MERGER ARBITRAGE: NJR (NYSE) & SJI (NYSE)
NJR & SJI: THE CHALLENGES OF NEGOTIATING MERGER PREMIUMS
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The opinions expressed herein address a limited number of aspects regarding a potential investment in securities of the companies mentioned and are not a substitute for a comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations as to its accuracy. LCMI recommends that potential and existing investors conduct a thorough investment analysis of their own, including a detailed review of the companies' SEC filings, and consulting a qualified investment advisor. This material is based on information obtained from sources believed to be reliable, but the reliability of that source information has not been independently verified. Any opinions or estimates constitute a best judgment as of the date of this presentation and are subject to change without notice. LCMI explicitly disclaims any liability that may arise from the use of this material.
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Executive Summary Several considerations, both financial and non-financial, suggest that if the rumors of a SJI/NJR merger are correct, the merger premium is not likely to be substantial. ▪ ▪ ▪
Market rumors of a New Jersey Resources (NYSE:NJR) merger with South Jersey Industries (NYSE:SJI) resulted in an initial stock price pop of circa. 6% However, at current market prices, the most likely outcome appears to be a low premium merger-of-equals funded with 100% NJR stock Beyond traditional earnings accretion and pro forma credit analysis there are several additional considerations pointing to a low premium deal, including o o o o o
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Governance sharing Taxation considerations; especially NOL utilization limitations Utility regulator sensitivity to pro forma leverage Merger synergy sharing Tax free sale structuring constraints
Our analysis includes a cross-sectional regression of current US utility forward P/E multiples o o
There is currently a relatively high correlation (Adj-R2 = 65%) between P/E and leverage, dividend payout ratios, portion of gas-related operations, and portion of merchant generation operations Based on these characteristics, SJI is mildly over-valued and NJR is mildly under-valued relative to their peers. This consideration will influence the willingness of NJR and SJI to offer (or accept) stock in any merger
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Table of Contents 1.
Merger Speculation
2.
Utility Sector Valuation Drivers
3.
Governance Arrangements
4.
Taxation Considerations
5.
Merger Synergies
6.
Merger Funding Alternatives (6.1) 100% cash
(6.2) 100% stock (6.3) 50% stock / 50% cash
7.
Leveraging the Unregulated Businesses
8.
Recap
Appendix
Section One
Merger Speculation
NJR & SJI Are Comparable In Several Key Respects Figure 1
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Contribution Analysis Across a range of metrics, NJR is marginally more likely to be designated the acquirer in any merger with SJI
Figure 2
4
After Rallying 6%, Both Stocks Closed Up ~ 2% On a probability weighted, net present value basis, this muted response appears valid. A merger announcement is not a certainty and we consider a high premium deal (30+%) a remote outcome
Figures 3 & 4
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Section Two
Utility Sector Valuation Drivers
The US Utility Sector Rallied Strongly Since 2014 After underperforming its peers for most of 2014 and 2015, SJI has outperformed since its early 2016 lows
Figure 5
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The Exchange Ratio Reflects SJI’s Recent Outperformance Figure 6
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Gas LDC Trading Multiples At first glance, both NJR & SJI may appear over-valued relative to many of its peers Figure 7
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U.S. Utility P/E Multiple Regression: Key Valuation Drivers Figure 8
9
NJR Appears Modestly Undervalued Based on Its Comps Figure 9 This will, all things being equal, make NJR less likely to issue its own stock as well as less likely to pay a high premium for SJI’s stock
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Section Three
Governance Arrangements
Governance Considerations Will Drive Merger Negotiations 1
Newco Board seat allocation to existing Directors (especially Newco Chairman)
2
Newco senior management team (especially CEO, CFO)
3
Board member retirement plans
4
Size of proposed merger premium
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Pro forma shareholder ownership (in particular, will SJI shareholder own > 50% of Newco)
The choice of governance structures is inextricably linked to the size of merger premium & the funding structure
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Section Four
Taxation Considerations
SJI Has Material NOL and Tax Credit Carryforwards Figures 10 & 11
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Section Five
Merger Synergies
Utility Regulators Require Regulated Utility Synergy “Sharing”
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Utilities often achieve merger synergies equal to ~ 10% of the combined non-fuel, operations & maintenance expense (“opex”)
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Utility regulators require “sharing” of merger synergies with utility customers. Generally 50% of the post-tax synergies are retained by merger shareholders, and 50% of the synergies are shared with utility customers (in the form of reduced utility rates). In theory, only regulated utility operations are required to share opex synergies
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There are three forms of “inside basis” accounting: • book (GAAP/IFRS), • cash (IRS) and • utility regulator
