Proposed utility merger seems like a sensible deal for shareholders

Narrow-moat-rated Manawa Energy MNW has received an attractive takeover offer from larger peer narrow-moat rated Contact Energy CEN. The offer consists of 0.5719 Contact shares (worth NZD 4.82 at Contact’s current price) plus NZD 1.16 in cash per Manawa share. The total value of NZD 5.98 is close to our unchanged fair value estimate of NZD 6.10 per share and represents a generous 48% premium to yesterday’s closing price. Directors unanimously recommend the offer in the absence of a superior proposal and subject to a positive recommendation from the independent expert.

We are likely to support the takeover as it is a mostly scrip bid at a fair price, and shareholders will gain ownership of a bigger, more diversified, and lower-risk business. We also expect significant synergies. Contact forecasts up to NZD 28 million per year of cost savings via the removal of duplicated functions and an additional up to NZD 20 million in benefits from a more diversified and reliable generation portfolio. Contact, which also has a narrow moat, currently trades at a 3% discount to our valuation, supporting our view that the offer is fair.

The takeover is via a scheme implementation agreement, requiring 75% of Manawa shares to vote in favor at the scheme meeting, which is likely to be held in the first half of 2025. Major shareholders Infratil and TECT, which own a combined 78% of Manawa, are supportive. Thus, we expect the vote to pass.

The main obstacle to the merger is gaining approval from the New Zealand Commerce Commission. We don’t think the merger will noticeably reduce competition because Manawa doesn’t have much in the way of retail operations. However, wholesale electricity prices are worryingly high, and the Commission may balk at even a small lessening of competition in generation amid an energy crisis. Contact supplies about 20% of New Zealand’s electricity, and Manawa about 4%.

Contact Energy business strategy and outlook

Contact Energy is one of New Zealand's leading producers and suppliers of electricity. It operates in an environment dominated by four electricity producers, resulting in disciplined competition and historically good pricing power. We believe Contact and the other major players will continue to dominate the industry and generate favorable returns in the long run.

Contact Energy possesses a diverse portfolio of generation assets—hydro, geothermal, and gas-fired—with an installed capacity of more than 2,000 megawatts, or MW. Due to this diversity, the firm is well positioned to take advantage of revenue optimization opportunities presented by changing fuel and weather conditions.

The generation business is significantly hedged by the supply of electricity to residential, industrial, and contract-for-difference customers. This minimizes the risk arising from price volatility in the wholesale market. During periods of low wholesale prices, the company can opt to reduce generation output from its thermal power stations if it is more cost-effective to purchase electricity for its retail business than to produce it. On the other hand, when wholesale prices are lucrative, Contact Energy makes significant returns by increasing output from its gas-fired power stations.

The company's cost of generation fell with the commissioning of the Te Mihi geothermal plant and further geothermal power stations are being built.

The New Zealand Aluminium Smelters, or NZAS, now plans to remain open to December 2044. This supports a good long-term outlook for Contact and peer Meridian, which should be able to push through price increases.

Manawa business strategy and outlook

Manawa is New Zealand's fifth-largest generator behind Contact Energy, Mercury NZ, Meridian, and Genesis. Like Meridian and Mercury, Manawa generates close to 100% of electricity from renewable resources. It owns 26 relatively small hydroelectric schemes in New Zealand, producing about 1,940 gigawatt hours of electricity in an average rainfall year. The firm's wind farms and retail business were divested.

Manawa sells most of its power to Mercury NZ under a long-term contract with consumer price-index-linked prices. With elevated CPI inflation, revenue has a solid tailwind. Contracted sales reduce progressively from 2025, and we think Manawa can secure even better prices to reflect the tight wholesale market.

We believe Manawa has a narrow economic moat based primarily on efficient scale and cost advantages, compared with new generation supply. Manawa's New Zealand hydroelectric assets are small and have much less storage capacity than some peers. Nonetheless, they have some flexibility to tailor supply, and they benefit from exposure to numerous catchments, thereby smoothing output.

Electricity demand in New Zealand has been subdued because of economic weakness, more-efficient energy consumption by households and businesses and shutting down energy-intensive businesses, such as those involved in the production of pulp and paper. However, wholesale prices have been strong, a function of high coal, gas, and carbon prices. We expect wholesale prices to normalize in the long term as new renewable generation supply gets the market back in balance.

Get Morningstar insights in your inbox

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.