SSEs acquisition of The Energy Solutions Group (ESG)

sou-sou-easts accomplishment of The get-up-and-go Solutions Group (ESG)EXECUTIVE SUMMARYThis answer for has been under taken to tot up with the inborn jimmy of south southeast plc which is run in nix industry, using sh areholder value analysis (SVA) mildew. The underlying value of the company is estimated to be 12,122.14m, which is lower than the securities industry value of 15757.52m (FAME database, accessed on 19th January 2017). The discrepancy of the two values may be explained by referencing to Efficient Market Hypothesis, asymmetric information issue and shortcomings of SVA model.Based on sensitivity analysis, it is determined that south southeasts inseparable value is passing sensitive to changes in operational brink and WACC. It is found out that an adaptation of +2% made towards operating margin and WACC forget remarkably change the company value by +86% and nearly -50% respectively. Therefore, analysts should pay more prudence to these two variables when employing SVA model.The later section of the report identifies SSEs acquisition of The Energy Solutions Group (ESG) as a critical financial event, highlighting that the transaction forget earn more synergy to the unswervings operation and enhance its competitive advantage in the susceptibility industry. However, it is imperative for destinyholders to keep track of the companys performance to alleviate problems of hubris or empire building.ObjectivesThis financial report is expected to achieve two primary objectives. First, this report aims to provide the valuation and analysis of SSE plc a company operating in the energy industry by employing Shareholder Value Analysis (SVA) technique. Second, SSEs acquisition of The Energy Solutions Group (ESG) in 2014 result be evaluated with reference to finance theories in Mergers and Acquisitions.1.2 Report structureThis financial report is organized in five main partsSection I IntroductionThis section provides main purposes of the repo rt and briefly describe structure of the report.Section II high society ProfileThis section gives an overview of SSEs business activities, its market share and competitive arrangement.Section III Company ValuationThis section covers the following contentsEvaluate the appropriateness of SVA model to value a companyPerform the valuation of SSE plc using SVA modelProvide justifications for variables and proxies used in the modelCarry out comparative analysis and sensitivity analysisSection IV Actual Corporate monetary EventThis section critically evaluates SSEs acquisition of The Energy Solutions Group (ESG) with reference to finance theories. Some implications would besides be proposed following the event evaluation.Section V ConclusionThis section summarizes the employment of SVA measure in case of SSE and then provide some recommendations.2.1 Business DescriptionSSE plc ( Scots and Southern Energy plc) is a British energy company headquartered in Perth, Scotland, United Kingdom. SSE was established in 1998 as a result of the fusion betwixt Scottish Hydro-Electric and Southern Electric. SSE is listed on London Stock Exchange and it stock forms part of FTSE 100, FTSE 350 and FTSE All-Share.SSEs business covers leash separates Wholesale, Networks and Retail. The Wholesale segment involves power generation from renewable and thermal plant in the United Kingdom, Ireland and Europe the Networks segment is responsible for distributing electricity to node premises in the North of Scotland and the South of England meanwhile, the Retail segment supplies electricity and artillery to residential and business customers in the United Kingdom and Ireland (Financial Times, 2017). Since SSE undertakes both generation and retail yield activities, it is considered a straightly unified energy business. This makes SSE unique since SSE is the only company listed on London Stock Exchange involved in such a giving range of energy businesses (SSE, 2016a).Market shareReg arding Wholesale business, in 2015 SSE had a small market share of 7%, accounting for only a quarter of EDFs share and active half of RWEs share (see appurtenance 1). Referring to Ofgem (2016b), in 2015 the market shares of dominant energy producers in the UK remain relatively unchanged compared with these of 2014, which is also the case of SSE.With respect to Retail business, there were over 43 active energy suppliers in Britain by March 2016, most of which offering both gas and electricity supply (Ofgem, 2016a). SSE is included in Big 6 which are widely known as dominant attracters in the market, including British Gas, EDF Energy, E.ON, SSE, npower and ScottishPower. These companies supply gas and electricity to over 50 million household and businesses in Britain, with 87% share of domestic customers by March 2015 (Ofgem, 2016a).SSE is operating in a in truth competitive and well-functioning energy retail market. The firms market share in the market for energy supply basis be illustrated in Appendix 2 and Appendix 3. By March 2016, SSE had the second largest market share of UK electricity supply market (about 15%), while its market share of gas supply (about 13%) only accounted for approximately one-third of British Gass share.Increasing competition in energy industry and SSEs competitive positioningOut of the three segments, Wholesale and