PNM Resources and a subsidiary of Continental Energy Systems announced a swap Tuesday that would dramatically build Continental’s natural gas operations and allow PNM to give full attention to its electric utilities in New Mexico and Texas.

PNM, which provides electricity to more than 835,000 homes and businesses in New Mexico and Texas and gas service to more than 492,000 in New Mexico, wants to sell all of its gas operations for $620 million to a subsidiary of Continental Energy Systems of Michigan. A new subsidiary of Continental, New Mexico Gas Co., would be based in Albuquerque, and about 800 PNM employees would transfer to the new company.

In a separate transaction, Continental would sell Cap Rock Holding Corp. and subsidiary Cap Rock Energy, an electric distribution and transmission company that serves 36,000 customers in 28 counties in North, West and Central Texas, to PNM.

“We came to the conclusion we were best off serving our customers and shareholders if we narrowed that focus solely to our electric operations,” PNM CEO Jeff Sterba said. The Cap Rock purchase “advances the vision and strategy of our company…It expands our geographical footprint in Texas.”

Sterba told financial analysts in a conference call Tuesday that PNM’s gas operations have historically underperformed, and management had been working to sell off the gas business for almost nine months.

“We believe that the gas business can earn a rate of return, but the reason for the transaction is to let someone else focus on gas and what they do well,” Sterba said in response to an analyst’s question. Last July PNM reported that in the past 10 years gas use per customer declined 26%, which has affected the company’s ability to adequately recover the costs of running and maintaining its natural gas system (see Daily GPI, July 3, 2007).

In addition to its Texas electric distribution assets, Continental provides gas distribution services to 410,000 customers in Alaska and Michigan through subsidiaries Enstar Natural Gas Co. and SEMCO Energy Inc. Following the closing of the proposed gas sale transaction, Continental would provide regulated gas distribution services to almost one million customers throughout New Mexico, Alaska and Michigan.

Of Continental’s operations, Sterba said, “From the buyer’s side, Continental is a very experienced gas operator, and it will fit very well within the fabric of our state. George [Schreiber Jr., Continental’s CEO and president] grew up in New Mexico, and he has strong ties to the state.” He said Continental was “wise in making a commitment to all of our gas employees and the support personnel” to hire them once the transaction closes.

New Mexico’s “strong economic potential, the markets served by PNM’s gas assets and its skilled workforce make this an attractive investment opportunity,” Schreiber said.

PNM recently announced plans to downsize its workforce of 3,300 by 15% over the next year as part of a companywide restructuring. Cost cutting was announced following an unexpected drop in 2Q2007 earnings — as well as rising costs. In 3Q2007 PNM again failed to meet analysts’ expectations following weak results in its retail supply business, which were slammed by higher fuel costs and plant outages.

The PNM/Continental transactions are slated to close by the end of the year, but several regulatory hurdles will have to be cleared. The sale of the gas operations is subject to approval from the New Mexico Public Regulation Commission (PRC) and federal antitrust review. PNM’s acquisition of Continental’s electric operations also requires antitrust review and approvals by the Federal Energy Regulatory Commission and the Public Utility Commission of Texas. Pending all approvals, the transactions are expected to close by year’s end.

In related news, Sterba said that Tuesday that PNM also is in “final negotiations” to sell some of its utility wholesale power and gas contracts through a joint venture with Cascade Investment LLC, an investment vehicle of Microsoft founder Bill Gates. However, Sterba said PNM would not be exiting the marketing and trading arena.

“This does not represent our exit from trading operations,” Sterba said. “It does mark the intention to remove PNM’s subsidiary from being involved in the market and trading other than what is needed to optimize deals for our customers. The marketing and trading business is being developed in a joint venture under Cascade to both be involved in the merchant business and marketing and trading.”

In its reaction to the news, Moody’s Investors Service said that over the longer term, PNM’s plan to exit the gas business and increase its exposure to the regulated electric utility sector generally would have “no material impact on its business risk profile or, based on management’s projections, its financial metrics. Nevertheless, in the near to medium term we expect this proposed divestiture and acquisition will further prolong the weakened financial conditions of the companies…

“We also note that, in general, the implementation of any type of regulated business combination/separation strategy can result in unanticipated costs and/or delays, which could impact the longer-term prospects of the transaction. As a result, we believe any potential improvement in financial credit metrics will likely be further delayed. The potential for financial stability remains, to a significant extent, dependent on a favorable outcome in [PNM’s] pending electric rate case, which has also been delayed. We note that there is currently a very large disparity between the company’s requested 14% increase along with the implementation of a recovery mechanism for increases in the cost of fuel and purchased power, and the PRC staff’s recommended 2% increase without any fuel cost recovery mechanism.”

PNM recently completed an electric rate case before the PRC to request a $77.3 million increase in electric rates. Several groups have intervened, including the PRC staff, which has said it would support a rate increase of just $18.3 million and oppose a fuel adjustment clause that would allow the utility to pass through fuel costs to customers. A ruling by the PRC is expected in February (see Daily GPI, Dec. 19, 2007).

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