Assessing the value of a strategic acquisition.

For 65 years, the mission of every electric cooperative has been to provide reliable, competitively priced electric service to its members. Some cooperatives have chosen to strengthen or expand this mission by offering other utility and non-utility products or services. Offering additional products or services -- diversification -- may be founded upon several possible objectives, including:

* To fulfill member needs and desires for products and services not now available in the area, or not provided by current businesses at favorable prices or desired levels of customer satisfaction.

* To strengthen the cooperative's relationship with its current members.

* To gain access to and build relationships with consumers outside the cooperative's defined service territory.

* To find additional revenue streams in the event customer choice results in a loss of retail customers for generation service.

Regardless of the reason, cooperatives appear to have three options for entering diversified businesses: they may start-up a new business, they may partner with an existing business, or they may acquire an existing business. The focus of this article is on the third of these options, acquisition. Specifically, we will ask how to determine the amount a cooperative should pay to acquire a business, and what lessons have been learned by other co-ops that have acquired a new business.

I. ASSESSING THE 'RIGHT PRICE' OF AN ACQUISITION

When considering an acquisition, there are two key questions board members and CEO's should ask. How should we decide what to pay for the acquisition? How should we know when to walk away?

Let's address the first question. In order to determine how much to pay for the acquisition, several concepts need to be defined. These concepts include the Net Present Value of the acquisition, the purchase price, the market value, and what we will call synergies, or organizational benefits that result from a relationship between the acquired business and the existing business of providing electric distribution service.

The first concept is "net present value". The net present value (NPV) equals the sum of the present value of the expected future cash flows of the target company completely independent of any acquisition. The net present value is the preferred method to analyze the potential return for different business opportunities. The NPV is used because it provides a consistent calculation for comparing different choices by converting money amounts from future years into current dollars. The present value is the amount of cash today that is equivalent in value to an amount of cash to be received or spent in the future. To calculate the present value, each future net cash flow is multiplied by a discount factor that is based upon the number of future years and a discount rate.

Net cash flows may be defined as the difference between cash inflows and cash outflows. Cash inflows principally result from the sale of a company's services and products. Cash o u t flows principally result from additional investment in plant and equipment, plus expenses incurred in providing those services and products.

The discount rate is an interest rate that reflects the cooperative's weighted average cost of capital (WACC) plus an adder for risk. The WACC is used because it is a fair basis for determining the value of capital the cooperative would invest in a potential acquisition. An important footnote is to remember that even if a cooperative has available general funds (cash) to make an acquisition, there is a cost to the cooperative for using that cash. The discount rate is never zero. The adder to the WACC should be determined by the risk associated with the acquisition. Does your cooperative have expertise in the area of the acquisition? How many years are required to achieve profitability? By adding a risk factor to the discount rate, any project that shows a positive Net Present Value is expected to provide a return greater than the risk associated with the investment, and therefore is a viable project.

The period of time (number of years) in the NPV calculation is a second factor that applies to the risk of the acquisition. Basically, it answers the question of how long you are willing to invest your capital in order to attain the desired discount rate of return on your investment. Since the further you extend projections into the future the harder it is to project accurately, you must shorten the period of time for acquisitions that you are less comfortable in predicting future years. For example, you might be willing to project 25 or 30 years on the acquisition of a competitor's distribution system because you have many years of experience in that area and you are willing to make a long term investment to receive the discount rate of return. However, if you are acquiring a propane company you will want to use a much shorter period of time because you aren't willing to wait as long for a return and you aren't willing to make the same long term projections for propane as you are for electric distribution (1 ).

There are three rules for interpreting the results of a net present value calculation. Any project where the NPV is greater than zero means that the project is expected to earn a return greater than the discount rate, and therefore the project is financially viable. If the net present value equals zero, the project is expected to earn a return equal to the discount rate. In this instance, the project is financially viable. When the NPV is zero, or close to zero, your assumptions have very little margin for error. If your assumptions overestimate the benefits or underestimate the costs, a projected NPV that is zero (or close to zero) could in reality be negative.

If the net present value is negative, the expected return is less than the discount rate, and such a project would not be financially viable. (However, you may still undertake projects for reasons other than financial, such as to provide a needed service to your service area.)

For example, consider the potential acquisition of a company we will call "A" , which could be a propane company, an Internet service provider, the distribution service territory from a neighboring investor owned utility, or some other kind of business. An analysis of Company A's expected future financial performance yields the following net cash flows (Exhibit 1).

This example will use a period of 7 years and a 10% discount rate (9% weighted cost of capital plus 1% for risk). The NPV of the cash flows is $416,712, meaning this business is expected to earn $416,712 greater than a 10% return.