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The utility regulator’s view of regulated utility opex may differ materially from book and cash tax definitions of opex (i.e. the regulator may include unregulated operations opex in their estimate of regulated utility opex)
The complexity surrounding utility merger opex synergy sharing with ratepayers is complicated by the fact that both NJR & SJI have relatively large unregulated subdiaries
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Section Six
Merger Funding Alternatives
Key Model Assumptions For A NJR/SJI Merger Figure 12
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Overview of Key Merger Scenarios
Financing Structure
Premium Low (~10%)
100% cash High (30+%)
NJR Financing Alternative s
Low
100% stock High
50% stock / 50% cash
Low
High 15
A 100% Cash Deal, At Any Premium, Is Not Likely Figure 13 A 100% cash deal is likely to result in material credit rating downgrades. Even if NJR & SJI were not ratings constrained, the utility regulators are unlikely to approve a merger with such high pro forma leverage Given the relatively large contribution of unregulated businesses to both of NJR’s and SJI’s credit profile, Newco will be more sensitive than usual to forma leverage
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100% Stock Deal At a 30% Premium Is A Non-Starter Figure 14 A 30% premium might be feasible under a 50% stock / 50% cash structure
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SJI Would Not Accept a 50% Stock Deal With a 10% Premium Figure 15 Relinquishing control of NewCo in exchange for a low merger premium is a non-starter
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Newco Can “Grow� Into A Higher Credit Rating SJI is projected to grow EPS at 6% per annum for the next 5+ years. If realistic, this growth could dramatically reduce Newco leverage
Figures 16 & 17
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Key Sensitivities For Pro Forma 2019E NJR Earnings Figure 18 As mentioned, we consider a 30% premium under a 50% stock deal to be the less likely outcome. Moreover, paying a merger premium in excess of 30% is even less likely as, for example, a 50% premium to the current SJI stock price would result in unacceptable earnings dilution in excess of 7%
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A 50% Stock / 30% Premium Deal Risks Major Dilution Unlike a 100% stock deal, a 50% stock / 50% cash deal is extremely sensitive to debt interest rate assumptions. Moreover, small changes in SJI’s future EPS growth rate are highly influential
Figure 19
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Section Seven
Leveraging the Unregulated Business(es)
It May Be Possible To Divest Unregulated Subs Figures 20 & 21 NJR and SJI have relatively large unregulated operations by US utility standards.
NJR
Sale of some of these subs will reduce the riskiness of Newco’s business profile, as well as enabling a more rapid repayment of merger debt It is unlikely that any such divestment(s) would permit a higher merger premium payment to SJI shareholders
SJI 22
Section Eight
Recap
Recap Of Major Structuring Alternatives Financing Structure
Premium
Implication(s)
Low (~10%)
SJI may veto &/or leverage concerns
High (30+%)
Leverage concerns
Low
Possibility
High
Dilution & non-MoE
Low
SJI may veto
High
Dilution risks
100% cash
NJR Financi ng Alterna tives
100% stock
50% stock / 50% cash 23
Several Considerations Point to a 100% Stock Deal (If Any) There are only two realistic alternatives for a NJR / SJI merger: a 50% stock deal at a 30% premium, and a 100% stock deal at a 0% to 10% premium
Figure 22
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Appendix: Statistical Tests for Utility P/E Model
Normality Tests Several tests pointed to normally distributed data: - Skewness & Kurtosis z-values - Histograms - Q-Q plots - Boxplot symmetry - K-S and S-W tests (note: GASSY and GENCO are dummy variables)
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There Was Tentative Evidence of (Mild) Heteroskedasticity Koenker test is preferred over B-P test for small samples such as ours (n=44), suggesting no statistically significant heteroscedasticity. The standardized residuals scatterplot was inconclusive To be conservative, we adjusted the standard errors for the presence of heteroscedasticity
Some statisticians have advocated making this adjustment even if there is no evidence of heteroscedasticity (e.g. Darlington & Hayes (2017))
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Regression Estimates Were Adjusted For Heteroskedasticity Appendix A eViews uses a HC1 process to correct for heteroscedasticity, resulting in PAYOUT being on the cusp of statistical significant at the 5% level (p=0.051) However, using HC3 or HC4 in SPSS, PAYOUT is no longer statistically significant (p=0.0875 and p=0.081, respectively)
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Absence of Multi-Collinearity Appendix B Several tests indicated that any multi-collinearity was mild and would not bias our results - Low VIFs - Absence of high R-sq combined with low ttest values - Abs. value of correlations did not exceed 0.7 (max. 0.325) - Low condition indexes - Dividing the sample into two did not change coefficient signs or magnitudes Even if there was evidence of MC, it may invalidate our coefficient estimates but not our overall model accuracy
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Alternative Regression Excluding PAYOUT Variable There are several methodological reasons for retaining the PAYOUT variable - including the risk of omitted variable bias and the fact that irrelevant variable bias will only inflate the standard errors of the other variables (i.e. it will make the regression results more conservative). However, even in a formulation where we exclude PAYOUT from our Forward P/E multiple model, NJR remains modestly undervalued and SJI mildly overvalued, relative to its regulated utility peers
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