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FPL, Constellation Merger Strategically Correct

The $28 billion combination of FPL Group and Constellation Energy announced Monday would create a company with substantial regulated operations -- Florida Power & Light and Baltimore Gas & Electric -- but the merger partners see the real growth opportunities in their nonregulated businesses. CEOs of the two companies also acknowledge they moved quickly to stay out in front of the merger play.

FPL Group CEO Lewis Hay III and Constellation CEO Mayo A. Shattuck III, speaking to analysts in a conference call Monday, touted the deal for nonregulated growth offered and predicted the utility industry will be seeing more M&A to come. "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,'" Shattuck said.

Hay, also chairman and president of FPL Group, will become CEO of the combined company which will keep the Constellation Energy name. Shattuck, also chairman and president of the current Constellation, will be chairman of the combined company and also will lead the competitive energy business.

One platform for growth of the combined company is nuclear operations. Both FPL Group and Constellation have significant and about equal nuclear generation holdings. Combined they would hold the country's third largest nuclear portfolio (8,228 MW). Hay and Shattuck noted that nuclear power 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," 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 and AREVA announced a venture called UniStar Nuclear to develop advanced nuclear generation in the United States (see Power Market Today, Sept. 16).

Earnings for the trailing 12 months as of Sept. 30, 2005 were nearly $1.58 billion for the companies combined, with $992 million coming from FPL Group and $584 million from Constellation Energy.

Nonregulated operations 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.

The combined company would own 45,194 MW of generating capacity from fossil, nuclear and wind sources and have more than 22,000 MW of competitive wholesale electricity supply and 16,550 MW of competitive retail supply.

"The merger will create a formidable nonregulated business combination with strong positions in the key New England, Texas, and PJM markets," enthused Merrill Lynch analysts, who called the deal a "stellar" combination. "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."

On the coal side, Hay said he was looking forward to making Constellation's coal-fired generation expertise available to customers in Florida, one of the fastest growing power markets in the U.S. Constellation could help FPL with coal-fired generation development and then with fuel procurement, he said.

On the natural gas side, 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.

"Through its competitive supply operation, Constellation currently serves over 29,000 MW of peak load in NEPOOL, PJM and ERCOT, but only owns 7,200 MW of generation in those regions, forcing the company to contract for a large amount of outside generation," Merrill Lynch said. "In contrast, FPL's unregulated generation business owns nearly 7,000 MW of generation in those regions, but serves 3,000 MW of load. The pairing of a naturally short generation position (Constellation) with a naturally long generation position (FPL) will serve to enhance competitive supply margins."

Risk-minded ratings agencies took a dimmer view of the nonregulated businesses Constellation brings to the merger table and the risks they engender. Both Moody's Investors Service and Standard & Poor's (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."

The all-stock "modified merger of equals" grants a 15% premium to Constellation shareholders. FPL shareholders would own about 60% of the company with Constellation shareholders winding up with 40%.

The regulated utilities combined would serve 5.5 million electric customers and about 600,000 natural gas customers (BGE) and would have a rate base of $14.2 billion and net income of $956 million. Long-term volume growth for FPL's service territory is projected to be about 3% per year and 1% to 1.5% in BGE's service territory.

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