This leads us to the next key concept, the purchase price. This is the actual price the acquiring company anticipates having to pay to the target company to be acceptable to the shareholders/owners of the target company. In our example, if the acquiring company paid $416,712 to the target company, and if this offer was accepted, the acquiring company would still earn the discount rate (a return) of 10%.

However, a third concept comes into play - market value. The market or the owners of the target company may add a "premium" to reflect the perceived likelihood that an offer for the company may be made or that a higher offer will be tendered than the one currently on the table. Let's assume the owners of the target company believe the market value of their company is $500,000. If the acquiring company agrees to pay $500,000, a "value gap" of $83,288 would be created (the difference between the NPV of$416,712 and $500,000, the market value).

However, if the acquiring company paid $500,000 today, this would result in the acquiring company's failure to earn a 10% return. In fact, it would earn $83,288 less than a 10% return. For this purchase price to be justified from a purely economic perspective, the acquiring company must find and realize $83,288 worth of additional synergies associated with the acquisition of the target company.

There are two primary types of synergies -- cost savings and revenue enhancements. Cost savings result from the elimination of job functions, jobs, facilities and related expenses that are no longer needed when certain activities at the acquired company are integrated with the on-going activities of the core business. For example, cost savings could result from an integration of the billing activities of the two companies. Assume an electric cooperative acquires a local Internet Service Provider. The cooperative assumes all billing responsibilities from the ISP, and the ISP's billing personnel and related equipment and expenses are no longer required. These avoided costs could be calculated and subtracted from the original cash outflows for each year, thus improving net cash flows and increasing the Net Present Value of the future cash flows, that in turn, could reduce or eliminate the "value gap".

The other primary synergy is revenue enhancement, which can result from the acquiring company achieving a higher level of sales growth than the target company achieved on its own. Assume a cooperative acquires a propane company. Because of a stated interest expressed by consumers and local communities, the cooperative has also decided to sell fuel cells, which require a fuel source. Prior to the acquisition, the cooperative did not sell any propane and the propane company did not sell propane for fuel cells. By acquiring the propane company and also making the decision to sell fuel cells, propane sales may be higher than if the acquisition was not completed.

After preparing your initial financial analysis to support the acquisition that is based solely on the acquisition, you should perform a second NPV analysis and factor in the benefits of the synergies that you feel confident can be attained. This is to provide you with a second valuation to use as you enter into negotiations. However, if the seller demands a price that is still greater than the second NPV, then you will need to look for and be able to achieve additional synergies, abandon the acquisition, or accept the fact that you will not earn the appropriate return on the investment.

The concepts used here to evaluate the purchase price of an acquisition are common throughout the business world. For another example of these concepts, consider the opportunity for a grain farmer to purchase additional farmland as an acquisition opportunity. Exhibit 2 presents the annual operating revenue and expenses for one acre of land devoted to raising corn. This data is from the Department of Agriculture and Consumer Economics, College of Agriculture, University of Illinois at UrbanaChampaign.

Using a 10% discount rate and a term of 30 years, the NPV for annual cash flows of $208.50 is $1,965. If the potential buyer can acquire this land for $1,965 per acre or less, then he will receive a 10% return on the purchase for the next 30 years. So, $1,965 becomes the purchase price that the buyer should be willing to pay.

Let's assume the owners of the farm land believes the market value of their land is $2,500 per acre, which is what similar land has recently sold for. If the buyer agrees to pay the $2,500, a value gap of $535 would be created (the difference between $1,965 NPV and $2,500, the purchase price).

However, if the buyer paid $2,500 today, this would result in the buyer's failure to earn a 10% return. (It would drop to a 7.3% return.) For this purchase price to make sense, the buyer must find and realize $535 worth of additional synergies associated with the purchase of additional farmland.

For our farm purchase example, cost saving synergies could accrue from lower machinery, storage, or drying costs through farming more total acres. Possible increased revenue synergies would include increased yields, switching to a more profitable crop, or higher average crop prices per bushel. The combination of all synergies must increase revenue or lower costs by a total of $57 per year to get back to the 10% return.

II. WALKING AWAY

How do you know when to walk away from a proposed acquisition? When is a proposed purchase price higher than can be justified?

To recap our earlier discussion, the acquiring company has calculated a NPV. However, the target company believes its market value is higher than the calculated NPV. The acquiring company should only pay this market value if it believes it can identify and realize synergies equal to or greater than the premium the target company expects. If it does not believe it can achieve synergies equal to the premium, the "numbers" dictate that the acquiring company should walk away from the deal.

