Putting a price on Contact Energy

Friday 19th October 2001

The market says Edison will have to pay more for our top generator - but how much more?

Once upon a time New Zealanders believed the boys at Californian energy giant Edison International just had to be pretty smart.

That wasn't down to any familiarity with Edison's strategic business nous or with its prodigious feats of financial engineering. Most likely it was just the respect we accord to companies with assets approaching our country's annual gross domestic product.

Lately, however, Edison's image has been slipping somewhat.

On October 8, just four days before it announced its $1.1 billion, $3.85 a share takeover offer for Contact Energy, Edison closed the book on one of its less-than-smart British energy investments.

It sold two coal-fired power stations to American Electric Power for £650 million, half of the £1.3 billion it paid for them in 1999.

The disaster will this year result in a charge of $US1.18 billion ($2.8 billion), suggesting a calendar year loss of impressive proportions even by Edison's standards - its June second-quarter deficit, mostly from the Southern California Edison subsidiary, was $US102 million ($242 million).

Back here in Noo Zeeland its Contact bid is in deep trouble early on in the piece.

At 25% above the six-month trading average Edison no doubt thought its $3.85 offer could be sold as generous. After all, only in May last year the shares hit a low of $2.38. As recently as June this year they were fetching a mere $2.96.

The market clearly thinks otherwise. Since Edison announced its offer Contact's share price has consistently exceeded the offer price, topping $4 at one point.

Sharebrokers are without exception telling their clients to hang on. JB Were values the stock at $4.36, assuming a $48 a megawatt hour long-term power price. ABN Amro, on the same assumption, is higher still at $4.86. Even at that price Contact is arguably a steal.

The arguments for a higher price by far - say, $5 or $6 - are probably more sophisticated than Contact's 136,000 mum-and-dad shareholders can take on board. But they won't be lost on the institutional holders.

Hence their intense scrutiny of the conduct of Contact's independent directors and of Grant Samuel, the valuer the independents have appointed.

Some in the sharebroking and funds-management fraternity feel, fairly or unfairly, that GS is the last valuer Contact's directors should have appointed.

GS, they reason, was called in only five months ago to appraise Edison's $3.10 offer to lift its stake from 42% to 51%. It found the offer fair to shareholders, valuing the company at $2.95 to $3.25 a share.

Now, with the instos demanding $4.50 plus, GS will have to defend that range. That will make it hard, critics allege, for it to acknowledge arguments the company is worth far more.

A lot has happened since May to alter GS' valuation, most significantly the huge retail market rationalisation caused by the winter power price surge.

And that surge has in itself demonstrated Contact's unique ability to leverage rises in wholesale electricity market prices. Some also feel neither GS nor the market have Edison's informed appreciation of the probable long-term electricity price path.

ABN Amro's $4.86 valuation is the Contact price implied by a "long run marginal cost" (LRMC) of electricity of $48 a megawatt hour (against a current seven-day rolling average of around $57, still edging down from the winter price spike).

ABN's $48 doesn't come out of thin air. It is the "representative" price a recent report of the electricity Market Surveillance Committee adopted based on a detailed survey of market players - arguably the most authoritative crystal-ball gazing exercise it's possible to conduct.

What's more, ABN reckons, valuations based on the LRMC don't take into account strategic or financial structuring benefits which might lower Edison's cost of capital.

And the broker's analysis of multiples of ebitda (earnings before interest, tax, depreciation and amortisation) paid in recent industry mergers and acquisitions implies Contact could be worth as much as $5.40 to $6 a share.

Contact has moved forward to next week - no specific day yet - its announcement of its September-year financial results.

The bottom line is expected to be uninspiring compared to last year but that's a bit of a red herring.

The number to watch for will be operating cash flow, which is expected to be more than double last year's $186.8 million. Investors need to ask how much of this is coming from the Maui gas Contact hasn't previously been able to take under its take-or-pay contracts. The gas will pump up OCF but that will last only for two or three years.

Adding to the "dumb Edison" view is the Big Californian's timing.

As already noted, only 18 months ago Contact's shares were trading at $2.38.

Edison's May move to 51%, at $3.10 a share, was plainly motivated by the July 1 advent of the Takeovers Code. If you accept analysts' valuations - and bear in mind the $5 a share Edison paid for 40% in 1999 - it's obvious Edison could have taken the company out, at any time over the past couple of years, at prices well below what the minorities are now demanding.

It looks to have been caught with its pants well and truly round its ankles by the winter price spike, as AGL was. On June 15, when AL unit On Energy announced it was going to have to raise prices, Contact shares were at $2.96. In mid-July they'd reached $3.35 and by the end of September they were at $3.48.

All eyes are now on Contact's independent directors - chairman Phil Pryke, Jock Milne, and Tim Saunders.

Saunders, most agree, is his own man and will weigh everyone's views carefully. Ditto Milne, an old Shell hand. Pryke is enigmatic.

How these three handle Edison's mop-up bid will write a fresh chapter in the history of New Zealand corporate governance.

Shoeshine owns Contact shares

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