New Zealand's source for business, stock market & currency news on Stuff.co.nz: How to harness energy across the big divide

What should you do to bring together two companies with complementary positions but differing outlooks? Something new, as Stephen Bartholomeusz reports.


Origin Energy's Grant King was confronted with a conundrum. Almost $2 billion of Origin's market value was tied up in a controlling interest in a very attractive business, New Zealand's Contact Energy.

He did not, however, have access to Contact's cash flow nor any straightforward opportunities to take advantage of the two companies' complementary positions in the Australasian energy markets.

Origin acquired its 51.4 per cent stake in Contact in 2004, after Edison Mission of the United States, like many of its US peers, decided to withdraw to its home turf and focus on reducing its excessive debt. Origin bid for the Contact minorities.

Like Edison Mission in 2002, however, Mr King knew the offer wouldn't succeed because Contact shareholders were very reluctant to part with their scrip. At the time, that wasn't a major issue because the bid wasn't about synergies – there weren't that many – but was based on a view that the two companies had complementary skills and positions in the sector. Origin was attracted by the diversification of geography, the regulatory jurisdictions and the portfolio of energy assets that the original Contact deal provided.

Nearly two years later, Mr King has changed his mind. Though he has been able to consolidate Contact's numbers, he hasn't been able to direct its cash flows. Contact has been a good investment, but the existence of large-scale minorities has complicated attempts at cooperation, creating conflicts that have stopped the companies doing things that both know would add value for their shareholders.

Origin looked at conventional mechanisms for bringing the two together. It knew from its own experience (and Edison Mission's) that, unless it grossly overpaid for the shares, a cash bid wouldn't succeed. It assessed the prospects of a scrip bid as even lower. New Zealand shareholders would lose their local sharemarket listing and lose access to dividends that are in effect franked. The solution was the first attempt to create an Australasian dual-listed company.

The benefits of a DLC structure for Origin and Contact – as with the BHP/Billiton and Rio Tinto/CRA mergers – are that the companies retain separate legal entities and tax positions but can pool cash flows and run as one entity at a management level.

Neither company nor their shareholders faces a tax event or change in the tax treatment of their income or capital. Indeed, the merger would enable both to maximise their ability to deliver tax-efficient returns.

By retaining both sets of shareholders, Origin also diversifies its investor base and its potential funding sources, lowers its cost of capital – the increased diversity of assets and cash flows should see its credit rating raised – and is able to make a major acquisition without taking on debt.

Origin doesn't have a big network business and therefore doesn't pursue the same leveraged approach to its balance sheet as many of the infrastructure-driven players in the energy sector.

The underlying business logic of the combination is strong. Both Origin and Contact are in the energy sector but they have very different profiles. Their operations are complementary rather than similar.

Origin's portfolio is diversified and integrated, covering the gamut of energy interests including gas and electricity retailing, upstream exploration and production, power generation and, to a limited extent, distribution.

Contact is primarily a generator with a very big retail electricity customer base. As a mainly hydro-electric business, it has been exposed to significant and quite traumatic shifts in the availability and pricing of energy.

It has tried to manage those exposures by diversifying into gas-fired plants and is also the major natural gas retailer and wholesaler. With the rest of the New Zealand power generating sector, however, it is facing a dilemma.

Local reserves of gas are declining rapidly and it will either have to discover new sources or contemplate importing lng, probably within five years, when Contact's forward cover on its fuel requirements falls away – it doesn't have much time to come up with a solution to the looming shortage of fuel.

The problem is compounded because Contact has two sites where it has New Zealand Government approval to build new plants – its growth prospects are also threatened by the doubts over its future access to gas.

Origin has expertise in exploring for gas, a big portfolio of exploration acreage in New Zealand waters and an interest in a gasfield expected to be producing by 2008. It also has significant reserves of gas in Australia.

Even if it cannot find significant new reserves of New Zealand gas within the time required, if the companies were merged, the portfolio effect of Origin's Australian reserves would provide a natural hedge to cover the market risk inherent in an imported fuel strategy. It would also enable Contact to expand its generating capacity and therefore create growth options for the business.

For Origin, the merger would give it a more balanced portfolio – its asset base would be split evenly between Australia and New Zealand and it would have a tilt toward generation, where today it is a net retailer.

It would have as big an integrated energy business – and a more balanced business – as anyone in the region, with a market capitalisation above $7 billion after the Contact stake is in effect cancelled.

Contact's experience in generation would also be useful for Origin, which is rapidly increasing its own gas-fired generation.