Gaynor: Fickle weather sets Contact's worth

By BRIAN GAYNOR

Contact Energy shareholders face a huge dilemma; should they accept Edison Mission Energy's takeover offer or not?

The decision is complicated because Edison's bid is conditional on receiving a 90 per cent acceptance level and it will lapse if that is not reached.

The deal will be financed by bank loans and the lenders have probably insisted that Edison reaches 90 per cent so it can move to compulsory acquisition and gain full control of Contact's massive cash flow.

In comparison, Danone's bid for Frucor is also conditional on 90 per cent acceptance but this condition can be waived. Logan's offer for Pacific Retail has no minimum shareholding clause.

These shareholding requirements will have an important bearing on the outcome of all three takeover offers.

The prospects of Contact Energy and the merits of Edison's offer depend on weather conditions in the South Island.

Most of the South Island hydro lakes are long and narrow and have about 10 weeks of storage, whereas hydro systems in Canada, Australia and Norway can have up to three years of storage. This means electricity generators cannot rely on stored water and need steady inflows into the hydro lakes.

If conditions are dry and cold, generation output falls and demand rises. The opposite occurs when the weather is wet and warm.

These factors have a big impact on wholesale electricity prices and the financial performance of the generators.

Contact, which owns and operates the Clyde and Roxburgh power stations, was hurt by wet and warm weather in the September 2000 year. At year-end southern lakes storage was 58 per cent above average and the company realised an average wholesale price of $31.33 per MWh for the year, compared with $35.41 previously.

The small decline in wholesale prices had a big impact and the company reported a 13 per cent fall in operating profit.

Last year was a different story. The country experienced an electricity crisis due to low rainfall, which reduced hydro storage and increased demand.

Inflows to the southern lakes were the lowest for 71 years and in June and July spot electricity prices were five to six times higher than normal.

These sky-high prices had a positive impact on Contact, and its average wholesale price last year was $82.70 per MWh compared with just $31.33 previously. Not surprisingly, the company reported a record operating profit of $355.8 million, a 53 per cent increase.

No one predicted the huge increase in spot prices. Six months ago the most bullish analyst was forecasting an operating profit of $257.8 million for last year, $98 million less than the actual result.

Contact Energy's directors were remiss in not keeping shareholders fully informed of the company's earnings prospects.

An early indication of the group's likely earnings would have had a positive impact on Contact's share price and Edison's initial offer would have had to have been higher than $3.85 a share.

That price was raised to $4.14 a share after Grant Samuel's independent advisers' report was released - shareholders will receive an 11c final dividend regardless of the offer's outcome. Their analysis concluded that Contact Energy is worth between $4.11 and $4.51 a share.

Grant Samuel would be the first to admit that the profit forecasts, on which its valuations are based, are extremely subjective, because they depend on unpredictable winter weather.

A meteorologist might have been better able to scrutinise Contact Energy's predictions.

The company is forecasting a 19.4 per cent decline in operating earnings for this year, based on an average wholesale electricity spot price of $44 per MWh compared with last year's $82.70.

Grant Samuel is taking a slightly more bullish view and expects the wholesale price to be approximately $2 higher and operating earnings to decline by just 10 per cent.

But the truth of the matter is that no one, with the possible exception of Jim Hickey and Augie Auer, has any idea what the weather will be like in the South Island next winter and how electricity spot prices will respond to lake inflows.

If we have a wet and mild winter then electricity prices could be lower and Grant Samuel's earnings forecasts and valuations are too high.

If it is dry and cold then prices may be higher and the forecasts and valuations are too low.

As far as small shareholders are concerned, the most pleasing aspect of the Grant Samuel report is its comments on the Takeovers Code.

Grant Samuel says: "Prior to the introduction of the Takeovers Code some market commentators held the view that, where a major shareholder had a controlling shareholding, any control premium attached only to that shareholding.

"One of the core foundations of the Takeovers Code is that all shareholders be treated equally.

"In this context any control premium is now available to all shareholders under a takeover offer regardless of the size of their shareholding, or the size of the offeror's shareholding at the time the offer is made."

Consistent with these comments, Grant Samuel has assessed the full value of Contact Energy, whereas Arthur Andersen has applied a 30 per cent discount to shares held by Pacific Retail's non-controlling shareholders. Arthur Andersen's approach is inconsistent with the objectives of the Takeovers Code.

But in the final analysis the outcome of the Contact Energy offer will be determined by the electricity price forecasts of institutional investors.

If Edison doesn't reach the 90 per cent mark then all acceptances will be returned to shareholders and Contact's share price can be expected to fall below $4.

A number of institutional shareholders have indicated that they will not accept the offer but they could change their minds, particularly if overseas markets weaken before December 6, the closing date.

At this stage shareholders are advised not to accept until the last moment because there is no advantage in doing so. Cheques won't be posted until the bid is declared unconditional.

There are different conditions in the Frucor and Pacific Retail offers.

Danone has made a $2.35 a share bid for Frucor and wants to go to 90 per cent. As this condition can be waived it is reasonable to assume that Danone will be happy with less than 90 per cent.

The French company already has acceptances of 38 per cent and the ideal outcome would be for it to acquire between 50 and 89 per cent and for Frucor to remain listed on the Stock Exchange.

The bid will lapse if it doesn't reach 50 per cent.

There are no shareholding conditions in Logan Corporation's bid for Pacific Retail. Logan already holds 73.2 per cent and the $1.76-a-share offer closes next Wednesday, but can be extended.

The offer price is ridiculously low when compared with Arthur Andersen's $2.13 and $2.95 a share valuation.

It is even more absurd when the 30 per cent discount for minority shareholdings is added back, increasing the valuation to $3.04 to $4.23 a share.

But there is no obligation on the bidder to match the independent valuation and Eric Watson has shown little generosity towards minority shareholders in the past.

He will be happy to sit below 90 per cent and then slowly gain full control of the company under the creep provisions of the Takeovers Code. This will allow him to buy 5 per cent every 12 months without making a full offer to shareholders.

* Disclosure of interest: none.

* bgaynor@xtra.co.nz