Constellation Energy Group CEO Mayo A. Shattuck said that a “perfect storm” of political and energy price events led the parent company of Baltimore Gas & Electric (BGE) to call off its $31 billion merger with FPL Group. During a conference call with analysts Friday, Shattuck said the company saw “no clear path to completion” of the deal and “no events on the horizon” that would have cleared up the uncertainty.

After the Maryland General Assembly enacted new legislation in June that completely disrupted the regulatory review process, Shattuck said the company was left not really knowing what the new review process would be, who would eventually approve the merger or how long such a review would take.

“We had a much clearer view on [it] 12 months ago than we do today,” he said on Friday. “Everyone described this as the perfect storm because of politics and energy prices and so forth. As we looked forward the key question was ‘Is it really wise to look at a risk-adjusted outcome here looking into the next nine months and take that bet.’ I think we just concluded that, no, we couldn’t predict the outcome.

“We didn’t know the process, we didn’t even really know the decision makers, and as a consequence, the best and safest course was just to pursue our independent course.”

In June it already was clear to the two companies that there had been a fundamental change. The General Assembly passed legislation (SB 1) that among other things sacked the Maryland Public Service Commission (PSC) for its handling of the merger case and BGE’s proposed 72% rate increase. The courts reinstated the PSC’s members but banned them from ruling on the merger. SB 1 also established new standards of review to be applied in the merger case.

State regulators subsequently determined that the merger partners basically would have to restart the regulatory process due to the change in legal standard and topics for consideration engendered by SB 1. On June 29, Constellation filed an amended petition, but regulators pressed for a more comprehensive refiling that addressed the stipulations made in the new state law (see NGI, July 17). Although companies complied with the request, the process remained riddled with uncertainty (see NGI, June 5).

The FPL-Constellation deal was under regulatory review for 10 months.

Merrill Lynch analyst Jonathan Arnold said last week that he was a bit surprised that the two companies did not stick it out. “Although both companies had warned about the strong possibility of the termination, we were somewhat surprised on the timing of the announcement,” said Arnold. “We believe both parties may have concluded that even with a favorable ruling…political obstacles in January [when BGE rates were scheduled to begin to increase] may have been insurmountable.”

Arnold noted that some of the reasons for the FPL-Constellation merger termination were similar to the Exelon-Public Service Enterprise Group merger cancellation (see NGI, Sept. 18). Regulators and legislators in several states recently have become more aggressive in demanding rate concessions from energy companies because of rising energy costs. Citing “insurmountable hurdles” at the New Jersey Board of Public Utilities, Exelon and PSEG gave formal notice of termination of their merger nearly two years after the deal was first announced.

Both the Constellation-FPL and Exelon-PSEG merger failures highlight “state opposition to mergers of integrated companies premised mainly on unregulated benefits,” said Arnold. “We believe such deals will continue to face state political and regulatory challenges.” As a result, he said companies may end up focusing more on pure unregulated acquisitions to avoid regulatory scrutiny. “This also supports the idea of corporate separation of regulated and unregulated businesses as a precursor to further consolidation.”

Shattuck said Friday that it was “premature” to conclude that the company will now spin off its regulated utility company, BGE, and focus on its rapidly growing unregulated generation and marketing business.Based on the termination agreement, neither company will pay a termination fee to the other. Constellation is barred from entering into a similar merger with another company prior to Sept. 30, 2007. In the event that it does negotiate another merger, Constellation would be required to pay FPL $425 million if the deal takes place prior to June 30, 2007, or $210 million if the merger occurs after July 1, 2007 but no later than Sept. 30. Such a fee, however, would not apply if Constellation spins off its utility business and merges its nonregulated operations with another company, the agreement said. Shattuck admitted that there are “strategic options” available with BGE, “but at the same time there are a lot of things we have to sort our with respect to SB1, the last piece of legislation that deals with Maryland’s examination of the structure of the market.

