SSEs acquisition of The Energy Solutions Group (ESG)

s step uph s let awayheasts acquisition of The Energy Solutions Group (ESG)EXECUTIVE abridgmentThis get across has been undertaken to come up with the immanent economic rank of south southeast plc which is ope assess(a) in button industry, using circumstancesholder time shelter psychoanalysis (SVA) model. The underlying treasure of the lodge is estimated to be 12,122.14m, which is embarrassed-spiriteder than the commercialise value of 15757.52m (FAME in varietyationbase, accessed on 19th January 2017). The discrepancy of the cardinal 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 intrinsic value is highly sensitive to changes in operating shore and WACC. It is found out that an adjustment of +2% make towards operating margin and WACC ordain remarkably change the company value by +86% and nearly -50% respecti vely. Therefore, analysts should pay much attention to these devil variables when employing SVA model.The later naval divider of the report identifies sou-sou-easts acquisition of The Energy Solutions Group (ESG) as a critical financial event, highlighting that the transaction give run more synergy to the levels operation and enhance its free-enterp renegade(a) advantage in the get-up-and-go industry. However, it is imperative for get byholders to keep track of the companys performance to completelyeviate problems of hubris or empire building.ObjectivesThis financial report is expected to achieve two indigenous purposes. First, this report aims to provide the valuation and analysis of south southeast plc a company operating in the cogency industry by employing Sh atomic number 18holder appreciate Analysis (SVA) technique. Second, sou-sou-easts acquisition of The Energy Solutions Group (ESG) in 2014 allow be evaluated with lengthiness to finance theories in Mergers and Acquisitions.1.2 Report anatomical structureThis financial report is organized in five main parts variance I IntroductionThis section provides main purposes of the report and briefly describe structure of the report.Section II Company ProfileThis section gives an every military postview of SSEs business activities, its foodstuff sh ar and competitive positioning.Section III Company ValuationThis section c tout ensemble overs the side by side(p) contentsEvaluate the appropriateness of SVA model to value a companyPerform the valuation of SSE plc using SVA model get out justifications for variables and proxies used in the modelCarry out comparative analysis and sensitivity analysisSection IV Actual Corporate m sensationtary EventThis section critically evaluates SSEs acquisition of The Energy Solutions Group (ESG) with reference to finance theories. Some subtractions would also be proposed following the event evaluation.Section V ConclusionThis section summarizes the employ ment of SVA measure in expression of SSE and then provide more or less recomm haltations.2.1 Business DescriptionSSE plc (Scottish and Southern Energy plc) is a British brawn company headquartered in Perth, Scotland, United Kingdom. SSE was established in 1998 as a publication of the merger among Scottish Hydro-Electric and Southern Electric. SSE is listed on jacket crown of the United Kingdom Stock Exchange and it line of descent forms part of FTSE 100, FTSE 350 and FTSE All-Shargon.SSEs business covers three segments in bounteous quantities, Networks and Retail. The Wholesale segment involves power generation from re in the altogetherable and thermal plant in the United Kingdom, Ireland and Europe the Networks segment is responsible for distributing galvanizing thrust to guest set forth in the due north of Scotland and the South of England meantime, the Retail segment supplies electricity and particle accelerator to residential and business customers in the United Kingdom and Ireland (Financial Times, 2017). Since SSE undertakes both generation and retail publish activities, it is considered a vertically integrated push business. This makes SSE unique since SSE is the sole(prenominal) company listed on corking of the United Kingdom Stock Exchange involved in such a great range of energy businesses (SSE, 2016a).Market shareRegarding Wholesale business, in 2015 SSE had a small foodstuff share of 7%, accounting for only a quarter of EDFs share and about half of RWEs share ( put on 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 role of SSE.With respect to Retail business, thither were over 43 active energy suppliers in Britain by inch 2016, nigh of which offering both torpedo and electricity supply (Ofgem, 2016a). SSE is include in Big 6 which are widely known as dominant leaders in the market, inc luding 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 very competitive and well-functioning energy retail market. The firms market share in the market for energy supply can be illustrated in vermiform 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 leash of British Gass share.Increasing competition in energy industry and SSEs competitive positioningOut of the three segments, Wholesale and Retail businesses m different been facing increasing competition in recent socio-economic classs cod to the ravish of hot rivals in the GB Energy Supply market. There have been some concerns over barriers to entering wholesale and ret ail energy market such as the complexity and conclusion 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 sextette large suppliers from 90% to 87% between March 2015 and March 2016 for electricity, and 90% to 86% for gas over the same period (Ofgem, 2016a). Specifically, the