Carving out value: How utilities can grow by shrinking

As growth curves regress toward the industry mean, some utilities are considering a new way to deliver shareholder returns: growth through subtraction. Executives need to ask a critical strategic question of their businesses: In today’s market conditions, what fits, and what doesn’t?

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Carving out value How utilities can grow by shrinking


Amsterdam Robert Oushoorn Partner +31-20-504-1981 robert.oushoorn Atlanta Tim Schutt Partner, PwC U.S. +1-678-419-1472 tim.schutt Dallas Tom Flaherty Senior Partner +1-214-746-6553 tom.flaherty John Corrigan Partner +1-214-746-6558 john.corrigan Donald Dawson Partner +1-214-746-6503 donald.dawson Todd Jirovec Partner +1-214-746-6525 todd.jirovec Earl Simpkins Partner +1-214-746-6571 earl.simpkins

DC Joseph Van den Berg Partner +1-703-682-5710 joseph.vandenberg Frankfurt Marcus Morawietz Partner +49-69-97167-467 marcus.morawietz Houston Rob McCeney Partner, PwC U.S. +1-713-356-6600 rob.mcceney Juan Trebino Partner +1-713-650-4151 juan.trebino

San Francisco Christopher Dann Partner +1-415-653-3491 christopher.dann Jeremy Fago Principal, PwC U.S. +1-415-498-7031 jeremy.fago



About the authors

Tom Flaherty is a senior partner with Strategy& based in Dallas. He specializes in power and gas mergers and acquisitions and restructurings, as well as strategy development, operating model design, and performance improvement. Todd Jirovec is a partner with Strategy& based in Dallas. He specializes in mergers and acquisitions, corporate strategy, and business transformation in the power and gas sectors. Jeremy Fago is a principal with PwC based in San Francisco. He specializes in mergers and acquisitions and restructuring within the power and gas sectors, particularly valuation, financial strategy, and commercial markets.

Also contributing to this report were Strategy& senior associate Gordon Avery and associate Sarah Nathan.



Executive summary

Shrinking demand and falling prices in electricity markets, and resulting drags in stock valuation, are leading some utility company executives to reassess their portfolios. In some cases, separating business lines that no longer fit together can build shareholder value by turning a larger, more diverse company into two strategically focused companies with stronger growth prospects and greater investment appeal. Executives who choose this path should understand that carving out business segments is a complicated strategic undertaking that requires as much planning and effort as a major acquisition. Carveouts create maximum value when they position the newly independent company for long-term success, and reshape the legacy organization to compete as a simpler, more focused business.



Growth through subtraction

For the first time in the memory of today’s utility executives, electricity demand is shrinking. Conservation and sluggish economic growth have dragged down power use for three straight years. At the same time, new drilling technologies have unlocked vast supplies of natural gas that are depressing wholesale electricity prices. And investment in new generating capacity — a traditional source of revenue growth for utilities — is now limited, as surplus power overhangs the market. Against that backdrop, it will not be surprising that utility stocks may come under pressure, particularly as interest rates rise. In the past, many utility executives have turned to mergers and acquisitions to produce economies of scale, broader operating platforms, and bigger balance sheets to fund future investment in a growth-challenged industry. But consolidation doesn’t make larger companies immune to the pricing pressures and sluggish demand squeezing profit margins and depressing growth rates across the utilities sector. As growth curves regress toward the industry mean, some utilities are considering a new way to deliver shareholder returns: growth through subtraction. Business portfolios assembled at a time of steadily rising demand appear unsuited to a new era of flat-to-declining electricity consumption and unpredictable market prices. Executives need to ask a critical strategic question of their businesses: In today’s market conditions, what fits, and what doesn’t? Other industries have faced similar challenges. A recent wave of corporate breakups in industries such as consumer products, manufacturing, and pharmaceuticals shows how diversified companies can boost growth and returns by rationalizing their portfolios into smaller, more focused parts. They’re shedding underperforming units that drag down overall growth, and spinning off business lines to create single-product companies that often grow faster than those operating in multiple markets. In the process, they’re winning higher stock valuations by capitalizing on Wall Street’s preference for “pure play” investments.

In today’s market conditions, what fits, and what doesn’t?



