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If at First You Don't Succeed...

Power-hungry Western Resources resuscitates a merger with Kansas City Power & Light.
Linda Corman, CFO Magazine
September 1, 1998

Three months after scuttling a long-sought- after, $2.3 billion deal, Western Resources Inc. returned to the fray with terms that finally captured Kansas City Power & Light (KCP&L). In March, nearly two years after Western Resources, in Topeka, Kansas, had launched a hostile bid for its Kansas City­ based neighbor, the two companies agreed to merge.

Aside from joining two utilities, say experts, the process might suggest a merger strategy for other companies seeking to lower the acquisition prices driven higher by fluctuations in stock price.

Such fluctuations scotched the original deal for KCP&L last December. Under terms reached in February 1997, Western Resources was supposed to exchange stock worth $32 a share for each share of KCP&L stock. At that level, the merger was priced at around $2 billion. But in November 1997, Western Resources closed two smaller deals.

On November 24, Western Resources exchanged its interest in the home- security business plus $258 million in cash for 82.4 percent of Protection One, a security-systems company based in Culver City, California. Less than a week later, Western Resources traded its natural-gas assets in Kansas and Oklahoma for a 45 percent stake in ONEOK (pronounced "one- oak), a natural-gas company in Tulsa.

Meanwhile, Western Re-sources was sitting on a pile of cash it had collected in the wake of a failed run at ADT Security Systems Inc., a security alarm company based in the Bahamas. During that takeover attempt, Western Resources had accumulated 38 million ADT common shares: not enough to fend off competing bidder Tyco International Ltd., of Exeter, New Hampshire. In July 1997, Western Resources capitulated. For its trouble, however, Western Resources collected $860 million, an 88 percent return on its ADT investment.

The cash allowed the company to pay down a large portion of debt accumulated over a two- year acquisition binge, says Greg Gordon, an energy-industry analyst at CIBC Oppenheimer, in New York.

Those events, combined with an ebullient stock market, pushed Western Resources stock above $40 a share in mid-December. At that point, Salomon Smith Barney, Western Resources's banker, ad-vised the company to back away from KCP&L.

Had the deal gone through according to its original terms, Western Resources would have faced a $340 million price increase, a 17 percent rise, with no change in KCP&L's earnings power. Because stock transactions do not deplete cash, a more cavalier management might have elected to wave the deal through. Western Resources, however, elected to return to the drawing board.

Starting from Scratch
Robin Diedrich, a securities analyst with Edward Jones, in St. Louis, says that Western Resources had no choice. It "needed to start from scratch." Short of a complete overhaul in the terms, shareholders of both companies might have felt cheated.

In stepped David Wittig, president and chief executive officer of Western Resources. Wittig, who had served as a co-director of mergers and acquisitions at Salomon Brothers Inc. before its merger with Smith Barney, proposed a novel approach.

The new agreement, announced last March 19, sweetened KCP&L's share price by $2, raising it to $34.50--provided that Western Resources shares continue to trade at prices ranging from $38 to $47 each.

The total price in this scenario is $2.18 billion. However, KCP&L shareholders will not collect all the proceeds in shares of Western Resources stock. Instead, they will surrender each KCP&L share for $23.50 in stock issued by Western Resources. They will also collect one share, with an expected value of $10 to $12, in a new subsidiary called Westar Energy. Westar will operate all of the regulated businesses owned previously by Western Resources and KCP&L, and Western Resources shareholders will end up with 80.1 percent of Westar.

Moreover, Western Resources shareholders will retain their interest in a larger share of such nonregulated activities as home security and natural gas that make up the company's fastest-growing segments. "In the pure stock deal, from the perspective of Western Resources shareholders, every share that was given to KCP&L diluted the value of the alarm and gas franchises. KCP&L was not giving anything of comparable value," says CIBC Oppenheimer's Gordon. In contrast with a more diversified Western Resources, KCP&L remains a largely regulated utility.

In the merger's last stage, Western Resources CFO Steven Kitchen played a key role in launching Westar as a public company--a hurdle set by KCP&L. "We understood what KCP&L management wanted in terms of maintaining a New York Stock Exchange­traded company," says Kitchen. "We figured out how to address that."

According to Kitchen, the revamped deal is better for shareholders in his company because they won't have to surrender as much of the value created during initial stages of the merger. Absent a larger interest in the more dynamic business segments, KCP&L shareholders will, at the very least, walk away with a higher price for their shares. Meanwhile, KCP&L management gets a key role in running Westar.

Drue Jennings, chairman and CEO of KCP&L, who strenuously opposed the hostile suit by Western Resources, will become Westar's CEO. In early August, it was still unclear whether KCP&L CFO Bernard Beaudoin would join Westar as its CEO.


A Free Carrot
How much independence Jennings and his comrades will enjoy at Westar remains to be seen. In the meantime, independence is a carrot Western Resources can offer at no cost. "It gives management a toy to play with," says analyst Alan Lindstrom, director of securities research at Redwood Securities, in San Francisco. Like Jennings, Larry Brummet, the former CEO of ONEOK, continues to run his own nonregulated shop under the Western Resources umbrella. Jerry Neal, ONEOK's CFO and treasurer, also has remained at his post.

Shareholders of both companies approved the Western Resources/KCP&L merger on July 30, leaving utilities regulators in Missouri and Kansas to mull over its implications. The Federal Energy Regulatory Commission also must weigh in. Although regulators could kill the merger with onerous re-strictions, in the round of consolidations sweeping utilities in the United States, analysts expect this one to go through largely intact.

By separating regulated and nonregulated activities in different publicly traded entities, this merger charts new territory, says investment banker Douglas Kimmelman, a Goldman, Sachs & Co. partner, in New York. Although several utilities, including New Orleans­based Entergy Corp. and Northern States Power Co., in Minneapolis, have reportedly explored prospects for splitting regulated and nonregulated businesses in publicly traded subsidiaries, none has taken that step yet.

Formally separating those businesses accelerates a process initiated when Western Resources merged with Protection One. Putting its home-security assets into a publicly traded vehicle fostered a more favorable reception in the stock market, where securities analysts who normally follow utilities have trouble assessing more nimble businesses.

Because of sluggish growth prospects, utilities tend to exhibit low price/ earnings multiples that drag down multiples for faster- growing components. By trading on their own, nonregulated businesses usually garner a stock market response more in line with loftier growth patterns. A resulting improvement in the stock price enhances prospects for future stock-based mergers.

"If you rely only on utility equity, then you're using more expensive currency," says Kimmelman. "If you can carve out the unregulated businesses, you're working with cheaper dollars." This also applies outside the utility industry, says Kimmelman. Any company with two businesses valued differently by equity markets, regulated or unregulated, is a candidate.

----------------------------------------------- --------------------------------- M&M's Legacy
What will be the legacy of the work of Modigliani and Miller? One implication that has almost gone unnoticed is the modern obsession with shareholder value. While academics have been busily proving that capital structure can affect shareholder value, few have questioned that shareholder- value creation itself is the goal of the corporation.

"The view which existed until the time our paper came out was that management was supposed to maximize profits," says Modigliani. "We replaced that concept with another one, maximizing the market value of the firm--you should do those things that the market likes. This concept has been very broadly used, and there is now a broad discussion that the goal of management is the maximization of market value."

Concurs Stewart C. Myers, co-author of Principles of Corporate Finance: "M&M sort of woke the field up and set a standard. If you are going to work in the field it is going to have be serious economics, and it has to take into account that there is a capital market out there. You can't spin theories about corporate finance without making it consistent with what is going on in capital markets."




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