entry and addition of new suppliers has led to SSEs market share declining. There is a decreasing trend in the number of energy customer accounts for the past(a) three years (see Appendix 5).In addition to the new rivalries overtake to the market, customers switching is another issue that reduce the market share of six large suppliers. Households are increasingly turning to smaller suppliers, with consumers complaining the heavens is slow to pass on wholesale energy cuts and offers poor service. The union number of users switching suppliers in March 2016, 4 76,528 customers, was the highest since November 2013 (Energy UK, 2016).As the market call on more and more competitive, attracting and retaining customers can pose challenges to SSE. However, SSE has a pull in strategy to contraryiate itself and create value by becoming a market-leading, digital and diversified retailer of energy and essential run. concord to SSE (2015a), for the past a some(prenominal) years SSE hasLaunched its first large-scale publicize campaign for the SSE brand in both Britain and Ireland, known as Proud to make a difference campaign. The campaign has been implemented in many forms from TV, radio, billboards, print media to various digital and social media formatsOverhauled its digital channel in score to create a simple, seamless and intuitive customer experience and provide the best possible service at the terminal possible embodyIntroduced a new customer relationship charge (CRM) platform which facilitates better customer understanding and tailo rs communications and propositions to the needs of different customersDeveloped and reopened gross gross revenue channels and processes to ensure compliant growth.Additionally, SSEs commitment to de carbon copyization bureau that the firm pass on continue potential expansion in renewable energy portfolio which are comprised of onshore waver, offshore wind and conventional hydro. Furthermore, SSE is the leader in the UK energy industry to handle customer complaints. accord to Energy Ombudsman in February 2016, only four out of 100,000 customer complaints compulsory further investigation 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 archetypeThere are many methods for estimating value of a company, including valuations based on asset, dividend, earnings and cash consorts. Among these methods, discounted cash flow valuation is the roughly technical f oul way of valuing a business as it is heavily dependent on assumptions about long business conditions. This measure is especially useful for cash-generating businesses which are still and mature. Alfred Rappaport (1998) developed a simplified approach 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 subject to different accounting policies used by different companies and thereof can be utilize across many business sectors. In addition, firms using SVA must concentrate on the time to come and customers, with specific concenter 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 plea of variables and proxiesEmploying the SVA nonplus to calculate a companys intrinsic value requires assumptions about a number of unwrap variables. Sales growth might be the most important factor in the model, setting the foundation to come up with other variables values such as operating profit, incremental capital enthronement and incremental working capital investiture. In sequel of SSE, sales growth is determined later careful consideration of historical growth rates, wrong 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 scorch prices therefore, when these commodities prices move upward or downward, 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 kind cipher 1 Brent Crude Oil price from 2010 to 2016(Source 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 charge 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 entrust be much pressure on expected revenue of large energy suppliers.Figure 2 periodical increases in the meat 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 search 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 being brink, IMF and EIU indicate 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 terms 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 expression 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 determin ed as the arithmetic comely of the changes in sales over the previous three years, giving the result of 0.82%. This sales growth is conjectural effrontery that SSE is operating in increasingly competitive industry, with customers be given 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 reason stooge this assumption is that SSE is an efficient energy supplier act to concuring relatively low operating costs in order to make a fair profit. According to SSE (2015a), SSEs indirect 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 announce 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 firm is do more investment in supporting the modernization of UKs energy facilities, and the total investment and capital expenditure by 2020 is forecast to blow over approximately 6bn.A relatively low working capital investment of 10% is determined since SSEs current assets are just enough to lactate current liabilities in the last few years. Trade and other receivables accounts for a large proportion of SSEs current assets due to the nature of the energy supply business. Meanwhile, current liabilities are generally comprised of trade and other paya bles, 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 utilize to company profits (HMRC, 2016), and SSEs business is also