuming 4.5 percent pre-tax; (2) the earnings growth rate of SJI which according to current consensus equity research analysts forecasts is 6 percent per annum, and (3) merger synergies equal to around 5 percent of the combined non-fuel, pre-tax operation and maintenance expense. We are going to use these base case
assumptions to compare and contrast both the low merger premium (say ~10 percent) and a high merger premium of around 30 percent. We will compare both of those
assumptions under three different funding
scenarios: (1) 100 percent cash takeover; (2) 100 percent stock merger; and (3) a 50 percent stock / 50 percent cash merger. Turning now to the 100 percent cash takeover scenario, this really is the easiest of all the alternatives to evaluate. Based on the pro forma leverage of
Newco it really doesn't matter what you
assume regarding merger premiums. NJR is unlikely to pursue this alternative. Not only would it wreck their credit rating and pretty clearly send them
to a sub investment grade rating - which
is not very sustainable for a regulated utility merger - it is also very unlikely that the New Jersey utility regulator would permit NJR to get that highly levered. We have seen over and over again that, even at much lower levels of pro forma leverage, the State utility commissions are reluctant to have their utility become financially "unsustainable". And being conservative they probably over-react to higher leverage. Similarly a high premium of, say 30 percent, stock merger is also unlikely. But in this case it's because the
pro forma earnings dilution for NJR would be so extreme. For NJR to break even in fiscal 2019 it would need combined merger synergies closer to 12 percent of non-fuel O&M and that number is assuming that the OpEx is tax deductible. Which, given the NOL credits and the tax credit carryforwards, it is possible that the effective
Newco tax rate will end up being a lot
less than 35 percent; so the required synergies may be a lot higher than 12 percent. We now turn to a true Merger Of Equals - which based on the
current stock prices - would entail a 100 percent stock merger. This appears feasible provided that the merger premium is
relatively low. That could mean anything from a no premium merger to, say, a 10 percent merger premium above the unaffected SJI share price. That type of merger
structure would not only be earnings accretive but it would also be credit
enhancing and would result in NewCo being
owned roughly 50 percent by NJR shareholders and 50 percent by SJI shareholders. In our base case this structure would probably involve some minor dividend dilution for the SJI shareholders which may not be acceptable in the current
market environment. It may be necessary to
adjust the deal structure and fund a higher pro forma
dividend. But, broadly speaking, the results would be the same. The 100 percent stock scenario does, however, come with the complexity of governance arrangements that we
discussed earlier. And we don't have a simple solution for how the NewCo Board
seats would be allocated or who would take on the NewCo CEO role. This seems the most complex part of the merger negotiations. Like the 100 percent stock merger alternative, a 50 percent stock
merger structure is best analyzed by
comparing the shareholder outcomes under both
the low premium (say 10 percent) and a high premium scenario (of, call it, 30 percent). The low premium, 50 percent stock deal appears unlikely because NJR would effectively control the pro forma company. It would have around 65 percent ownership and it would want to appoint most of
the Board of Directors and senior management
positions of Newco. However, the SJI senior management and Board of Directors would
presumably not want to relinquish their jobs
without a larger merger premium. Despite the attractive pro forma economics, we still consider a low premium, 50 percent stock merger unlikely given the current relative stock
prices of NJR and SJI. On the other hand, the SJI Board of Directors may decide to sell the company with no expectation of post-merger control in exchange for a higher
premium. This structure would be modestly
challenging to NJR's credit profile and potentially earnings accretive. It is certainly possible that both
Boards are currently trying to negotiate
this type of outcome and to do that they would be trying to provide certainty to the other side around the key earnings variables. Often times execution uncertainty of this type can be mitigated by serving up a healthy dose of due
diligence. Both NJR and SJI are projected to grow earnings per share by 6 percent per
annum for the next five plus years. This would mean that, despite an immediate deterioration in credit quality under a 50 per
cent stock deal with a 30 percent merger premium, NewCo could potentially grow into a higher credit rating in just a few
short years. It is possible under a 50 percent stock acquisition for the pro forma earnings to be accretive starting in fiscal 2018. Even if SJI was to receive a high merger premium of, say, 30 percent. However, we should point out that
this outcome is very dependent on several key
earnings drivers. Not surprisingly, the pro forma NJR earnings are very sensitive to the
merger premium being paid to the SJI shareholders. Given the current
utility sector trading multiples, it is probably reasonable to assume
that a 50 percent merger premium is not on the table under any merger
