Expert case by Ian

Cutting Carbs - Divestiture in the Electrical Power Market

Cutting Carbs - Divestiture in the Electrical Power Market Cutting Carbs - Divestiture in the Electrical Power Market
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Problem Definition

Our client is Energy England, one of northern England’s largest electric utility companies. They were created over the past decade through an aggressive series of mergers of existing utility companies each specializing in a single energy generation source.

Recently, the CEO has embarked on an initiative to return to the core of the business. She is looking to increase free cash flow and cash reserves in order to prepare the business for evolving future trends.

The following can be verbally provided to interviewee if asked:

  • Energy England is made up of assets across the energy-generation space. These include coal, gas, nuclear, and wind
  • We are looking to divest from just one of our previous acquisitions (i.e one target is sufficient)
  • There are no specific goals/metrics – the client trusts our judgement

Comments

This is a candidate-led case whereby the candidate needs to identify the ideal business unit (energy type / previously acquired company) to cut from the existing business. This decision-making is based purely on which unit is the least efficient AND will free up the most capital.

This case was designed for candidates preparing for consulting roles in private equity, deal advisory, transaction services etc. In particular, it should be useful for candidates preparing for Bain, Big 4 Transaction Advisory Services (TAS), PwC Deal Advisory, EY Wealth Management, etc.

Solution

Paragraphs highlighted in green indicate diagrams or tables that can be shared in the “Case exhibits” section

Paragraphs highlighted in blue can be verbally communicated to the interviewee

Paragraphs highlighted in orange indicate hints for you how to guide the interviewee through the case

I. Operation Cost Comparison

The candidate needs to recognize that we need to evaluate our existing assets. They should ask for information regarding our current asset performance (operating costs, revenues, etc.) with the hypothesis that we will need to scale down or improve certain non-performing assets.

When sufficiently prompted, you may share Exhibit 1 with them.

If asked about column 5 Expected Carbon Tax, tell the candidate that our company places a very high probability on future regulation doubling the carbon tax. If pressed for a specific % probability, simply state that we are very confident of this.

You may provide the following clarifications when they are asked for:

  • MwH stands for Megawatt hour, a unit of measurement for energy produced
  • 1 GwH stands for Megawatt hour
  • 1 Gwh = 1,000 MwH
  • Total Annual production can be calculated by leveraging # hours per year

A good candidate will note the following:

  • Coal and gas make up the majority of our business
  • Carbon taxes play a notable role in the ultimate cost of coal and gas assets

The candidate should proceed to calculate the MwH Operating cost per energy type when incorporating carbon. They should note that they are as follows:

  1. Coal = 110 GBP/MwH
  2. Wind = 100 GBP/MwH
  3. Nuclear = 90 GBP/MwH
  4. Gas = 85 GBP/MwH

While the candidate should clearly indicate now that coal is the most expensive, an excellent candidate will also note that wind, while 2nd, should continue to decline in price over time due to current market trends.

The candidate may now attempt to calculate benefits from plants. Remind them that electricity is electricity and that, for the sake of simplicity, we can assume all MwH are sold by our company at the same price.

If the candidate is stuck, remind them that revenues are essentially constant per unit across all revenue streams. If they insist, you may clarify that profits are generally 10-15% of operating costs.

The candidate may opt to calculate the total annual free cash flow from Exhibit 1. They may proceed with this calculation at this time, or later in the case. The calculations are as follows:

[Column 2 “Energy Production”] X [Column D+F “Cost per Mwh”] X 1,000 Mwh per Gwh X 24 hours per day X 365 days per year

Inform the candidate they can round to 20 hours per day and 350 days per year for the sake of simplicity.

Coal operating costs = $2.695B

Wind operating costs = $1.05B

Nuclear operating costs = $1.575B

Gas operating costs = $1.19B

2. Divestiture Target Identification

At this stage, the candidate should be locked into coal as the ideal candidate for divestiture. They should ask if we have any information on sale value, carve-out logistics, etc., essentially looking to compare savings to value.

At this point you may share Exhibit 2 with them.

Upon receiving the exhibit, the candidate needs to realize that total cost savings need to be compared to our market offering and cost of divestiture execution.

A good candidate will quickly realize the following:

  • Coal will free up the most cash flow (Exhibit 1) and result in the highest cash pile (tied for 1st, Exhibit 2)
  • CoalCo has declined in value in the market’s view
  • Calculating the total annual free cash flow from Exhibit 1 is important to determine total benefit (they may realize this now or earlier)

If the candidate opts to calculate the total operating costs for the various energy sources now, they may do so (see end of Section I. for answers)

If the candidate looks to clarify whether CoalCo represents all the coal assets, GasGuys all the gas assets, etc. you may confirm that this is the case.

The candidate may be dissuaded from selling CoalCo given the large difference between column 2 “Initial Deal Valuation” and column 3 “Market Offering”. This is a distraction. The initial deal valuation is a sunk cost that has already passed. The market is offering less than the original purchase price precisely because of the high operating costs and expected future carbon tax hikes.

If the candidate does not move past this thought after a light/gentle nudge, this is a mark against them.

If the candidate asks if we know how many assets we would like to part with, you may clarify that one entire energy stream is entirely sufficient.

3. Total Benefit Calculation And Final Recommendation

It should now be clear the CoalCo is the best target for sale and the candidate needs to clearly state this. The candidate needs to be clear about the objective of the case, namely “to increase free cash flow and cash reserves”.

A good candidate will recognize that divestitures cost money. A large amount of time and money goes into separating out two previously intertwined companies.

When prompted, you may inform the candidate that a divestiture of any of the business units will cost $1.5B (one-off cost).

A good candidate will look to calculate the NPV of the divestiture of CoalCo. This can be done as follows:

NPV of Operating Costs ($2.695B / 10%) + $8.5B - $1.5B = $33.95B

Recommendation:

A strong candidate will lead with the recommendation that we divest from CoalCo, noting that this will bring us $33.95B in NPV in the form of $2.695 of free cash flow AND $7B cash reserves.

Notable risks to consider include the following:

  1. Loss of potential profits from continued operation of CoalCo
  2. Loss of the largest part of our business (one third)
  3. Difficulties in executing divestitures (IT, Staff, Legal, etc.)
  4. Selling CoalCo at a markdown

A strong candidate would counter these risks by proposing the correlated next steps:

  1. Further investigation into the Revenues earned by CoalCo to understand loss
  2. Identification of exactly how the additional cash/cash flows will be used, with ultimate evidence of higher returns than would have been achieved by keeping CoalCo
    1. Investment into gas, wind, nuclear, etc.
    2. Investment into additional projects/initiatives
    3. Share buybacks/dividends
  3. Due diligence into carve-out logistics to confirm $1.5B cost
  4. Look for higher bidders

Exhibits

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1.6k
Times solved
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Exhibits