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FPL-Constellation Deal Focuses on Non Regulated Assets

The much-anticipated combination of FPL Group and Constellation Energy announced last week is likely a harbinger of things to come in a post-PUHCA era, analysts say. However, don't expect a frenzy of activity, and utility combinations in the absence of non regulated assets will have less appeal than pairings like FPL and Constellation, a deal predicated on non regulated business.

"I don't see [what's to come] as being a tidal wave of announcements. It's hard to do a deal," Stephen Stolze, R.J. Rudden Associates managing director, told NGI. "Just because a barrier [the Public Utility Holding Company Act], that was quite honestly a soft barrier, has been removed, many of the other barriers, regulatory approvals at the state level, the ability to capture synergies and implement [still exist]. The players who are the most likely candidates to participate [in mergers] are busy absorbing existing mergers."

All of this, Stolze said, will keep a lid on any merger frenzy, "but I believe it will be a steady diet of activity." It was Constellation CEO Mayo Shattuck III who sounded a call for consolidation last year at the Deutsche Bank Electric Power Conference in New York (see NGI, June 21, 2004). He said at the time that, "I think consolidation will accelerate and that you'll begin to see people making moves, but from that standpoint it's probably going to be driven by those people who really don't have the same kind of growth prospects and shareholder proposition that I think that we [Constellation] have at this point."

But Shattuck apparently decided that boarding the consolidation bus early would mean a better selection of traveling companions. Last week he and FPL Group CEO Lewis Hay touted their deal in calls with analysts and reporters. "Both Lew and I felt, 'let's pick our partners and get to the end game soon so we can take advantage of other opportunities going forward.'" Last May Shattuck said consolidation may cut the number of U.S. utilities from more than 100 to 50 in less than five years (see NGI, May 30). The $11 billion FPL-Constellation transaction would create a company worth about $28 billion with annual revenues of $26.5 billion and $57 billion in total assets. The company would have 5.5 million regulated electric customers at Florida Power & Light and Baltimore Gas & Electric (BGE), along with 625,000 gas customers at BGE, making it the second largest regulated gas and electric utility.

However, non regulated businesses are viewed by management as the platform for growth. Wholesale competitive electric supply would total 22,040 MW, and retail competitive supply would be 16,550 MW. Combined generation capacity would be 45,194 MW, which includes nuclear, fossil and wind facilities. FPL Group serves 3,000 MW of peak load in NEPOOL, PJM and ERCOT combined and has 7,631 MW of generation in the three regions. Constellation Energy serves peak load of 29,300 MW in the same three regions but has only 7,213 MW of generation. "Constellation Energy's customer market shares combined with FPL Group's deregulated assets create a balanced footprint," the companies maintain.

Nuclear in particular is viewed by management as a growth opportunity. Both FPL Group and Constellation have significant and about equal nuclear generation holdings. Combined, they would have the country's third largest nuclear portfolio (8,228 MW). While presenting their merger plan last week, executives noted that nuclear power especially lends itself to economies of scale and said they see the nuclear area as a consolidation play.

"There are still quite a few companies out there that have only one or two nuclear units," FPL's Hay said. "The nuclear business is clearly a scale business. I think we are in an incredibly advantageous position to be able to buy those and operate those at lower costs." In September, Constellation increased its commitment to nuclear when it and AREVA announced a venture called UniStar Nuclear to develop advanced nuclear generation in the United States.

"It does seem like a prime motivation for this merger and several others that we've seen recently is the generation side and building larger fleets of, particularly, unregulated generation plants," Ronald Moe, R.W. Beck Inc. national director of generation planning and analysis, told NGI. "Nuclear is an important part of that, but I don't think it's the only part. I think just generation in general is a motivation for that. Clearly, there are economies of scale in having larger fleets." For example, Moe noted, trading around 40,000 MW does not require twice the trading floor and collateral that it takes to trade around 20,000 MW.

If/when the combined FPL and Constellation ventures into the market for generation assets, the company likely will find sellers with more pricing power than they have had in the past. "I believe that the value of assets being auctioned is recovering," Stolze said. "We're seeing that in several recent deals. Certainly the Texas Genco transaction is an indication of that, and also the recent purchase of the Reliant assets in New York is evidence of strong value in the market."

In July 2004, CenterPoint Energy Inc. and Texas Genco Holdings Inc. agreed for GC Power Acquisition LLC to acquire wholesale generator Texas Genco for $3.65 billion (see NGI, July 26, 2004). GC Power was formed by Blackstone Group, Hellman & Friedman LLC, Kohlberg Kravis Roberts & Co. LP and Texas Pacific Group. Six months after the deal's completion, NRG Energy Inc. agreed to acquire Texas Genco from the private equity-backed GC Power for $5.8 billion ($4 billion cash and $1.8 billion stock) plus assumption of $2.5 billion in debt (see NGI, Oct 10).

