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Project Royal Synergies Quantification Analysis
Enclosed please find our initial impressions of the study
purported to calculate the synergies related to a Western
Resources (WR) Kansas City Power and Light (KCPL) merger. Our
analysis is preliminary and is based entirely on our initial
examination of the "Project Royal Synergies Quantification"
report. We have not performed a conclusive review of that report
nor have we performed any review of the underlying work papers
and supporting documentation.
Our preliminary examination of the Western Resources synergy
report resulted in the identification of three areas of concern:
flawed methodology, invalid assumptions, and the use of incorrect
data. We believe that these concerns significantly undermine the
credibility of the $1 billion synergy number presented in that
study. The following paragraphs highlight our concerns in each
of the three areas.
Flawed Methodology
The following paragraphs discuss two areas of synergies in which
we believe the methodologies employed by WR are flawed: labor
savings and procurement savings.
Labor Savings--Analysis of the quantification of labor synergies
resulting from a WR/KCPL merger identified several weaknesses:
the use of announcement vs. process/function analyses or
achievement based data, the assumption of leading practices
inherent in the announcement information data base, the
variability of the data included in the announcement information
database, and the employment of FTE reduction benchmarks that
significantly exceeded the averages included in the announcement
information database.
WR determines labor reductions using benchmarks derived from
previous utility merger announcements. Reviewing previously
announced synergies, WR identifies percentage reductions for each
of the utility processes reviewed. Those individual function
percentages are averaged and the means are then adjusted to
reflect the unique characteristics of the specific merger. These
percentages are applied to the FTEs in each process of the
combined company to estimate total company FTE reductions. Ernst
& Young believes this methodology has several flaws.
Announcement Data--We believe that the use of announcement data is
inferior to process/function analysis or to the use of
achievement based data. Announcement data is a forecast of the
synergies that the two parties hope to achieve as a result of the
merger. In the WR/KCPL analysis, we believe the announcement
data has been strongly influenced by prior announcement data
rather than either management estimates or process/function
analysis. Consequently, the WR methodology for quantifying labor
reductions is a "best guess" based upon other "best guesses",
which again are based upon prior "best guesses". Because these
estimates do not appear to be based upon results actually
achieved in prior mergers nor are they based on reductions
identified through functional/process analysis, this methodology
appears to have no analytical basis.
Leading Practices and Ongoing Initiatives--Assuming that
announcement data benchmarks are acceptable, as implied by WR's
reference to the KPL/KGE merger as support for some of their
analyses, we believe that these benchmarks include the value of
best practices. To the extent that the WR benchmarks may be
based on the results of previous mergers, they necessarily
include the effect of both the application of leading practices
and ongoing cost reduction or revenue enhancement initiatives.
For example, in the consummation of the KPL/KGE merger,
management of the merged company would employ best practices and
leading edge technology in combining the two companies.
Moreover, it could also be expected that a competent management
group would continue with initiatives that were under way at the
time of the merger. The effect to these two efforts, which in
some cases could be significant relative to the savings
identified from the merger, would be to achieve savings at a pace
well ahead of the timeline identified in the synergies study.
This results from the fact that these efforts should have been
excluded for the synergies analyis and therefore is additive to
the merger savings. Consequently, simply achieving synergies
identified prior to the merger could only mean two things: the
synergies study overstates synergies by including such things as
ongoing initiatives or that secondly, management made no positive
contribution to competitiveness of the organization during that
timetable, but for the merger. Excepting incompetent management,
the benchmarks employed by WR would tend to overstate synergies.
Data Variability--The third issue relative to the WR labor
quantification is that the benchmarks employed are developed from
nine data points (previous transactions) which have deviations
around the functional means of over three times the means
themselves. These deviations imply that the means themselves
have little statistical relevance in predicting FTE reductions
related to individual functions. Moreover, these deviations
point up the uniqueness of each merger and the problems inherent
in employing such statistics to forecast future merger-related
FTE reductions.
FTE Reductions in Excess of Functional Means--The final labor
savings issue is that in calculating individual functional
process FTE reductions, WR employed an average of over 120% of
the announcement database mean in calculating FTE reductions.
Using this multiple overstates synergies relative to what the
database average would imply.
In summary, our preliminary examination indicates that labor
savings are derived from benchmarks that are based upon
irrelevant data (announcement data), that inherently include
leading practices and ongoing initiatives, that have significant
statistical problems at the functional level, and that are
calculated based upon statistics that are far in excess of the
means of the benchmarks of the individual functions.
Procurement Savings--Analysis of procurement synergies developed
by WR indicates three potential areas of concern: overstatement
of the types of materials on which supplier leverage can be
achieved, overstatement of the volume of materials on which
leveraged discounts can be obtained in the types of materials
identified above, and finally the overstatement of the value of
the discounts available resulting from increased supplier
leverage.
Generation Materials--It appears that the WR synergies study
calculates material and contract service savings by simply
assuming a 5% discount on all purchases of the merger parties.
An analysis of KCPL and UtiliCorp generation materials indicated
that the standardization required to achieve significant
discounts from increased volume was not possible in the short
term and speculative in the long term. Our analysis indicates
that an assumption of any discount on all material purchases
overstates the synergies of the two merging parties.
Small Volume Items--As stated above, it appears that WR has
included all purchases in its calculation of supplier leverage
discounts. Again, our study found that a significant portion of
items were unique to the merging parties or were purchased in
such small volumes that significant additional discounts could
not be obtained from the combination of purchases. To the extent
that purchases of the two merging parties in the WR study include
small volume or unique items, the WR synergies are overstated.