Hybrid utilities are now wrestling with a similar decision. Most still try to differentiate themselves through strategy, innovation, execution, or capital deployment. But in doing so, they may be overlooking opportunities to unlock value by separating business lines. Many operate a combination of nonregulated merchant generation assets and regulated utility assets. These hybrid structures are proving ill-equipped for current industry conditions, as merchant generation units plagued by stubbornly low wholesale power prices sap the steady returns of regulated utility operations. There’s a strong case for breaking up these portfolios, which no longer have the strategic fit they once did. Separating regulated and nonregulated businesses can be a “win-win,” creating two companies with clear strategic focus and financial characteristics valued by distinct groups of investors. Individually, they can produce higher sustained returns than they did as an integrated company.



Reevaluating the portfolio

Executives looking to create value by paring back the portfolio can choose from a range of carve-out transactions. They can simply sell business segments or groups of related assets that don’t contribute to the company’s longer-term growth and strategy. They can spin off business lines as stand-alone companies. Or they can execute a “merge-and-spin” transaction by combining parts of the business with similar assets from another company and spinning them off as an independent entity. Each of these approaches requires the same degree of analysis, due diligence, and planning involved in a merger or acquisition. It starts with a review of the business portfolio to determine which units advance the company’s longer-term strategy and generate acceptable growth and profitability. Then management should consider the likely benefits of separating units that don’t clear the bar, the best method of doing so, and the market, financial, and regulatory implications of such a move. In a spin-off or a merge-and-spin, the viability and operational needs of the new company deserve as much attention as the benefits for the parent company. At the same time, it’s essential to rethink the strategic positioning and organizational requirements of the former parent in light of its reduced size and narrower focus. It’s worth the effort. Although acquisitions still play a role in utility growth strategies, executives know they need more options to produce sustained, profitable growth. The question of portfolio coherence is particularly urgent for hybrid utilities weighed down by merchant generation assets. But the basic rationale for carve-outs can apply to any company with multiple business lines or disconnected geographies. Separating business lines that no longer complement each other creates a strategically coherent business portfolio with clear competitive differentiators, stronger growth prospects, and a more attractive investment profile. Separating the discrete assets or business segments of a diversified company creates value in two primary ways. It can improve the core business by removing operations that no longer fit the company’s broader
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The question of portfolio coherence is particularly urgent for hybrid utilities.

strategy and investment rationale. At the same time, it allows noncore businesses to find an audience among investors who may value it more highly as a stand-alone company. Although they may appear novel, these transactions are a natural step in the evolution of a business. As the risk profiles and growth rates of various assets and business segments evolve, so will their consistency with the investment priorities of various stockholders. When alignment between investor expectations and business characteristics breaks down, structural actions can do more to create value than performance improvement efforts. Investors, therefore, welcome nontraditional approaches to value creation. That’s why share prices often initially rise on news of a carveout. Nevertheless, structural separations have been rare in the utilities industry, where companies are reluctant to part with assets except under duress. But markets have responded enthusiastically when utilities have carved out business units (see Exhibit 1). Merchant power businesses spun off in the late 1990s and early 2000s fetched high stock market valuations at a time when growth prospects for such companies seemed limitless.

Exhibit 1 Merchant generator indexed market cap performance
Indexed value 1,400 1,200 1,000 800 600 400 200 0 1994 1996 Initially positive growth prospects 1998 2000

Merchant meltdown 2002 2004 2006

Partial recovery 2008 2010 2012 2014

Enron collapse and bankruptcy Source: Capital IQ; SNL Financial; Strategy& analysis



Since the merchant power meltdown, a few utilities have carved out portions of their portfolios. In the mid-2000s, Duke Energy concluded that the differing risk profiles and financial characteristics of its midstream and electric businesses kept markets from recognizing the full value of each. So they carved out natural gas gathering, processing, and pipeline operations as a company called Spectra Energy. That closed the value deficit, and then some. A single company with a market capitalization of US$26 billion spawned two discrete market entities with a combined equity value in excess of $75 billion. Even more impressive, Duke’s price-earnings multiple has largely exceeded industry averages since the split (see Exhibit 2). In recent years, various types of carve-outs have occurred in different sectors of the utilities industry. For example, Dominion Resources exited retail power marketing, while Ameren shed generating assets. Some utilities have placed midstream gas businesses into master limited partnerships, while others have created investment vehicles called “yieldcos” to hold generating assets with long-term supply contracts. And a few companies have considered spinning off generation or transmission operations with sufficient scale to operate independently. Results of these transactions vary, and an approach that works for one company might not help another.