Also in October, Reliant Energy agreed to sell its three New York City power plants to an investor group led by Madison Dearborn Partners and US Power Generating Co. for $975 million (see NGI, Oct. 10).

Non regulated generating assets are more attractive these days than they were several years ago, Moe said. "The fact that a lot of the unregulated side has fairly long-term power purchase agreements with credit-worthy counterparties makes it not nearly as risky, either on the upside or on the downside, as it was seven years ago or five years ago when folks were building plants without any off-takers and taking all that spot market risk. The energy-only traders seem to be scaling back and getting out and being replaced by the banks or the financial institutions. The folks that are either building assets or buying up generating assets, they're trying to get power purchase agreements. And most of them are successful at that, but they're also scaling back their own trading activities and depending on financial institutions to do that."

Stable cash flows from assets whose purchase can be financed largely with debt appeal to private equity firms, and they have acquired a taste for non-regulated generation assets. Deals announced this year -- Duke Energy's proposed merger with Cinergy (see NGI, May 16), MidAmerican Energy Holding Co.'s planned acquisition of PacifiCorp. (see NGI, May 30), and the Texas Genco transaction -- could ultimately bring assets to market, some of which will likely attract private equity.

"I believe that the mergers, all of them, will result in certain assets being spun off of all types because in capturing synergies and gaining focus, there might be some market power issues that are created by some of the combinations that will have to be resolved," Stolze said. "However, I don't see those assets hitting the market until after all the necessary approvals for the mergers have occurred. Nobody is going to sell an asset on speculation, but they will be defined in the process."

While mergers represent the integration of assets, it remains to be seen whether the bankruptcy of Calpine Corp. will mean the disintegration of its holdings. "I believe that that will result in assets being sold off, but we're likely a couple years down the road because any sale will be tied up in bankruptcy," Stolze said.

That timing could be just about right for a merged FPL-Constellation. Calpine has an abundance of late-model gas-fired generation. In commenting on the FPL-Constellation deal, Merrill Lynch noted that Constellation's gas supply knowledge would help optimize fuel costs for FPL's 4,500 MW of gas-fired merchant generation, which is not in its current market valuation. "CEG's strong load servicing capabilities could accelerate FPL's ability to realize earnings from those assets," Merrill Lynch said. Building its gas-fired portfolio could very well build FPL-Constellation's economies of scale on the gas side. Merrill Lynch and others generally received the FPL-Constellation merger news warmly, with Merrill going so far as to call it a "stellar" combination. "The merger will create a formidable nonregulated business combination with strong positions in the key New England, Texas, and PJM markets."The company will have one of the largest and diverse nonregulated generation portfolios. Moreover, the nonregulated operations will be balanced by stable and growing utility operations." Merrill Lynch noted the merger "should resolve the long-term growth limitations faced by CEG [Constellation] given its small balance sheet relative to the size of its competitive supply business." According to the companies' presentation materials, nonregulated operations of the combination would account for 54% of the combined company, based on earnings before interest and after taxes. Of that share, 17% would come from generation (including wind) with power purchase agreements in place; 21% would come from baseload plants; 12% would come from wholesale competitive supply; 3% from retail competitive supply and 1% from other.

While it was non regulated operations and opportunities that were the impetus for the deal and the cause for Merrill's excitement, risk-wary Standard & Poor's (S&P) and Moody's Investors Service each cocked an eyebrow at Constellation's non regulated exposure. Both Moody's and S&P revised ratings outlooks for FPL Group issues to negative or negative implications, respectively.

"The negative outlook reflects the higher business risk associated with CEG's unregulated generation and risk management businesses, CEG's larger competitive wholesale and retail operations, and the higher proportion of cash flow generated from unregulated businesses for CEG as compared to FPL Group," Moody's wrote. "The negative outlook also considers that there will be about $3 billion of debt at the CEG holding company and that dividends from FPL Group could be a significant source of cash for CEG following the merger."

The ratings agencies, however, smiled upon Constellation, revising outlooks to positive based on strengths brought by its merger partner. "The bigger and stronger balance sheet of the combined company should allow Constellation's unregulated business to seek growth opportunities," wrote S&P credit analyst Tobias Hsieh. "The balance sheet, along with the access to FPL Group's power plants, will also give Constellation a competitive advantage in terms of hedging cost and flexibility."

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