Retail businesses have been facing increasing competition in recent familys due to the entrance of new rivals in the GB Energy Supply market. There have been some concerns over barriers to entering wholesale and retail energy market such as the complexness and extent of credit requirements or low levels of liquidity in the market. Despite of these, new presentation has taken place (see Appendix 4).The result of new suppliers entry is falling market share of the sise large suppliers from 90% to 87% amid March 2015 and March 2016 for electricity, and 90% to 86% for gas over the same period (Ofgem, 2016a). Specific ally, the entry and harvest of new suppliers has led to SSEs market share declining. There is a decreasing trend in the repress of energy customer accounts for the past three years (see Appendix 5).In addition to the new rivalries entrance to the market, customers shift key is a nonher issue that reduce the market share of six large suppliers. Households are increasingly turning to smaller suppliers, with consumers complaining the sector is slow to pass on wholesale energy cuts and offers poor service. The total number of users switching suppliers in March 2016, 476,528 customers, was the highest since November 2013 (Energy UK, 2016).As the market become more and more competitive, attracting and retaining customers can pose challenges to SSE. However, SSE has a clear strategy to spot itself and create value by becoming a market-leading, digital and diversified retailer of energy and essential services. According to SSE (2015a), for the past few years SSE hasLaunched its first la rge-scale advertising campaign for the SSE brand in both Britain and Ireland, known as Proud to make a divagation campaign. The campaign has been implemented in many a(prenominal) forms from TV, radio, billboards, print media to various digital and social media formatsOverhauled its digital channels in order to create a simple, broadloom and intuitive customer experience and provide the best possible service at the lowest possible apostrophizeIntroduced a new customer race management (CRM) platform which facilitates better customer understanding and tailors communications and propositions to the needs of different customersDeveloped and reopened sales channels and processes to ensure compliant emergence. hang onitionally, SSEs trueness to decarbonization essence that the firm will continue potential expansion in renewable energy portfolio which are comp countermandd of onshore go, offshore wind and conventional hydro. Furthermore, SSE is the leader in the UK energy industry to handle customer complaints. According to Energy Ombudsman in February 2016, only four out of 100,000 customer complaints compulsory further investigating in the first three quarters of the year, pointing out the fact that 99.969% of SSEs customer issues were fully resolved (SSE, 2016a).3.1 Evaluate the appropriateness of SVA ModelThere are many methods for estimating value of a company, including valuations based on asset, dividend, earnings and cash flows. Among these methods, discounted cash flow valuation is the most technical direction of valuing a business as it is heavily dependent on assumptions about long-term business conditions. This measure is especially useful for cash-generating businesses which are stable and mature. Alfred Rappaport (1998) developed a simplified memory access of cash flow discounting called shareholder value analysis (SVA). SVA model makes assumptions about steady changes in a number of cash flow factors as they are all relevant to sales level .There are obvious advantages associated with the use of this model. SVA is not rout to different accounting policies used by different companies and therefore can be applied across many business sectors. In addition, firms using SVA must concentrate on the future and customers, with specific focus on future cash flows. On the other hand, SVA is not a perfect model as it contains some shortcomings when being used in practice. Irrational assumptions about value drivers, as well as data unavailability are possible drawbacks that analyst frequently encounter when employing this model.3.2 Justification of variables and proxiesEmploying the SVA Model to calculate a companys intrinsic value requires assumptions about a number of key variables. Sales growth strength be the most important factor in the model, screen background the foundation to come up with other variables values such as operating profit, incremental capital enthronisation and incremental working capital coronation. I n case of SSE, sales growth is determined after careful consideration of historical growth rates, price forecast and potential future projects. For the last three years, sales growth has witnessed a decreasing trend, which can be explained by a number of reasons.First, energy prices in the UK are influenced by oil and char prices therefore, when these commodities prices move upward or downwards, they are likely to drive gas and electricity prices in the same direction (Ofgem, 2016b). Since the second half of 2014, there were downward trends in oil and coal prices due to oversupplied markets for these commodities, contributing to declining energy prices and therefore SSEs revenues. The movements of oil price can be illustrated in the following figure betoken 1 Brent