Origin Contact Merger - Attachment 2 - Background
Attachment 2 - Background
Origin and Contact agree to merge to create Australasia's largest integrated energy group
Origin Energy acquired a 51.4% interest in Contact Energy in October 2004. It did so with the objective at that time that the acquisition:
- secured a controlling interest in a well managed business that pursued similar business strategies to Origin Energy but focussed primarily in the New Zealand energy market;
- provided greater scale and diversity of business and cash flows therefore improving the overall business mix within Origin Energy;
- created more opportunities for growth by establishing through Contact Energy a sound competitive position in New Zealand that complemented Origin Energy's existing businesses;
- provided appropriate returns for shareholders at the price paid.
Origin Energy has achieved these initial objectives. However, since acquisition it has become evident to the Directors of both companies that the similarity of strategy and operations is such that significantly more value could be created if the two companies combined.
The combination of the two companies would create the market leading company in the domestic energy market in Australia and New Zealand. The combined companies:
- Produce and supply energy to more than 2.6 million electricity, natural gas and LPG customers throughout Australia, New Zealand and the near Pacific region.
- Own and/or operate around 3,000 MW of hydro, geothermal and thermal generation.
- Have fuel security through long term access to hydro and geothermal resources and over 2,000 PJs of gas and liquids reserves on an equity (2P) or contracted basis.
- Have the largest portfolio of exploration acreage in New Zealand and significant exposure to exploration opportunities and reserves growth in Australia.
- Have a strong set of growth projects through exploration, development of existing 2P reserves, development of major generation projects in Australia and New Zealand, growth in market share in domestic energy markets particularly in Australia and development opportunities through development expenditure on solar photovoltaics and hot dry rock (HDR) technology.
- Have a lower carbon intensity portfolio of energy producing assets than market average with the prospect of benefiting significantly from carbon costs should they be introduced.
- Will have a market capitalisation exceeding A$7 billion. Both companies currently have between them 200,000 shareholders.
- Will have EBITDA estimated to exceed A$1 billion pa, total assets of A$8.8 billion and sales in excess of A$5.5 billion.
- Employ more than 4,000 people through the region.
Benefits of a Combined Business
The potential to significantly increase the value of the combined businesses arises for three key reasons.
- A combined business can eliminate conflicts and inefficiencies at a strategic and operational level that arise under the current ownership structure. The current structure whereby Origin Energy owns 51.4% of Contact Energy can result in competition for opportunities rather than co-operation. Through the requirement for shareholder approvals for related party agreements inefficiencies are created in not being able to maximise benefits for all shareholders.
An illustration of this conflict is where Contact Energy wishes to undertake exploration to find more gas to fuel its thermal generation but Origin Energy is better placed to conduct that exploration. Should Origin Energy undertake that exploration and be successful, the sale of gas to Contact Energy by Origin Energy under the current structure would require shareholder approvals which would not be required if Origin Energy was to sell that gas to a third party. Another example is where the integration of Origin Energy's LPG business in New Zealand with Contact Energy would create both cost savings and revenue enhancements for the combined businesses. However, under the current structure the sale by Origin Energy to Contact Energy of its business would require Origin Energy to forego 48.6% of its interests in the business. Origin Energy would not do this without being appropriately compensated for the long term value it has foregone.
At an operational level combining the companies would facilitate savings in operating costs. It is expected that combining the companies will result in reduced costs in corporate functions such as tax and treasury, savings in procurement, harmonisation of management systems, and reduction in retail operating costs through shared development of systems. Some revenue enhancements are also expected through shared product and marketing strategies in the retail business. Savings in capital costs are also expected through co-ordination of procurement of major capital items, spares and maintenance contracts.
- A combined business will benefit significantly from managing its financial position on a unified basis. The current cash flows generated by Origin Energy and Contact Energy cannot be easily managed on a combined basis. The combined companies can better allocate cash flow to opportunities at times most likely to maximise value to shareholders from both companies. The companies' capital raising (both debt and equity) are separately managed. The combined business would have a lower cost of capital due to lower volatility of earnings, increased market capitalisation of the combined business and improved liquidity.
- A combined business will better manage the strategic challenges that Contact Energy faces in New Zealand and create more opportunities for growth. Both companies have pursued the same strategy of building an integrated business across the fuel, generation and retail segments of the competitive energy markets in Australia and New Zealand. However, each Company faces different challenges in implementing that strategy.
Contact Energy is a net generator with its large investment in generation in excess of its retail requirements. It has fuel security for hydro and geothermal generation but only five years forward cover on fuel for its current thermal generation. It has valuable options in consented sites to expand its thermal generation but lacks the fuel certainty to underpin these options.