Exhibit 2 Duke Energy performance comparison
Price–earnings per share (P/E) multiple 24 23 22 21 20 19 18 17 16 15 14 13 12 Spectra Energy 11 spin-off 10 9 2006 2007 2008

Duke Energy

Industry peer group







Source: Capital IQ; SNL Financial; Strategy& analysis



Board considerations

Choosing the right transaction format is the critical challenge for utilities looking to rationalize their portfolios. The characteristics of each portfolio component determine the range of choices. Ultimately, the decision will turn on the attractiveness of each business on a stand-alone basis, the financial viability of the carve-out business, and the overall upside of the separation to shareholders. Utility directors evaluating carve-out possibilities should start by assessing the long-term growth and valuation prospects of their existing portfolio. That’s a tricky task, given the way various industry sectors fall in and out of favor over time. For example, generation assets regarded as powerful profit drivers in the late 1990s are now dragging down profits at integrated companies. Upstream and midstream gas assets are highly valued today, but what does the future hold? We have identified five key areas of inquiry that will provide directors with a frame of reference for weighing a proposed carve-out. 1. Is there a compelling financial case for a carve-out? The threshold question is whether a carve-out will produce higher shareholder returns over the long haul. The analysis can start with a look at valuation gaps, such as the differential shown in Exhibit 3 (next page) between the price-earnings multiples of pure regulated utilities and those of hybrids with regulated and unregulated assets. Directors should ask if such a disparity stems from transitory factors or lasting shifts in fundamental market conditions. In this example, directors could reasonably conclude that the hybrid discount — which has persisted for five years — results from long-term demand trends and natural gas supply levels, which may further depress wholesale electricity prices and create continuing market price volatility. This suggests the hybrid structure will continue to erode shareholder value, strengthening the case for separating merchant generation from regulated operations. 2. Is the carve-out viable? If the board sees a strong financial rationale for carving out a business unit, the next question is whether that unit can stand alone as an independent company. This analysis turns largely on the
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Start by assessing the growth and valuation prospects of the existing portfolio.

Exhibit 3 Hybrid utilities vs. regulated utilities
Price–earnings per share (P/E) multiple 24 23 22 21 20 19 18 17 16 15 14 13 12 11 Hybrid 10 premium 9 2008 2009 2010

Regulated utilities

16.3x 15.3x

Regulated premium Average premium: 1.1x 2011

Hybrid utilities




Source: Capital IQ; SNL Financial; Strategy& analysis

scale, profitability, and capital needs of the proposed carve-out. For example, some hybrid companies have decided their merchant generating units are too small to survive in the low-margin, capital-intensive power market. This doesn’t necessarily rule out a separation, however. Companies can give a small merchant generating unit the scale it needs by combining it with the generation assets of another hybrid operator in a merge-andspin transaction. 3. How will the market react? A separation won’t succeed if it doesn’t present the strategic and financial profile investors want. Directors should examine the market reception of similar transactions for indications of the likely response to their proposed carve-out. Given the value that investors place on coherent strategies and focused business portfolios, they are likely to look favorably on transactions that separate generating and utility assets. 4. Will regulators approve? Utility restructurings face numerous regulatory hurdles at state and federal levels. Each set of regulators has its own hotbutton issues. The Federal Energy Regulatory Commission might block a



merge-and-spin that concentrates too much market power in a single entity, unless the combined company divests assets. State regulators, for their part, often raise concerns about capital structures and the impact of a transaction on customer rates. Directors should demand a realistic assessment of likely regulatory responses to a proposed carve-out. 5. Can we pull it off? A carve-out can be every bit as complicated and difficult to execute as an acquisition. Directors should make sure management treats it that way, insisting on a robust, formalized effort, with detailed plans, thorough risk assessments, and full engagement of critical functions across the organization. Managers should model outcomes and measure progress against key milestones, from the planning stage through standing up the new company and the final, physical separation of the businesses.