Crude Oil price from 2010 to 2016( consultation Bloomberg, 2016)Second, there are more and more energy suppliers in the UK market. Levels of new entry have been very high recently 14 new suppliers became active between April 2015 and March 2016, compared to five between April 2014 and March 2015 (Ofgem, 2016a). The presence of new rivals leads to SSEs declining market share as well as the firms revenue.Third, more and more customers are switching to small and medium-sized suppliers, as shown in Figure 2. If this trend goes on, there will be overmuch pressure on expected revenue of large energy suppliers.Figure 2 Monthly increases in the total number of domestic gas and electricity meters supplied by small and medium-sized suppliers(Source Ofgem analysis of data provided by Xoserve, DNOs and iDNOs, 2016)From the above data, it might seem that SSEs revenue will be struggling in the next few years. However, there are evidences for investors to believe in SSEs sales growth for at least the next 5 years. First, oil price forecasts by World Bank, IMF and EIU destine crude oil prices will observe steady increases from 2017 to 2025 (Knoema, 2016) (see figure 4, figure 4 and figure 6).Figure 3 World Bank Oil wrong Forecast(Source Knoema, 2016)Figure 4 IMF Oil Price Forecast(Source Knoema, 2016)Figure 5 EIU Oil Price Forecast(Source Knoema, 2016)Second, some renewable projects will be fully operational in 2017 and these will definitely support revenue growth in the next few years. As reported by SSE (2016c), three onshore wind projects under construction are expected to come into operation in 2017, including Dunmaglass (94MW), Clyde Extension (173MW) and Bhlaraidh (108MW).After above analysis has been taken into account, the sales growth is determined as the arithmetic average of the changes in sales over the previous three years, giving the result of 0.82%. This sales growth is reasonable given that SSE is operating in increasingly competitive industry, with customers tending to switch to small and medium-sized suppliers in recent years.The operating profit margin is predicted to be 2.87%, which can be worked out by taking the average of the margins in previous three years. The re ason behind this assumption is that SSE is an streamlined energy supplier committed to maintaining relatively low operating costs in order to make a fair profit. According to SSE (2015a), SSEs validating costs per customer are around 20% lower than the average across the rest of the major suppliers. The effect of low operating costs can be demonstrated by stable operating profit margins for the last three years, and it is expected that this trend will continue for the coming financial years.The incremental capital investment of 53% is understandable as the company continues to develop secure, sustainable and low carbon energy infrastructure, given that the energy industry is switching to renewable energy sources. In its interim results for the six months to 30 September 2016, SSE announced it plans to invest a record 1.85bn of capital expenditure and investment in Great Britain and Ireland in 2016/17 (SSE, 2016b). According to Alistair Phillips-Davies, SSE Chief Executive, the fir m is making more investment in supporting the modernization of UKs energy facilities, and the total investment and capital expenditure by 2020 is forecast to reach approximately 6bn.A relatively low working capital investment of 10% is determined since SSEs current assets are just enough to absorb current liabilities in the last few years. Trade and other receivables accounts for a large counterpoise of SSEs current assets due to the nature of the energy supply business. Meanwhile, current liabilities are mainly comprised of trade and other payables, which is because the company is making heavy investment in renewable energy infrastructure. Simply put, an incremental working capital investment of 10% is appropriate for SSE given that many potential energy projects will be under construction in the coming years.The corporation tax rate of 20% is applied to company profits (HMRC, 2016), and SSEs business is also subject to this rate.Another key variable in SVA is weighted average cos t of capital (WACC). The cost of debt is determined as SSEs weighted average interest rate, which is 3.73% for year 2016. Meanwhile, the cost of equity is computed using CAPM model. SSEs beta (0.74) was makeed from FAME database, while the UK Gilt 10 Year Yield (1.40%) collected on Bloomberg website is used as the proxy for risk-free rate all of these figures were retrieved on 19th January 2017. In addition, the UK market risk premium (5.3%) by Fernandez, et al., (2016) is another key component in the CAPM. Subsequently, a WACC of 4.59% is achieved and this is the required rate of return for SSEs capital providers.In short, the following seven value drivers will be applied in case of SSETable 1 Seven value drivers for SVA modelKey DriversValueSales growth0.82%Operating Profit margin2.87%Tax rate20%Incremental persistent capital investment53%Incremental working capital investment10%Planning Horizon5Required Rate of Return4.59% Source Analysts estimate3.3 Employment of SVA ModelTab le 2 illustrates how SVA model is utilized in SSEs case. SSEs revenue of 28,781m (recorded on 31st March 2016) was increased annually by a sales growth of 0.82% over