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Assessing the Exelon Acquisition of Constellation Energy
In March of 2012, Exelon (EXC) acquired Constellation Energy Group for about $7.3 billion in stock. Each company was the parent of regulated utility operations, and each had a significant presence in nonregulated power generation. Constellation also had an energy-services operation that was complementary to the power-generation business. So, the companies appeared to be a good fit.
Proposed mergers and acquisitions in the electric utility industry sometimes fall through due to an arduous regulatory process. Each of these companies had tasted failure in a merger attempt— or multiple attempts, for Constellation. In 2004, Exelon agreed to merge with Public Service Enterprise Group (PEG), but the deal was terminated in 2006 because intervenors in New Jersey wanted more concessions than the companies were willing to give. In 2005, Constellation and NextEra Energy (NEE), then known as FPL Group, agreed to merge, but the transaction fell through a year later due to heavy opposition in Maryland. Several years earlier, the company’s planned merger with Pepco Holdings (PHI) also failed to win approval in Maryland. More recently, following the credit crisis that caused Constellation’s stock price to plummet in September of 2008, the company sought a deal that would provide liquidity. First, it agreed to be bought by Berkshire Hathaway (BRK/B), then the company chose a subsequent asset-purchase offer from Électricité de France (EDF.PA) instead.
That merger took 11 months to complete—an unusually short period for a utility deal. For a while, however, it appeared as though the transaction might be in trouble. Exelon initially proposed concessions for the customers of Baltimore Gas and Electric (such as a $100 credit on the bill of each residential ratepayer), but had to sweeten its offer when some officials in Maryland expressed opposition to the takeover.
Once an acquisition is completed, there are typically some up-front merger-related costs. This deal is no exception. These operating and maintenance expenses are estimated at $325 million in 2012 and $80 million in 2013. The expected capital costs are $80 million in 2012, $40 million in 2013, and $8 million in 2014. Among the expenses related to the transaction are severance costs and fees paid to investment-banking and legal advisors.
Exelon expects merger-related benefits to increase over time. Management is targeting operating and maintenance expense reductions of $170 million in 2012, $350 million in 2013, and $500 million in 2014. Of these, 75% are expected to come from the nonregulated side of the company’s operations. Thus, the bulk of the savings will not have to be passed on to customers. The cost reductions will come from such areas as labor, information technology, reduced collateral requirements, and supply-chain savings stemming from Exelon’s increased size. (One example is that the utilities will save $1.2 million a year by standardizing one set of cables that they use.) In fact, the company has stated that labor and IT savings are running greater than expected. The management integration appears to have gone smoothly, with several former Constellation executives holding key positions with Exelon.
Exelon’s earnings are likely to decline significantly this year. But this doesn’t mean that the Constellation purchase was a bad idea. It is not unusual for merger-related costs to far exceed merger-related benefits initially. Furthermore, even on a stand-alone basis, Exelon’s profits would have been lower, due to unfavorable conditions in the power markets. Exelon had avoided significant exposure to low power prices through its effective hedging program, but the low prices finally caught up to the company in 2012. There is only so much that hedging can accomplish.
As of August 2, 2012, Exelon stock had a dividend yield of about 5.5%. This is about one-and-a-half percentage points above the average for the electric utility industry. Management has stated that the dividend is secure, and we believe that this financially solid company will maintain the payout at the current level. For more information in regard to the investment merits of Exelon stock, subscribers should take a look at our full-page report in The Value Line Investment Survey.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.