subject to this rate.Another key variable in SVA is weighted average cost 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 truth is computed using CAPM model. SSEs beta (0.74) was obtained from FAME database, while the UK Gilt 10 year Yield (1.40%) collected on Bloomberg website is used as the proxy for unhazardous rate all of these figures were retrieved on 19th January 2017. In addition, the UK market fortune 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 septet value drivers will be applied in case of SSETable 1 Seven value drivers for SVA modelKey Drivers determineSales growth0.82%Operating Profit margin2.87%Tax rate20%incremental fixed capital investment53%Incremental working capital investment10%Planning Horizon5Required Rate of Return4.59% Source Analysts estimate3.3 Employment of SVA ModelTable 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 prese nt value of future cash flows was estimated by discounting the firms operating cash flows by 4.59% cost of capital. It is state that SSEs terminal 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 total debt. After all, SSEs intrinsic value was determined at 12,122.14m.Table 2 SSEs Shareholder value analysis (unit million pounds)Year123456+Sales29,018.429,257.729,498.929,742.229,987.529,987.5Profit833.6840.5847.4854.4861.5861.5 harmonise 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 debt7,168.8 beauteousness Val ue 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 invoice for this discrepancy is that all relevant information may not be in somaticd 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 real 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 and then lacking reliability. Furthermore, the information asymmetry, e.g . between focus 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. receivable 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 continual sales growth every year is not very realistic because the growth depends on potential t individuallying and firms strategies, which are subject to annual reviews. In the same manner, keeping 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 parting might result in considerable change in ul timate intrinsic value.3.5 Sensitivity AnalysisThe sensitivity analysis performance indicates that SSEs underlying value is highly sensitive to changes operating profit margin. A absolute adjustment of 2% made towards the operating margin will result in a substantial increase of 86% in the firms beauteousness value (see Appendix 6). It is worth remembering that SSE is committed to spare low operating costs so as to gain a fair profit. According to SSE (2015b), the firm has participated in a value program to ensure effective use of people 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 increase as well as disposal of non-core assets. In general, this value evasion is likely to help SSE optimize its investment and re-balance its business.Moreover, it is noticeable that the firms intrinsi c 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 Order 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 unploughed 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 fulfil until at least September 2017.4.1 Background informationIn the e nd of July 2014, SSE completed the acquisition of The Energy Solutions Group Topco Limited (ESG), the North west-based provider of energy worry services, from Bridgepoint Development Capital for 66m with an additional 6m if hold targets are achieved. Working with private and public sector customers, ESG identify improvements in their direction of energy consumption as well as install, maintain and support building management systems and solutions, saving customers 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 in the beginning or after it in the supply chain process. In case of SSEs acquisition, both SSE and ESG work in the energy industry. SSE invol ves 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 getting 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 matter of course of supply or market outlet reducing cost of search, contracting, hire 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 commercial customers. These services are comprised of electrical 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 an 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 categorise strategic acquisitions by type of capability transferred and by their relation 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 by the transfer of strategic capabilities including resource sharing, functional expertness transfer and management skill transfer. The presence of ESG management team in SSEs Enterprise division 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 constituent to corporate-level strategy. In other words, acquisitions are assessed considering their connections in maintaining and changing the balance between the firms existing field of battle and the ren ewal of its capabilities (Goold Luchs, 1995). An acquisitions contributions are classified into either domain strengthening, domain extension or domain exploration. In light of SSEs acquiring ESG, this would be an illustration of domain strengthening because this acquisition will sharpen 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 declaration about the acquisition of ESG. Theoretically, when a firm acquires another one, a short-term impact on the stock price of both companies is expected. Specifically, a draw play 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, muzzy producti vity, 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