Standing up the carve-out

The decision to carve out a business unit as an independent company arises from an analysis of anticipated strategic and financial benefits. But capturing those benefits requires the right approach to separating and standing up the new company. The first phase, separating the two businesses, requires expertise in transaction structuring. The second phase, standing up the new company, requires the operational perspective to design a new company capable of standing on its own in the marketplace. More than an execution challenge, the process of separating and standing up is as complex and important as the original decision to carve out the business. It’s a multifaceted process of creating a new company that’s legally, financially, and physically distinct from the legacy business, and that is capable of standing on its own. A key strategic challenge is defining the carve-out’s competitive value proposition, or way to play, in the market, and identifying the differentiating capabilities it will need to execute that strategy. The separation and stand-up process should provide the carve-out with the resources and supporting structures to strengthen and sustain those capabilities. At the functional level, planners need to determine the carve-out’s basic business requirements, design its infrastructure and operating model, unwind support systems currently provided by the parent company, and set up transitional support services. Companies often focus more on structuring the separation transaction and less on the stand-up phase, which plays a larger role in determining the ultimate success of the transaction. In particular, they tend to overlook the carve-out’s business and compliance requirements and its post-separation strategy (see Exhibit 4, next page). An effective separation process addresses five key aspects of operational planning: 1. Business requirements. A carve-out that depended on parent company support in areas such as information technology and human resources will have to perform these functions for itself. Similarly, some may face
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Exhibit 4 Carve-out readiness planning
Related challenges Transaction planning and execution Asset and resource impacts Business alignment Regulatory positioning Operating model selection Functional interfaces Market positioning Readiness requirements - Detailed game plan for driving subsequent processes and activities through separation - Thorough identification of impacted assets, contracts, costs, and staffing - Clear definition of affected parent company, corporate center, and support functions - Coherent perspective on the optimal “theory of the case” for separation - Structured approach to shaping the concept of how the new entity will functionally align and operate - Specific assessment of requirements for operating and supporting the combined going-forward business - Distinct strategy for positioning the separated and remaining core businesses Source: Strategy& analysis

public-company reporting obligations they didn’t have as part of a larger organization. Planners should define the new company’s business requirements, with a bias toward creating as simple a corporate model and infrastructure as possible, as well as limiting the extent of any necessary transitional support arrangements with the parent. 2. Capabilities. Management should identify the differentiating capabilities that will set the carve-out apart in the marketplace, enabling it to compete effectively by creating value for customers in ways its rivals can’t. These key competitive differentiators should get the lion’s share of resources and investment, whereas carve-out planners may decide to outsource less critical capabilities. 3. Resource levels. As it replicates many functions formerly performed by the parent company, the new stand-alone business will determine the amount of resources required to support itself, based on near-term operating needs. Current resource levels provided by the parent company offer some guidance, but the carve-out can get a better sense of its future needs by looking at similar-sized independent entities.



4. Operating processes. After deciding which functions it will perform, the carve-out faces the question of how to perform them. Processes designed for a larger, more complex organization aren’t necessarily ideal for a smaller, narrowly focused company. Carve-out managers should carry on the processes that make sense for their company, and develop new ones tailored to the unique needs of their business where necessary. 5. Road map. The parent company generally takes the lead in planning separation activities, at least through the point of actual separation. But these plans often aren’t sufficient to guide carve-out strategy after that point. Therefore, managers of the soon-to-be-independent company need to create their own road map for the future activities of their business. Addressing these issues enables managers to shape and size the new company, determining its future cost structure based on current costs and sources of support (see Exhibit 5). The carve-out’s total costs will equal its current direct expenses, plus the difference between current allocations for parent company support services and the cost of performing those services independently, if they are still essential.

Exhibit 5 Carve-out future cost development
Parent cost distribution
Potential avoidable costs

Carve-out future cost buildup

Net incremental costs

Total corporate groups

Governance allocation

Other allocation

Direct assigned costs

Reconfigured embedded costs

Additional carve-out cost reduction

Carve-out stand-up cost

- Understand cost drivers and activity necessity - Determine current resources/activities - Eliminate resource allocations

- Determine new/expanded activity resource requirements - Estimate cost to reproduce essential corporate services - Understand incremental cost implications