a 5-year planning horizon. Subsequently, an operating margin of 2.87% was applied to revenues to come up with the firms operating profit. Before arriving at SSEs operating cash flows, a corporation tax rate of 20% was imposed on the operating profit, followed by subtractions of 53% in incremental capital investment and 10% in working capital investment. Afterwards, the present value of future cash flows was estimated by discounting the firms operating cash flows by 4.59% cost of capital. It is noted that SSEs conclusion value at year 6+ was discounted twice, the first of which worked out the value at year 5 and the second one brought out the value in present day. After the net present value of 18,930.7m was figured out, adjustments were made by adding 360.2m cash and marketable securities, and then deducting 7,168.8m t otal debt. After all, SSEs intrinsic value was determined at 12,122.14m.Table 2 SSEs Shareholder value analysis (unit million pounds)Year123456+Sales29,018.429,257.729,498.929,742.229,987.529,987.5Profit833.6840.5847.4854.4861.5861.5Associate Profit206.5208.2209.9211.6213.4213.4Less Tax166.7168.1169.5170.9172.3172.3Less ICI125.1126.1127.2128.2129.30Less IWCI23.723.924.124.324.50Operating Cash Flow724.6730.6736.6742.7748.8902.6PV of cash flows692.8667.8643.8620.6598.315,707.4NPV18,930.7Add mkt secs19,290.9Less debt7,168.8Equity Value SVA12,122.14millionActual Value15,757.52millionFAME access on 19th January 2017 Source Analysts estimate3.4 Comparative AnalysisSSEs intrinsic value derived from SVA model was 12,122.14m while its market capitalisation was recorded at 15757.52m (FAME database, accessed on 19th January 2017), pointing the difference of 3,635.38m between the two values.One possible interpretation for this discrepancy is that all relevant information may not be incorporate d into the share price. It could be inferred from Efficient Market Hypothesis (Fama, 1970) that the extent to which the share price is reliable depends on the efficiency of the markets. Under the strong form efficiency, the market value of 15757.52m will fully reflect all past, present and insider information. On the other hand, if the market is under the weak form efficiency, the market value of 15757.52m will only reflect the historical prices of the security, and hence lacking reliability. Furthermore, the information asymmetry, e.g. between management and investors and between investors themselves, is another explaining factor. Plesco Sobol (2013) states that investors who are ill-informed about financial disclosures can make unreasonable decisions in their investment. Due to irrational trading behaviours of these investors, share prices may not yield a fair market value.Another cause of the difference between the two values lies in the limitations of SVA model. The constant sa les growth every year is not very realistic because the growth depends on potential development and firms strategies, which are subject to annual reviews. In the same manner, belongings WACC (4.59%) constant over 5-year planning horizon is not rational in practice, because the firms capital structure will change over time. Last but not least, the assumptions of sales growth and other key variables depend on each analysts subjective viewpoint. Changing these values by a small percentage might result in considerable change in eventual intrinsic value.3.5 Sensitivity AnalysisThe sensitivity analysis performance indicates that SSEs underlying value is highly sensitive to changes operating profit margin. A positive adjustment of 2% made towards the operating margin will result in a tangible increase of 86% in the firms equity value (see Appendix 6). It is worth remembering that SSE is committed to preserve low operating costs so as to gain a fair profit. According to SSE (2015b), the f irm has participated in a value program to ensure effective use of pot and capital, the overall objective of which is business streamlining and simplification. This program comes with efficiency target, with expected 100m of annual savings in overheads. In addition, the program involves reduction in offshore wind development as well as disposal of non-core assets. In general, this value scheme is likely to help SSE optimize its investment and re-balance its business.Moreover, it is noticeable that the firms intrinsic value is susceptible to changes in WACC. An adjustment of +2% in the WACC will lead to approximately 50% reduction in the firms equity value (see Appendix 6). According to Fitch Ratings (2016), SSEs equity has been diminishing recently due to the influence of sustained asset impairment losses and generous dividend pay-outs. In agreement with Pecking erect Theory, debt takes priority over equity in case external finance is required (Donaldson, 1961). Because SSEs cost of debt (3.73%) is lower than cost of equity (5.32%), it is appropriate for SSE to obtainmore bank loans to finance its long-term operations, while still making sure cost of capital is kept to a minimum. Particularly Fitch Ratings (2016) claims that SSE has a policy of accessing debt markets, ensuring that its committed borrowings equal to at least 105% of forecast borrowings over a six-monthly rolling period and adequate liquidity will be fulfilled until at least September 2017.4.1 Background informationIn the end of July 2014, SSE completed