The Upside of the RRI Energy and Mirant MergerErik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Mark Barnett, utilities analyst here at Morningstar. Mark, thanks for coming.Mark Barnett: Thanks, Erik. It's a pleasure to be here.Erik Kobayashi-Solomon: Just a couple of weeks ago, RRI Energy, an unregulated utility, announced that they were merging with Mirant, another unregulated utility. At the time, I wrote this option strategy, a bullish option strategy on RRI, and I just wanted to ask you a little bit about that.Mark Barnett: Sure.Erik Kobayashi-Solomon: First of all, big picture question: RRI and Mirant are both unregulated utilities. What's the difference between an unregulated and a regulated utility?Mark Barnett: That's a good place to start. About 50% of the country's markets, electricity markets, are regulated, meaning that you have elected officials or appointed government officials that work with utilities to set formulaic rates that they are able to charge.Erik Kobayashi-Solomon: This is what we see in the newspapers, going for a rate increase or something like that.Mark Barnett: Exactly. And while its sort of deceiving to call RRI and Mirant unregulated generators because they have to deal with environmental regulations, the power markets still operate under the overview of state governments and the federal government. Basically, there is an actual market where the marginal cost of providing electricity is what you'll receive if you're going to the market that day and selling your power. So there's no intermediary saying, "This is what the rate payer wants to pay and this is what we think they should pay."Erik Kobayashi-Solomon: So basically the regulated utilities are saying, "We want to charge our customers this much." The unregulated utilities are kind of selling power into this power market.Mark Barnett: They're price-takers.Erik Kobayashi-Solomon: They're price-takers, OK. So what kind of effect does this have on them? Is this a good business? Is this a very volatile kind of business?Mark Barnett: Opinions vary on whether it's a good business. It certainly has looked great at times. It's an incredibly volatile business, especially on a year-to-year basis.Erik Kobayashi-Solomon: So it's not really what we'd think of as a utility, kind of a very staid thing. In other words, they're price-takers, they're kind of energy traders, basically.Mark Barnett: Right. The power markets themselves are very volatile. Your location, your fuel costs, the type of plant that you have can really leave you exposed to some pretty difficult pressures when the winds change, when people stop using electricity, when it's a hot day and you're not ready for it, that sort of thing. It's a very difficult business, and it's taken many a company down.Erik Kobayashi-Solomon: So RRI and Mirant have announced they're going to merge. Can you tell me a little bit more about this merger?Mark Barnett: Sure.Erik Kobayashi-Solomon: When is it going to happen? What's the idea?Mark Barnett: It's expected to close by the end of this year. The companies have said that they're pretty comfortable with the regulatory approvals. Now, typically the difficulty in a power merger is, is the combined entity going to have a lot of market power, too much generation in one location, for instance? But as both of these companies are a little bit spread out and aren't as megalithic as, say, an Exelon or an NRG, that shouldn't be an issue.Erik Kobayashi-Solomon: So their geographical footprints don't really overlap then?Mark Barnett: Precisely. They'll have power plants in California. But they'll really be concentrated in the Mid-Atlantic region: Pennsylvania, Washington, D.C., more or less. So market power is really not much of an issue.Erik Kobayashi-Solomon: Right, one of the things that really attracted me to this story when I heard it the other day was this idea of synergies between these two companies. A lot of mergers and acquisitions are predicated on this idea that synergies will be created, it'll be great for shareholders, et cetera. Can you walk me through exactly what management is saying about the synergies?Mark Barnett: Sure. The expected synergies that they announced were about $150 million annually starting in 2012.Erik Kobayashi-Solomon: And these synergies involve costs, right? Where the costs overlap and they can cut some employees or something.Mark Barnett: Right. That's primarily where the costs are going to be which is one of the reasons why we buy these synergy numbers more than in other deals, is that they're entirely on the administrative side, so the back office, your accounting, your phone staff they're not at all incorporating any plant-specifics.Erik Kobayashi-Solomon: So it's not operational.Mark Barnett: No maintenance-related or operational, “no”. It's purely we're going to basically fire a lot of people from our staff, merge our headquarters together, and this is where they're arriving at that number.Erik Kobayashi-Solomon: I see. So they're not making Herculean assumptions as to what they can cut.Mark Barnett: Exactly. We've seen other merger proposals where some of the synergies are supposed to come from fuel procurement. You know, "We're a larger player now, we have a better stance for negotiation." Which is somewhat of a dubious thing?Erik Kobayashi-Solomon: A lot more tenuous of a synergy.Mark Barnett: Exactly. We expect this one to be a little bit more achievable.Erik Kobayashi-Solomon: So right now, I know that the price of RRI and Mirant both popped when this announcement was made. But even the pop, you think, was not sufficient. It didn't really reflect all of the synergies.Mark Barnett: Yeah. Based upon our calculations of when the synergies would start and the closing price of both the securities was on Monday, the day that it was announced, it looked like the market was giving them about a 38-40% chance of realizing those.Erik Kobayashi-Solomon: So worse than not. In other words, they really thought the chances were worse than 50/50.Mark Barnett: Right, which we think is a bit pessimistic. Now there could always be other factors at work, but in our valuation, we give them about a 60% chance of achieving those synergies and given the sort of synergies that they're looking for, that could be a little conservative.Erik Kobayashi-Solomon: I see. So maybe they can get closer to their entire synergy.Mark Barnett: It's possible, yes.Erik Kobayashi-Solomon: Mark, thanks very much. It's an interesting idea.Mark Barnett: Thanks, Erik.Erik Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website. You can read more about the RRI deal, and also other great option ideas based on Morningstar's fundamental research.