structure. Not only is it highly earnings dilutive to the extent of around 7 percent in fiscal 2019 but the merger premium is often a contentious issue in utility merger approval processes where the utility regulator is very reluctant to include that merger premium in the Regulated Asset Base. Paying such a high premium would create a lot of cost recovery issues in addition to the earnings
dilution problems. The pro forma earnings are also highly sensitive to the acquisition
debt interest rate. This is obviously not
a problem under the 100 percent stock scenario but under the 50 percent stock/ 50 percent cash scenario there is significant downside. If interest rates move, for example, 150 basis points above our base case assumption of 4.5 percent then NJR's pro forma 2019 earnings go from mildly accretive to almost 6 percent dilutive. And again this is assuming that all of the interest is tax deductible; which may or may not be the case
given all of the NOLs that can be utilized post-merger. There is also significant downside risk from the assumed long-term earnings growth rate for SJI. If, for example, that long-term growth rate ends up
being not 6 percent but, say, 3 percent - a reduction of 300 basis point - NJR's pro forma fiscal
2019 earnings go from mildly accretive to around 3 percent
dilutive. There is not much that NJR can do to hedge the risk that the SJI earnings do not grow at the
forecast rate of 6 percent per annum. Having said that, regulated utilities generally have more earnings transparency and certainty than other businesses. Although, as we discussed
previously, this may not be the case with SJI or NJR because of their relatively large unregulated
business segments and there is always
political risk with utility earnings growth rates. Lastly, there is the synergy risks that we discussed in the previous
section. What does this all mean for the
merger negotiations? Well, the major takeaway is that it
would only require a few minor adjustments to some of our base case assumptions to transform this 50 percent stock / 50 percent cash merger, with a 30 percent premium, from mildly earnings accretive to highly dilutive. For example, in our base case, NJR's pro forma earnings in fiscal 2019 are accretive to the extent of around 3 percent. If we assume a modest increase in the acquisition debt interest
rate from 4.5 percent to 6 percent pre-tax - which is not inconceivable given the pro forma leverage for NJR - then the pro forma NJR earnings in fiscal 2019 would be around 6 percent dilutive, instead of 3 percent accretive. But it gets worse. If SJI doesn't meet the 6 percent earnings growth rate
target - say it only achieves 4 percent -
then the pro forma earnings dilution is
now almost 10 percent of fiscal 2019 NJR earnings. Finally, if the combined non-fuel, pre-tax O&M synergies are not 5 percent but only 2.5 percent of OpEx, then the combined pro forma earnings dilution for NJR is over 11 percent in 2019. This kind of earnings sensitivity downside may not be a deal breaker for an aggressive Board of Directors. However, the Board of Directors of
utility companies tend to be conservative and risk averse. Their natural inclination may be to favor the certainty, or the relative
certainty, of a Merger Of Equals where they
share control of NewCo rather than risk a, not inconceivable, downside scenario of major earnings dilution. Despite these concerns, the 50 percent stock merger
structure still represents the most realistic scenario for the SJI shareholders to recognize a merger premium in
excess of 10 percent. If we put aside for the moment the unlikely scenario of an aggressive bidder who doesn't
feel bound by earnings constraints or who isn't worried about being
downgraded to a sub investment grade credit rating, putting those aside, there is an alternative scenario
where SJI shareholders may be able to achieve a higher merger premium. That has to do with the relatively large unregulated business operations of both NJR and SJI. NJR's
unregulated operations are equal to about 45 percent of its total operations and SJI's is about 35 percent. This compares to an average US utility's regulated business of over ninety two (92) percent. Which means the average U.S. utility only derives eight percent of its total economics from
its unregulated operations. So it may be possible, at least in
theory, to divest some or all of the unregulated operations
of NJR or of SJI and then use those
post-tax proceeds to pay down merger acquisition debt, or to fund a
higher merger premium payment to SJI. . And then they use those use those taxes they say to pay down acquisition debt or to fund a higher merger premium payment to SJI. Unfortunately, when we think through
the issues involved with divesting their unregulated businesses, it doesn't really take
us much further. If there is a Merger Of
Equals, the goal of both sides will be to keep the merger premium
relatively low. And the pro forma leverage with the Merger Of Equals scenario is already quite low. Divesting the unregulated operations isn't, strictly speaking, necessary to maintain a quality credit rating. Under what scenario would you
consider divesting the unregulated
businesses? Well, it could be useful under the ~30 percent premium, 50 percent stock merger scenario. There are some complications though, even under that scenario where
you're trying to fund a higher premium and you have high pro forma leverage to contend with. The problems include the fact that many of these unregulated businesses benefit from the "halo" effect of being associated with the regulated utility. You are going to be more willing to "trust" the unregulated businesses when they are associated with your local utility. That may mean that if the unregulated businesses are sold to a third party, the third party