Source: Strategy& analysis



As essential as these operational considerations may be, addressing them doesn’t ensure the carve-out’s long-term success. Planners can’t overlook the critical work of determining a differentiating business strategy for the new entity. Simply extending an existing strategy won’t necessarily work. Planners should rethink the business’s competitive position from the vantage point of a newly independent company. On the one hand, the new company may lack some advantages it enjoyed as part of a larger entity, such as access to capital on relatively favorable terms. On the other hand, it may have more agility and flexibility to respond faster to market trends. Moreover, the carve-out needs a strategy that reflects its characteristics as an independent entity, with a focus on how the company’s unique capabilities differentiate it in the marketplace. For example, a company may have a distinctive ability to leverage an integrated operating model, giving it an advantage over competitors that operate as a collection of disconnected “asset islands.” Regardless of the chosen strategy, carve-out executives should keep in mind that they are now responsible for delivering shareholder value, not just operating a business with a new name.



Reshaping the legacy business

Standing up the carve-out is a complex, disruptive process. But it’s only half the battle. To capture the full benefits of the separation, management also needs to reshape the legacy business. Shedding a significant business segment has far-reaching organizational effects, and creates an opportunity for strategic and operational renewal. Managers who capitalize on this opportunity can build a tightly integrated operating company focused on the differentiating capabilities that create competitive advantage and drive superior shareholder returns. To get there, they will need to align business priorities and operational structures with the company’s smaller, more focused portfolio. This involves three key steps: 1. Resetting the strategy. A dramatically altered business portfolio requires a new strategy and growth plan. Management should rethink the company’s way to play, based on the differentiating capabilities that enable it to deliver unique value to customers. For example, a company that has exited merchant generation to concentrate on regulated utility operations might reassess its responses to solar power generators and other new players that are disintermediating electricity markets and grids. It also might evaluate the potential of its transmission business as a growth vehicle. The resulting strategic reset will guide decisions on investment, resource allocation, and operational priorities. 2. Redefining the operating model. Companies with mixed portfolios are designed to operate unique business segments side by side, with some sharing of support services such as information technology and human resources. Divesting assets should trigger a reevaluation of this operating model in light of the narrower strategic focus. The company’s previous structural choices may no longer make sense for the smaller portfolio. Management should revisit such questions as whether support services should be centralized at headquarters, distributed across operating units, or a mix of both, and whether various corporate

Managers can build a tightly integrated operating company.



functions should be outsourced or handled internally. This is an opportunity to redesign operating structures and processes for maximum efficiency while reducing organizational complexity. 3. Resizing the business. A company won’t capture the full benefits of a carve-out if it maintains the cost structure of a larger organization. The reduced scale of the company requires a corresponding reduction in the size of its corporate functions, particularly in corporate services and back-office operations (see Exhibit 6). The company’s needs in these areas will decline as, for example, smaller scale reduces demand for human resources services, and a smaller array of subsidiaries reduces accounting and financial reporting requirements. Scaling back these functions protects profit margins by aligning cost structures with the narrower portfolio.

Exhibit 6 Future cost outcomes
Current cost baseline
Costs not borne by carve-out Re-spread within the parent Incremental costs to carve-out - Board of directors - Financial reengineering project - IT help desk - Human resources Re-spread dollars – costs that will not change for the parent after carve-out (e.g., fixed governance, unique projects) Resized dollars – costs that are partially variable with business scale and would change with the carve-out (e.g., support costs that are related to employees or business units) Avoided dollars – costs that relate to functions or activities that are not needed at the carve-out level (e.g., replicated costs within carve-out or where discrete skills already reside)

Cost category impact

Resized and then re-spread within the parent

Avoided Relevant parent responsibility centers Responsibility centers assigned/allocated to carve-out

- Strategic planning - M&A support

Source: Strategy& analysis




Utilities with diversified portfolios may find investors put a higher value on their parts than the company as a whole. Carving out merchant generation, or any other asset segment, can create two companies with distinct appeal to different investor groups. But it’s more than a financial maneuver to boost share valuations. Separating business lines can give the old and new companies greater strategic clarity, coherent operations, and potential for higher long-term returns. A successful carve-out requires the same level of analysis, planning, and attention to operational details as an acquisition. The new company will need the right strategy, capabilities, resources, and operational structures to succeed on its own. At the same time, company leaders should rethink the strategic positioning, capabilities, structures, and resource levels the legacy company will need as a smaller, more focused organization. By following these steps, utilities confronting low prices and slack demand can jump-start growth.



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