History is filled with examples of transactions in which the acquiring company paid too large a premium, thus hurting its overall financial position. Why does this happen? The acquiring company could fall into one of three traps.

Trap #1: "It's the last deal of its kind." (Comment: "No! It will never be the last deal.")

Trap #2: "If we don't acquire them, our competitor will." (Comment: If the "numbers" don't work for you, chances are they won't work for your competitor. It may be better to let your competitor run the risk of failure than you.)

Trap #3: "You fell in love with the idea of the deal." (Comment: Take your emotions our of the equation. You'll just get burned.)

If you believe an acquisition opportunity is still justified despite a lack of financial performance, we have 3 suggestions:

l. Be prepared to demonstrate where and how the non financial benefits will accrue.

2. Be prepared to convince your banker the deal is worth it.

3. If you make the acquisition and it ultimately fails, be prepared to explain to your members why you originally did the deal.

III. LESSONS LEARNED FROM ACQUISITIONS

As you work toward building financial models and completing other analyzes to assess future opportunities, you may encounter some challenges during the decision making process, including:

1. Privately owned companies frequently have incomplete or poorly maintained data. When estimating revenues and expenses, base projections upon reasonable, defined assumptions.

2. Verify the existence, validity and value of the assets you are purchasing. For example, if the target company is a propane company, require the owner to provide evidence regarding the number of rental ranks or other equipment they claim to own.

3. Be cautious when considering "market evaluations" produced by outside consultants. Do you know that the consultant has no vested interest in the purchase? Is the consultant qualified to provide a fair, objective evaluation?

4. Carefully study any threats and opportunities associated with this new business BEFORE you make the purchase. Ensure that you are not over-estimating your ability to generate sufficient revenue with your diversification effort. Ensure that you are not underestimating the threat of competitors. Be especially sensitive about entering any business that is already provided by your own members. There are cases where co-op diversification efforts have produced member and community unrest. In other Scott Luecal ([e-mail]) serves as NISC Executive Vice President and is responsible for NISC's Strategic Services division. Prior to the NISC consolidation, Scott Luecal was the Director of CADP's Competitive Solutions Group, which provides utility management with customized services and products to effectively compete in the changing electric utility environment. Some of these services include strategic planning, business planning for diversified services, and operational analysis. Prior to joining NISC, Sc ott worked for NRECA managing all of its University of Nebraska based management and director training programs. In addition, he provided training to managers, management staff and directors through NRECA director and management curriculum courses, and edited NRECA's Management Quarterly. Prior to joining NRECA, Scott was employed at Coles-Moultrie Electric Cooperative in Illinois holding positions as Accountant, Office Manager and General Manager. Scott earned his Bachelor's of Science Degree from Millikin University, his MBA from Eastern Illinois University and is a graduate of the NRECA Management Internship Program.

David Fricke ([e-mail]) serves as NISC's Electric Industry Relations Executive, coordinating NISC activities with national associations and other entities within the electric industry, as well as performing other activities within the Strategic Services division and consulting services to electric cooperatives. Prior to the NISC consolidation, Dave came to CADP as Executive Assistant in 1988 with 16 years rural electric background. Prior positions include Member Service Representative for the Association of Illinois Electric Cooperatives 1972-74, Office Manager for Eastern Illinois Power Cooperative 1975-80, Assistant Manager, 1981-82 and General Manager, 1983-88. Dave holds an MBA from Lindenwood University, a Bachelor of Science Degree in Business Administration from the University of Illinois and has completed NRECA's Management Internship Program, Lincoln, NE. He was Secretary of Soyland Power Cooperative 1984-87 and successfully consolidated two neighboring cooperatives on September 1, 1987.

(1.) For a more detailed explanation of Net Present Value and WACC, please see the article, "Use of Net Present Value Analysis by Electric Cooperatives" in the Summer 2000 edition of NRECA's Management Quarterly.

EXHIBIT 1

Future Year  Net Cash Flow  Present Value

     1           98,000        $89,091
     2           97,000        $80,165
     3           57,000        $42,825
     4           78,000        $53,275
     5           95,000        $58,988
     6          110,000        $62,092
     7           59,000        $30,276
                   NPV=       $416,712
EXHIBIT 2

                                       Corn

Revenue Per Bushel                     2.50
Yield (bushels per acre)                165
Revenue/acre                         412.50
Annual Costs:
Fertilizer & Lime                     63.00
Seed                                  33.00
Pesticide                             34.00
Machinery Replacement, fuel & labor   12.00
Storage                               30.00
Drying                                23.00
Operating Interest                     9.00
  Total Expenses                     204.00
Net Profit (before interest, taxes   208.50
 and principle)