“I don’t for a minute believe that BGE is always going to be credit dilutive [to Constellation],” he said.

Fitch Ratings anticipates that BGE’s cash flow contribution will “weaken substantially through May 2007 due to the effects of the utility’s recent electric rate stabilization plan,” which spreads out its proposed rate increase over several years. But Fitch also said it believes BGE will continue to support its own obligations comfortably and is not expected to require parent company support. Both Fitch and Standard and Poor’s have negative outlooks on Constellation and BGE.

Shattuck said he expects the regulatory situation in Maryland to “sort itself out” eventually. “We will restore ourselves to a normal regulatory regime once the politics subside. There are some aspects to the legislation that give BG&E some flexibility, particularly with respect to energy procurement. And I think we want to put all these things into perspective before we make any types of decisions” regarding a potential sale or spin-off.”

The FPL merger would have created a company worth about $31.2 billion (based on current market capitalization) with annual revenues of $26.5 billion and $57 billion in total assets (see NGI, Dec. 26, 2005). The company would have had 5.5 million regulated electric customers at Florida Power & Light and BGE, along with 625,000 gas customers at BGE, making it the second largest regulated gas and electric utility in the nation.

However, the expected growth of the combined nonregulated business was the impetus for the transaction.

“We are disappointed that it came to this because the merger would have been a strategic move creating a clear leader in competitive markets,” said Shattuck. “It is unfortunate that we could not get this deal done because it would have benefited Maryland customers and would have been good for shareholders in the long run. Ultimately the merger determination came down to making the right decision for shareholders by focusing Constellation’s efforts on a growth plan that the company can control.”

He added that the reasons for the merger’s demise also are not confined to Maryland and could impact other mergers in other states. Similar reasons led Exelon and PSEG to call off their merger. “They include rising commodity prices, removing rate caps and election year politics.” It’s a climate that is not healthy for utility mergers, Shattuck noted.

However, he said the situation will improve. And Constellation will continue to show positive financial results. In fact, Constellation management raised 2006 earnings guidance Friday and reaffirmed guidance for 2007 and 2008. It also reported strong financial results across all areas of operations for the third quarter.

The company reported third quarter earnings (under generally accepted accounting principles) of $1.79 per share, compared to $1.03 per share for the same quarter last year. On an adjusted basis, the company earned $1.56 per share, exceeding its guidance range of $1.10-1.25 per share and the $1.08 per share of adjusted earnings in the third quarter last year. Adjusted earnings exclude the impact of special items, certain economic hedges and synfuel earnings.

“This past quarter’s results mark a significant milestone for Constellation Energy — five years of meeting or exceeding our quarterly earnings guidance,” said Shattuck. “This steady performance is a function of a proven business model, crisp execution by management and our employees, and rigorous risk management. Despite the potential for distraction associated with our recently terminated merger with FPL Group, our employees continue to execute and, as a result, we are on track to outperform our business plan for the year. At the same time, our long-term outlook continues to strengthen.”

BGE reported adjusted earnings of 20 cents per share, which were down 4 cents from the third quarter last year but in line with guidance. The merchant energy division reported adjusted earnings of $1.34 per share, above the company’s earnings guidance range and up 50 cents per share on an adjusted basis from 3Q2005. Wholesale competitive supply, driven by the power business and portfolio management and trading, primarily portfolio management, added 34 cents compared to last year. NewEnergy, the retail marketing business, added 14 cents per share versus the prior year.

The company also is expecting $1.5 billion in proceeds from sale of its gas-fired generation (3,145 MW) to Tenaska. Most of the proceeds will be used for debt reduction, which will be modestly dilutive to earnings through 2009 and accretive thereafter. Constellation said it expects 10 cents/share earnings dilution in 2007 related to the debt reduction program.

UBS analyst Ronald J. Barone said both Constellation and FPL “stand strong on their own with a solid portfolio of businesses, among the best managements in our space and a robust [earnings per share] outlook over the next few years.”

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