the acquisition of The Energy Solutions Group Topco peculiar(a) (ESG), the North west-based provider of energy management services, from Bridgepoint Development Capital for 66m with an additive 6m if agreed targets are achieved. Working with private and public sector customers, ESG identify improvements in their management of energy consumption as well as install, maintain and support building management systems and solutions, saving customer s around 20% to 30% of their energy consumption (SSE, 2014).4.2 Evaluation of the issue in the context of finance theoriesThis acquisition is classified into vertical MA (Mergers and Acquisitions). According to Arnold (2013), vertical MA occur between companies operating in the same industry at different stages of production, i.e. one company acquires another company that is either before or after it in the supply chain process. In case of SSEs acquisition, both SSE and ESG work in the energy industry. SSE involves in all many stages of energy supply chain including wholesale, networks (distribution) and retail meanwhile ESG engages in the retail business where it is the designer and provider of energy management solutions. Therefore, SSEs acquiring ESG would be a downstream vertical acquisition.So, what is SSEs motivation behind this acquisition? Vertical integration has some advantages, including the attraction of increased certainty of supply or market outlet reducing cost of sea rch, contracting, payment collection, advertising, communication and co-ordination of production (Arnold, 2013). SSE (2014) states that the acquisition of ESG will strengthen SSEs services in competitive markets for industrial and technical customers. These services are comprised of galvanising and mechanical contracting, lighting services, private energy networks and telecoms, all of which are under the control of Enterprise division which forms part of SSEs retail business. According to Arnold (2013), one of the merger and acquisition motives is synergy in which the two firms together are worth more than the value of the firms apart hence in this case, ESG will bring commercial synergies to SSEs Enterprise division.SSEs Chief Executive Alistair emphasized that managing energy costs and environmental impact are SSEs big priority for large industrial and commercial customers. Benefiting from ESGs expertise, SSE expects to meet the energy and related demands of these customers in a n enhanced manner. It was confirmed that the ESGs existing management team would be in charge of the Enterprise division, and the firm believed that the commitment of the ESG management team and other employees will benefit its customers and the environment in terms of effective energy management solutions delivery.SSEs acquisition of ESG is considered a strategic acquisition in order to achieve external growth. There are two ways to categorize strategic acquisitions by type of capability transferred and by their congress to corporate strategy (Goold Luchs, 1995). Regarding capability transfer, SSE (2015a) asserts that the acquisition of ESG added new capabilities to the business. (Goold Luchs, 1995) claims that value is created in an acquisition when competitive advantage of one firm is enhanced with the transfer of strategic capabilities including resource sharing, functional skill transfer and management skill transfer. The presence of ESG management team in SSEs Enterprise d ivision will upgrade SSEs capability of strategic planning, ensuring that effective energy management solutions are delivered for the sake of customers. Generally, SSE is expected to benefit from management skill transferred from ESG.Another way to categorize strategic acquisitions is based on their contribution to corporate-level strategy. In other words, acquisitions are assessed considering their connections in maintaining and changing the balance between the firms existing domain and the vicissitude of its capabilities (Goold Luchs, 1995). An acquisitions contributions are classified into either domain fortify, domain extension or domain exploration. In light of SSEs acquiring ESG, this would be an illustration of domain strengthening because this acquisition will deepen SSEs presence in retail business, especially reinforcing Enterprise divisions operation.Next, it is essential to see what happened with SSE stock price after the firm made announcement about the acquisition o f ESG. Theoretically, when a firm acquires another one, a short-term impact on the stock price of both companies is expected. Specifically, a lot of practical studies point out that the acquiring firms stock price will go down while the acquired entitys stock price will rise (Investopedia, 2016a). With respect to the takeover company, its stock will go down mainly because of a number of uncertainties associated with the acquisition, such as turbulent integration process, lost productivity, additional debt or expense incurred and accounting issues (Investopedia, 2016a). Figure 6 demonstrates SSEs stock prices after the acquisition of ESG was disclosed.Figure 6 SSEs stock price movements after acquisition of ESG (Source Hargreaves Lansdown, 2014)As can be seen from the above figure, SSEs stock prices witnessed decreases in two consecutive days after the acquisition and this conformed with the empirical studies implication m