The key strategic challenge for Contact Energy is to create fuel certainty to maintain the value of its current thermal generation and add value through the conversion of its consented sites to expand generation to meet New Zealand's growing energy requirements. Clearly the discovery of more natural gas would achieve this objective. However there is insufficient gas focussed exploration in New Zealand to address this problem in the time frame required by Contact Energy. Contact Energy alone does not have the resources or skills to mount an exploration program that has any real prospect of creating value through exploration.
Origin Energy, in contrast, has assembled a significant portfolio of exploration opportunities in Australia and New Zealand and has both the skills and resources as well as the incentive through its interest in Contact Energy to aggressively pursue these opportunities. Whilst this program cannot guarantee success in New Zealand, it is part of a broader exploration portfolio in Origin Energy through which Origin Energy has demonstrated success in adding value through exploration.
If additional gas is not to be found in New Zealand and Contact Energy has to rely on imported liquid fuels (oil, LNG, GTL) it is exposed to significant profit risk should the input cost of these fuels not be able to be recovered from higher electricity prices. In a merged business Contact Energy has the benefit of Origin Energy's gas and liquids production which can provide a natural hedge against that profit risk.
In Australia, Origin Energy is a net retailer with limited investment in generation and long-term fuel security through its gas purchase agreements and growing gas and liquids reserves and production. The next phase of Origin Energy's strategic development in Australia is through significant investments in generation. To this end, Origin Energy is currently consenting sites in Queensland and Victoria to develop up to 1,000MW power stations in both locations.
Contact Energy's demonstrated skills in the development and operation of power stations will significantly enhance Origin Energy's ability to deliver value to shareholders in undertaking these developments.
Combined, the two companies are one of the largest consumers of natural gas for power generation and onsale in its retail businesses and one of the largest energy retailers in the region. These positions will allow the combined business to leverage more opportunities for growth than each company could identify on its own.
In considering how to best unlock the benefits of combining the two businesses, the Directors of Origin and the Independent Directors of Contact have concluded that the proposed merger:
- should deliver improved financial performance for shareholders through higher share of earnings and/or increased dividends;
- produces (for any given level of dividends) lower gearing to fund growth and thereby create additional value for shareholders.
- allows Contact and Origin to each retain their national identities by not requiring the combined business structure to be domiciled in only one country;
- recognises that New Zealand investors would prefer to hold shares in a prominent New Zealand business as opposed to an Australian business with operations in New Zealand and vice versa;
- recognises that as Contact is one of a limited number of "blue chip" stocks on the New Zealand sharemarket it ensures that New Zealand investors continue to have access to such a New Zealand investment and that as such each company continues to be appropriately represented in each country's share indices;
- provides greater flexibility in the future to raise equity in different jurisdictions as shares in either Contact or Origin could be provided as consideration when making future acquisitions; and
- preserves to a large extent existing shareholder taxation treatment in that it does not involve shareholders having to dispose of existing shareholdings which could impact their ability to continue to receive equivalent levels of imputation and franking credits.
Given these considerations, Origin Directors and the Independent Directors of Contact have concluded that the only viable way to merge the two companies is by combining Origin Energy's New Zealand business with Contact Energy and then merging these businesses by way of a dual listed company (DLC) company structure. This form of merger will secure and make available to both Origin Energy and Contact Energy shareholders the maximum benefits that will arise from combining the two companies.
Details of the proposed merger
The practical effect of the merger is that with a common Board and management team, the business will be effectively unified. There will be cross guarantees between the merged companies.
Merging of the company cash flows and implementation of cross guarantees will enhance the company credit rating. Advice from Standard & Poors is that the merged companies would retain Origin Energy's BBB+ credit rating compared to Contact Energy's current credit rating of BBB.
The merged group will be called ContactOrigin. The legal identity and stock market listing of both companies will be maintained. Origin Energy will trade on the ASX and its share ticker will be ORG - Origin Energy's current ticker code. Contact Energy will trade on the NZX and its share ticker will be CEN - Contact Energy's current ticker code. Both companies will continue to carry on their businesses under their current brands of Origin Energy and Contact Energy. No shareholder in either company will need to exchange or tender their shares in order to give effect to the merger.
Following the merger, it is anticipated that Origin Energy's relative weighting in the benchmark S&P200 Index and similar indices will remain unchanged. Contact Energy is also expected to remain high in the benchmark NZ50 Index and discussions will be held with the NZX to determine Contact Energy's weighting following the merger. Both Origin Energy's and Contact Energy's participation in the relevant MSCI indices is not expected to change as a result of the merger.
It is proposed that the common Board have 10 directors comprising the seven current Directors of Origin Energy and the three Independent Directors of Contact Energy. Mr Kevin McCann will chair the Board and Mr Phil Pryke will be deputy chair.