Leverage Discounts--As discussed above, it appears that the WR
study calculated procurement synergies by multiplying all
purchases by 5%. As indicated above, our study indicates that
the universe of materials that should be included in the
calculation of the procurement synergy is significantly less than
all purchases. In addition, we found, based upon a limited
vendor survey, that the mean discount that could be obtained for
transmission and distribution materials was well below the 5%
assumed by WR. This overstated discount rate results in the
overstatement of the value of the WR procurement synergy and
compounds the overstatements described above.
In summary, the procurement savings synergies reported by WR
appear to be overstated because the universe of materials upon
which they calculate savings is too large and because the
discount rate applied to the overstated volume is also too large.
Invalid Assumptions
In developing WR/KCPL synergies, Ernst & Young found what we
believe to be several questionable assumptions: the inclusion of
skills, technology and philosophy transfers, the assumption that
all but some IT synergies are achieved on January 1, 1998, the
assumption of aggressive benefits multiples and escalations, and
a short depreciable life of the proposed avoided information
technology systems.
Skills, Technology and Philosophy Transfers--In calculating
WR/KCPL synergies, WR has stated that they have included skills,
technology and philosophy transfers. While specific examples of
these transfers are not identified in the report, the implication
is that pure merger synergies, those that result simply from the
merging of existing processes and functions, have been leveraged
by the adoption of leading or better practices, technology, or
philosophy transfers that could otherwise be purchased by either
of the merging parties. Because efficiency enablers such as
philosophy transfers could be purchased, and do not arise simply
as a result of merging functions or processes, only the avoided
cost of these items should be included as a synergy. For
example, if one party has an existing CIS that will increase the
productivity of its merger partner, we believe that labor savings
benefits related to that CIS should be included as a synergy,
only in the case where those savings are less than the avoided
cost of constructing, implementing and maintaining the avoided
system. Similarly, the adoption of better or leading practices
by NewCo, brought to the merger by either of the parties, should
be valued not by the efficiency gains achieved by the party
without that practice, but at the cost that party would have had
to pay to acquire that knowledge. This same philosophy should
apply to all skills, technology or philosophy transfers, as
valuing synergies in excess of purchase price results in a
distortion of the nature of the synergies and an overstatement of
their value.
Synergies Achieved by January 1, 1998--The WR study assumes that
all synergies will be achieved by January 1, 1998. We do not
believe that this timetable is realistic, particularly in light
of the proposed reductions of 531 FTEs. Further, we do not
believe that 531 FTEs can be eliminated on January 1, 1998
without involuntary separations. It is our belilef that the
growth potential related to this combination will not support a
scenario where these reductions could be achieved through avoided
hires by January 1, 1998. We also do not believe that an
attrition rate of 1% can support a reduction of 531 employees by
that date. Finally, it may be possible that WR could introduce
such draconian measures as to make employment by the proposed
NewCo so unpalatable to existing employees that they leave, but
we believe this is still a stretch in this time frame. In any
case, the employment of such measures would effectively
constitute a involuntary separation. In summary, we believe the
savings identified by WR associated with labor reductions is
significantly overstated, not only because these reductions are
calculated employing a flawed methodology, but also because the
savings are assumed to be generated, but for information
technology, immediately.
Aggressive Benefits Multiples and Escalation Rates--The WR study
includes what we believe to be generous benefits multiples and
aggressive escalation assumptions. In calculating benefits, WR
assumed a 34% benefit rate for KCPL when in fact, based on
information from KCPL, the rate is about 26%. Secondly, WR
assumes that salaries and benefits will escalate at an average
rate of 4.3% for the next ten years. We believe 3.5% to be a
more realistic rate. The result of aggressive benefits and
escalation assumptions is to overstate labor synergies.
Short Depreciable Lives--The WR study appears to assume the
replacement of avoided information systems every five years. We
believe that, on average, these systems are not replaced five
years subsequent to their implementation, but rather over a 7-10
year period. Our study assumed the replacement of all systems
only once during the ten-year period. The effect of using a five-
year useful life in calculating synergies is to include system
construction costs, and related capitalization costs, twice
within the ten-year period.
Incorrect Data
The third area of concern relates to the incorrect data used by
WR to support the calculation of synergies for the WR/KCPL
merger. Examples of incorrect data include CIS development costs,
transaction costs, data center costs and FTE information.
CIS Development Costs--In developing information technology
synergies, WR significantly overstated the KCPL CIS
implementation costs. This overstatement was identified by the
review of the KCPL budget. Because the value of the synergy was
calculated based upon an assumed avoided KCPL cost to construct
the CIS, this synergy is overstated by the difference between the
WR assumption and actual budgeted cost, increased by the
capitalization factor.
Transaction Costs--The WR study did not include $88 million of
transaction costs identified by WR as required to consummate the
deal. The nominal value of the synergies is simply overstated by
that value.
Data Center Costs--In performing an analysis of KCPL data center
costs, WR overstated the cost of KCPL data center operations.
The data center synergy is calculated based upon the adoption of
KCPL cost structure, which, as identified by Western Resources,
was significantly lower. Because the cost of the KCPL data
center is overstated, the related synergy is overstated.
FTE Information--In calculating FTE reductions, WR has
overestimated the number of actual FTEs employed by KCPL. This
overstated FTE number was then allocated among the relevant KCPL
processes to provide the basis for calculating process by process
FTE reductions. Process specific FTE reductions then were then
calculated by multiplying the number of FTEs in each process by a
percentage established based on previous merger announcement
data. (See Methodology Flaws.) While the allocation scheme to
distribute FTEs among those processes is not identified in the
report, it is clear that the total KCPL FTEs tie to the sum of
the FTEs identified in each process. Consequently, we believe
the number of FTEs identified as reductions in each process are
overstated in proportion to the overstatement identified by the
analysis of total KCPL FTEs.