Bright Spark

The power industry in Europe has seen frantic M&A activity, as key players consolidate and rethink their corporate structures to meet the demands of an industry that has undergone significant transformation in recent years. The competitive battleground has changed, and successful companies have had to make bold moves to stay ahead of the game.

As the electricity industry has deregulated, opening itself to competition, the main players have had to take a fresh look at value creation, reworking growth strategies and financial planning. Their experiences hold lessons for firms in many industries.

Electricity company Vattenfall was among the first companies to translate deregulation into a new corporate structure, and has seen others in its industry play catch-up ever since.

Vattenfall’s core business is producing and providing electricity and heat to industrial, corporate and private customers throughout Europe. It began operations in Sweden, but has grown to become a major player in the wider Nordic region, Germany and Poland.

Its international expansion began in 1996 with the acquisition of Finnish electricity distribution company Hämeen Sähkö, followed in 1999 with the purchase of a stake in HEW from the City of Hamburg.

Since 2000, Vattenfall has also bought a major stake in Polish heat production company EW in Warsaw, Mirant’s shares in Berlin’s Bewag energy company and a stake in Danish company Elsam A/S. It has also built up its Danish wind power and combined heat and power presence with assets from energy company DONG.

AHEAD OF THE GAME

Vattenfall’s successful growth strategy has been supported by its early grasp of how the power industry would change and its courageous decision to split the company into 13 business units. Each unit is aligned in a value chain, allowing each to adopt a standalone approach to value creation in the key segments of generation, distribution and sales.

Jonas Florinus, group vice president, group controller and head of corporate finance explains: "We moved early to divide our company into a value chain, with generation at one end and sales at the other. We predicted that electricity would become a true commodity, and that demand and supply would determine prices. Now we have power trading on commodity exchanges."

The company’s recent expansions into Germany and Denmark, which have made it the third-largest power producer in Germany and the fifth-largest in Europe, are the latest fruits of this policy on corporate restructuring and value creation. Its portfolio of value chain components serves a risk management purpose – with sales being a volume hedge to generation – and has enabled Vattenfall to maintain a tight focus on growth in electricity generation, distribution and sales, including combined heat and power.

A careful balance of organic growth and key acquisitions has greatly benefited the company’s financial performance in recent years. Valued at €6bn in early 2000, the company was worth €35bn in 2006. Over the last ten years, return on equity has risen from around 8% to 20%.

In the late 1990s, Vattenfall forecast that the electricity industry would become a true commodity business after deregulation began in the Nordic and UK markets. While it was not alone in recognising this development, it was among the first to respond to the implications by reorganising its business. Since then, profits have climbed and the company has expanded.

Florinus notes: "The new group structure has proven very efficient in terms of returns and the level of service to customers. Since we made the move, our business model has become more common in the industry."

Anticipating the future development of a market, therefore, has proven crucial in Vattenfall’s strategy, but is not the sole ingredient for success. Value creation also requires a thorough knowledge of the strengths and weaknesses of the existing business, as well as a clear process by which to manage and implement strategies for future growth.

A CLEAR PROCESS FOR CREATING VALUE

Vattenfall’s process for value creation is built on its five long-term ambitions: profitable growth, benchmarking the industry, achieving a top rating for environmental issues and customer service and being recognised as an employer of choice.

Each of these criteria has clearly defined long-term (five- to ten-year) targets, plus a number of intermediary, short-term (three-year) targets. Progress is assessed on a monthly and quarterly basis to keep projects on track.

These separate initiatives combine to move the company towards its overall target of pure financial value creation, punctuated by the long-term goals and short-term milestones of each business unit, which serve to close the gap between the current financial position and strategic performance targets.

If progress on any specific project is faltering, this prompts a serious strategic discussion on the future of that business. Florinus says: "It may emerge in some cases that someone else might be a better owner and we can capitalise on that expectation and move on with the business that we are best at. All in all, however, we are very focused on what type of business we do – electricity generation, distribution and sales."

Identifying strategic goals, however, is only part of the equation. It is also vital to have a stringent process for translating strategy decisions into operational reality.

At group level, Vattenfall has a small, responsive team handling strategy, M&A, management and control. From this tight working environment emerges a relatively short business planning process, conducted each autumn, which addresses long-term strategic directives and derives bottom-up business plans, which are then turned into top-down, three-year rolling business plans.

Florinus continues: "Every month, I visit each of our 13 business units to discuss progress, business challenges, milestone deliveries and financial status. I give my CEO and CFO a quick but fairly detailed status overview.

Exactly a week after my monthly trip, the three of us sit down with each of our three division CEOs and sum up events and actions. This model works very well, creating tight teams and effectively transferring strategic initiatives into operational actions."

MAKING M&A WORK FOR YOUR BUSINESS

M&A is vital to Vattenfall’s success story, but in an industry where consolidation has been rampant, it could have been tempting to invest too quickly to grow the company. Vattenfall recognised this danger and stuck to a tightly focused M&A policy.

Florinus says: "Our industry has seen a lot of consolidation, with many mergers and acquisitions, but there are also many stakeholders involved. We are relatively weak financially compared to the top three companies in the industry, so we have to take a different approach to M&A.

"This is not a mature business yet, and consolidation is still the name of the game. The industry is very tightly regulated, so deals are costly. This means we have to balance organic growth for profit with mergers and acquisitions to increase our size." Increasing the size of the company brings many advantages, but can be risky unless organic growth also happens at a healthy rate.

He adds: "We love organic growth, extending the life of assets and increasing capacity, as the infrastructure is already in place, but M&A is still important in this industry. Increasing our size is important if we are to influence our own destiny with regulators and other stakeholders.

"You need organic growth, not only because it is very profitable, but because it is less uncertain than M&A opportunities, as you know your assets better than you know the assets of another company. Increased size, however, is also good for improving cost-to-serve."

Whether stimulating value creation through organic growth or M&A, Vattenfall has worked on the basis of an honest appraisal of its strengths and weaknesses.

It recognises that its finances are not as strong as the biggest companies in Europe’s power industry and has, therefore, kept its sights trained on expanding in its core strengths of electricity generation and sales.

AN EYE ON THE FUTURE

Coupled with the courage to respond to the major changes it foresees in the industry, this strategic approach has been very successful. It must, however, continue to respond to the demands of the future. To this end, Vattenfall has taken a lead in addressing climate change issues, which it feels will be the defining factors shaping the industry in the coming years. The company is committed to investing in sustainable development and security of supply in a dynamic environment.

The lessons for finance directors are to have the courage to take the lead on issues that will change their industries, to develop defined processes for the creation of business value and to establish a clear structure within which to monitor and manage the implementation of strategic goals at the operational level.

Vattenfall has shown the strength of such an approach in its highly regulated, competitive industry. No doubt a similar approach can work in many sectors.