Brian Gaynor: Kiwis not buying merger sales pitch

It wasn't a great week for Grant King, managing director of Origin Energy. King, who is also chairman of Contact Energy, was in New Zealand to promote a proposed merger between the two companies.

King's charm offensive was unsuccessful as most analysts and institutional investors believe he is trying to gain full control of the New Zealand generator without paying a premium for control.

The Australian will have to put up a much more compelling argument if Contact Energy shareholders are to vote in favour of the proposal.

The story began at 8.31am on Monday when Contact Energy requested a trading halt in respect of its shares.

Three hours later, simultaneous releases were made to the NZX and ASX regarding the proposed merger of Contact Energy and Origin Energy, the interim result of both companies and the resignation of Contact's chief executive, David Hunt.

Hunt's resignation was a major surprise as he only took up his position on October 1, 2005. He has a base salary of $550,000 and the ability to double this through bonuses.

The resignation suggested that the merger did not have unanimous approval although the press release, and Hunt's personal statements, claimed the two issues were unrelated.

Contact announced net earnings of $146.6 million, including a one-off gain of $33.4 million from the sale of subsidiaries, compared with $91.9 million for the six months to December 31, 2004.

The result was better than expected and Contact's share price would have risen if the merger proposal had not been announced.

Origin reported net earnings of A$193.7 million ($216.5 million) for the six months to December 31, 2005, compared with A$169.8 million for the previous corresponding period.

The result was below market expectations and Australian analysts said the group's share price would have fallen if the merger proposal had not been revealed.

Contact Energy contributed A$226.5 million, or 51.3 per cent, of Origin's earnings before interest and tax (ebit) in the six months to December 31, 2005, compared with $85.7 million, or 26.2 per cent, in the previous corresponding period when it was included for only three months. (Origin accounted for its 51.4 per cent stake from October 1, 2004.)

Contact has supplied almost all of Origin's ebit growth in the past 18 months.

King and Contact Energy director Phil Pryke hosted a telephone conference for analysts from Wellington after an earlier presentation to the media was abandoned because of a communications breakdown with Origin chairman Kevin McCann in Sydney.

The early afternoon conference was a great opportunity for King and Pryke to gain first advantage and put a strong case for the merger to analysts and fund managers.

They failed miserably.

The brunt of their argument was that the two companies should combine for these reasons:

* It would eliminate the conflicts at a strategic and operational level arising out of the present ownership structure.

* It would enable them to manage the two companies' financial position on a unified basis.

* New Zealand faces fuel shortages, and the combined company would be in a better position to face this challenge.

King and Pryke mentioned several additional reasons why the merger should proceed, but they were frustratingly short on detail and financial projections.

Most of the financial benefits - a stronger balance sheet, strong cashflow and a 60 per cent dividend ratio - are more advantageous to Origin shareholders as the New Zealand company already has a strong balance sheet and cashflow. In addition, Contact normally has a dividend payout ratio in excess of 75 per cent whereas Origin's has been around 35 per cent.

The first question from the floor was about the absence of the normal takeover premium for Contact Energy shareholders. The reply was that this was not a takeover; the two companies were coming together to reduce risk.

The next were about Contact's three independent directors, Pryke, John Milne and Tim Saunders.

Why do they support the offer before the independent appraisal report has been prepared? Why did they appoint an investment banker to prepare this report when these organisations can have conflicts of interest because they are constantly seeking different mandates from listed companies?

In reply to more questions, King and Pryke said there were virtually no cost savings from the merger but Origin's exploration and production activities would reduce the risks to Contact shareholders.

How could this be when the exploration and production division makes a much smaller contribution to Origin's ebit than Contact?

Not surprisingly, most New Zealand analysts were negative on the merger while Australian analysts covering Origin were positive.

James Miller, of ABN-AMRO, who has a great deal of credibility as far as Contact is concerned, was particularly negative about the merger terms. He revised his Contact DCF valuation from $7.34 to $8.24 a share after the superb interim result and concluded: "The offer will be voted down by the Contact shareholders at the EGM, which, in our view, will result in a revised bid from Origin."

Miller also went on the offensive in 2001 when Edison Mission made a takeover offer for Contact Energy and Pryke, Milne and Saunders recommended acceptance.

Miller played an important role in the failed 2001 bid. He also opposed a $5.57 a share offer from Origin in 2004, as did the independent directors.

King and Pryke held one-on-one meetings with institutional investors and the media on Tuesday and Wednesday, but they had surprisingly little to offer.

They continued to emphasise the main terms of the merger as:

* Contact will purchase Origin's New Zealand assets and buy back its 51.4 per cent shareholding. As a consequence, about $1 billion of debt will be transferred from Origin to Contact.

* Contact shareholders will own 24.3 per cent of the merged business and Origin shareholders 75.7 per cent. The ratio is based on share prices over the past nine months.

The transfer of $1 billion of debt from Origin to Contact is a loss to the New Zealand Government as the merged group will pay less tax in this country and more in Australia.

It is difficult to understand why the merger terms are based on share prices instead of earnings, particularly as last year's annual meeting had a big impact on Contact's share price.

One week prior to the meeting, which was held on October 12, Contact's share price closed at $7.66. The meeting was surprisingly negative - particularly in view of this week's result - with King placing a great deal of emphasis on the group's gas-supply problems in 2008 and 2009.

Contact's share price fell to $6.75 less than two weeks after the meeting.

By the middle of this week, King and Pryke were on the back foot and were claiming the Explanatory Memorandum, which will be published in May, will contain compelling arguments in favour of the merger.

But one of the most important objectives of a merger proposal is to gain first advantage, and King has failed in this regard. The Explanatory Memorandum will have to be particularly convincing or King will have to change the merger terms if New Zealand shareholders are to vote in favour of the proposal.