may not value those assets as highly as the
regulated utility would value those assets. There is also a lot of execution
risk involved, obviously, in selling the
unregulated operations. You would have to query whether the NJR shareholders want to be burdened with that execution risk. They have already got to contend with the fact that they are
undertaking a massive merger with a similarly sized company. On the other hand, the SJI shareholders may not want to provide what is called
an "earn-out" where they would receive additional merger consideration if, and when, the unregulated operations
have been sold. They would want the operations to be
sold prior to the deal closing. It is true that SJI could use some of its Net Operating Loss
("NOL") carry forwards to offset the taxable gain on the sale of its unregulated operations. This could be a useful strategy if there is a reasonable chance that those NOLs will expire before they are utilized. That benefit
would need to be weighed against the increase in both deal execution risk and uncertainty and the possibility that the NOL carry forwards might be utilized before they expire anyway. A pre-deal divestment of either company's unregulated operations would also impact a
number of viable alternatives for a
tax-free merger. A number of the Section 368 tax-free structures prohibit any asset divestments, while other structures would limit
divestments to 30 percent of gross assets and 10 percent of net assets. It is possible, potentially, to structure a pre-deal divestment but it is not going to be
easy. Certainly not a slam dunk. Other structuring alternatives such
as, say, a spin-off of the unregulated businesses might be viable. Even if they are viable
alternatives, they are not going to permit you to
pay a higher merger premium. Each of these alternatives would
impose their own set of restrictions on the
post merger operations and ownership of Newco. To summarize all of that... there
are a number of steps that NJR could
potentially take to monetize the unregulated operations of either, or both, of the merging companies. All those steps would involve more deal complexity, execution uncertainty and general risk that may not be willing to be borne by either side. It is also reasonable to expect that
NJR would not look to share all of this valuation upside with the SJI shareholders. After all, if NJR takes all the execution risk, they are not going to want to
hand that all over to the SJI shareholders; who have taken none of the execution
risk. If NJR and SJI go down the route of a Merger Of Equals, then there is no immediate need to de-lever the balance sheet and they would not even be wanting to pay a higher merger premium to
SJI. You cannot do a Merger Of Equals if one side is getting a huge premium. We have covered a lot of ground but what are the key takeaways from
this analysis of a potential merger? Well, the first one is that a 100
percent cash acquisition of SJI at pretty much any merger premium is a non-starter. There are regulatory approval
concerns, the pro forma leverage doesn't
appear to be sustainable for a regulated
utility etc etc. Similarly, the high premium, 100 percent stock deal is
challenging for several reasons including stock dilution, governance sharing and, thirdly, we can probably rule out a 50 percent stock merger at a low premium even though it is earnings
accretive because it would not make sense to the SJI Board of Directors. If we turn to the realm of what is actually possible... We think that a 50 percent stock
merger at a 30 percent premium makes sense - on paper at least - for NJR's
shareholders. Although, there are a number of
earnings risk items that would need to be
resolved before such a deal can proceed. Based on their current financial
profiles, a low-risk merger structure for
these two companies would have to be the Merger Of Equals alternative. A 100 percent stock deal at a low
premium would require NJR to share control of NewCo but it would also provide pro forma earnings and leverage that makes sense for both sets of companies. If a merger is announced, the US State utility commissions
have shown a willingness in recent years
to strike down an inordinate number of otherwise financially sound utility merger proposals. Which is to say that any merger
premium should take account of the fact that
it is not uncommon for the utility regulatory approvals to take upwards of 12, even 18 months. Even then, after that long wait, there is no guarantee that the regulators will approve the
transaction. Which, to our mind at least, goes a long way towards explaining why both the NJR are SJI stock prices closed up only 2 percent on the day of the Wall Street Journal blog merger speculation. If the most likely
scenario is a 10 percent merger premium and it's going to take 18 (maybe more) months for that deal to
close - and it may never close - then on a probability-weighted, net present value basis a 2 percent lift might actually be the right market reaction. We'll have to wait and see whether
any deal is announced. That concludes today's recap of the merger analysis. If you would like to read more about
the challenges of negotiating merger premiums, you can download the
written article from the Seeking Alpha website and the PowerPoint slides are
available from the Lateral Capital Management
website. Links are provided below the video