Mr Grant King will be Managing Director and CEO of ContactOrigin. The CEO of Contact Energy will become part of the Executive Management Team at Origin Energy and will report to the Managing Director.
In New Zealand, the merger will be implemented through a Court-approved Scheme of Arrangement and therefore Court approval will also be required in addition to regulatory and shareholder approval. The merger is subject to receiving those approvals.
Under the terms of the Merger Agreement the companies will secure the necessary regulatory, courts and shareholder approvals to give effect to the merger and send their respective Explanatory Memoranda to shareholders in each company.
If approved, implementation of the merger is targeted for early in the new financial year.
The key commercial element of the Merger Agreement is the establishment of the merger ratio which determines the proportion of the merged entity that is attributable to Origin Energy and Contact Energy minority shareholders. As part of their review of the merger proposal, the Independent Directors of Contact Energy and the Origin Board have considered the merger ratio and determined that a merger ratio of 75.7: 24.3 is fair for Contact and Origin shareholders. This ratio has been determined on the basis of the volume-weighted average trading prices of the two Companies over the past nine months.
As the merger will make redundant Origin Energy's 51.4% shareholding in Contact Energy, this interest will be acquired by Contact Energy and amalgamated so that Origin no longer has shareholding in Contact. This will be funded by relocation of debt from Origin Energy to Contact Energy sufficient for this purpose. The relocation of the debt will change the relative profits of Origin Energy and Contact Energy but will have no impact on the profitability of the merged Companies nor the earnings or dividends attributable to shareholders. Notwithstanding the changes, it is expected that the merged companies can continue to pay a fully imputed dividend in New Zealand and fully franked dividends in Australia.
The MIA also provides for certain adjustments to the total number of shares on issue as follows:
- Contact Energy will declare a special dividend which will be paid by way of a taxable bonus share of 7.3 shares per 100 existing shares and a cash dividend of NZ$0.05 per share.
- Origin Energy will undertake a bonus issue of 18.3 shares per 100 existing shares to Origin Energy shareholders to equalise the value of all shares within the merged companies.
Following the issue of bonus shares and the amalgamation Contact Energy and Origin Energy will together have 1,238 million shares on issue. All shares will have one vote per share and will participate equally in all dividend payments.
Directors' intend to adopt a dividend policy that will see approximately 60% of earnings per share paid out as dividends and that all dividends will be fully imputed/franked. Contact Energy has a policy to pay out approximately 80% of earnings as dividends. However it is expected that the payment ratio of 60% will result in a dividend to New Zealand shareholders that is at least equal to that in the dividend previously envisaged for Contact Energy shareholders. This reflects the fact that at the agreed merger ratio, Contact Energy shareholders will have benefited from an accretion to the earnings per share they would have achieved prior to the merger.
Notwithstanding the increase in share of earnings attributable to Contact Energy shareholders, all shareholders will receive the same dividend. Origin Energy shareholders will, therefore, receive a significant increase in dividends following completion of the merger.
Should the merger be approved and implemented based on current forecasts, Directors expect to declare a final dividend in respect of the current financial year of NZ$0.15 per share (whereby Origin Energy shareholders will receive the $A equivalent).
Origin Energy currently consolidates Contact Energy within its accounts. As a guide to shareholders, Origin Energy's financial statements prior to the elimination of minorities serve as a useful starting point for the financial position of ContactOrigin. This position should then be adjusted for:
- relocation of debt to fund the acquisition of Origin's New Zealand shareholdings. This will have a significant impact on the accounts of each company but only a minor impact on the accounts of the merged entity;
- adoption of the new dividend policy which will result in increased distributions to shareholders;
- incorporation of a modest level of efficiency gains; and
- the change in the number of shares on issue.
The Directors of Origin Energy and the Independent Directors of Contact Energy have determined that combining the two companies can create significant additional value for shareholders. They believe that the most effective way to access this value is to merge the companies by way of a DLC to ensure that both sets of shareholders can effectively participate in the continued growth and development of the company.
The Independent Directors of Contact Energy have concluded that the proposed terms of the merger, and most specifically the merger ratio which determines the Contact Energy minority shareholders' interests in the merged business, is fair.
It is acknowledged that the process of merging the companies involves a number of steps which have not previously been implemented in New Zealand. The steps will require regulatory and shareholder approvals in Australia and New Zealand and Court Approval in New Zealand for the Scheme of Arrangement. Both companies will be working diligently to ensure the necessary approvals are obtained in an appropriate time frame.
The Directors of Origin Energy and the Independent Directors of Contact Energy believe that the merger of the two companies will create significant additional value for shareholders and therefore recommend that shareholders approve the proposed merger.