In announcing Exelon’s proposed $12.5 billion merger with NJ-based Public Service Enterprise Group (PSEG) last week, Chairman John Rowe said market power concerns probably will force the combination to divest several thousand megawatts of fossil-fuel and nuclear generation because of its dominance on the PJM grid.
The new company, Exelon Electric & Gas, will be the largest U.S. combination utility. It will be the parent company of Commonwealth Edison in Chicago, PECO Energy in Philadelphia and Public Service Electric and Gas in Newark, serving 2.1 million natural gas utility customers and 7.1 million electric customers. It also will be the nation’s largest power generator with about 52,000 MW of generation, including 20,000 MW of nuclear power, much of it on the PJM grid.
“I don’t think the federal government is much concerned about our being the largest utility in the country,” Rowe said during a teleconference last Tuesday. “What they’re concerned about is how much power and capacity we have in PJM East. And in order to meet that challenge we will be filing a proposal to sell off a small part of the fossil generation.”
Rowe said the companies “haven’t worked out all the details” but also expect to have a “formal auction procedure at wholesale” for several thousand megawatts of its nuclear output. “We do not propose to sell nuclear plants, which would diminish the operating advantages,” Rowe said in a separate teleconference with analysts on Monday.
“We have spent a great deal of time studying this, and we believe because of the baseload nature of nuclear operations, a stable output process can be developed which will meet the FERC objections,” Rowe added. “We are committed to beginning to work with FERC on that at the earliest possible date.” The two companies hope to complete their merger by the end of next year.
The transaction calls for each common share of PSEG (237.71 million shares outstanding) to be converted into 1.225 shares of Exelon, for a transaction value of about $12.82 billion. In addition, Exelon is expected to raise its $1.60/share dividend a further 14% in 2005, yielding even more value to PSEG shareholders.
Following the merger, PSEG stockholders will own 32%, or 306 million of Exelon Electric & Gas’ proforma shares outstanding, and Exelon shareholders will own 68%, or 650 million shares. Shareholders on both sides of the aisle appeared to like the deal. EXC shares rose to more than $44 from less than $42 prior to the announcement. PEG shares went from less than $48 on Friday Dec. 17 to $51.63 as of 1:40 p.m. last Thursday.
The merger, which has been approved by the boards of both companies, will create a combined utility holding company with total assets of $79 billion, $27 billion in annual revenues and $3.2 billion in annual net income. Merrill Lycnh analyst Steven Fleishman calculated the total combined market value of the company at $40 billion last Monday.
A key component of the transaction is the projected savings. PSEG and Exelon expect greater efficiencies at all levels of their operations, including generation, transmission, distribution and power marketing. They expect to save about $400 million in the first year due to operation efficiencies. That will increase to $500 million/year by the second year.
About 1,400 workers, or about 5% of the 28,000 employees, are expected to lose their jobs because of the merger. A portion of any job losses will be offset by anticipated retirements and normal attrition, the companies said. In addition, they expect to reduce the impact of the merger on the workforce through appropriate severance plans. About 38% of the post-merger workforce will be located in New Jersey.
Rowe, who will be president and CEO of the new company, called the transaction “compelling” because it satisfies all the typical criteria for a combination: “It is accretive [to both companies’ earnings per share] with sound returns; it can be accomplished without compromising our financial integrity; and it creates a strategic mix of assets.
“With complementary skills and common regulatory frameworks in three competitive state jurisdictions, all within the same regional transmission organization, we can create additional scale and scope that will provide operational synergies well into the future. This combination is a natural next step on the part of two companies whose assets, geography and strategies complement one another and whose partnership history is already established.”
Exelon itself is the product of a merger in 2000 of PECO Energy and Unicom Corp. of Chicago, parent of Commonwealth Edison.
E. James Ferland, currently CEO of PSEG, will become non-executive chairman of Exelon Electric & Gas until his planned retirement in the spring of 2007. The new board will be comprised initially of 12 members nominated by Exelon and six members nominated by PSEG.
“This is a truly unique opportunity for two major companies,” said Ferland. “Exelon is the leader in the nuclear generation business and will have an immediate positive impact on our operations. By contrast, we are highly regarded for our expertise in transmission and distribution operations and retail auctions, which will be a valuable addition to Exelon’s business.”
Merrill Lynch’s Fleishman calculated the first year savings from the deal at about 10-15 cents/share. He said the cost-reduction potential of the transaction made it particularly attractive. “On balance, we view the combination of EXC and PEG favorably given the significant cost reduction potential, diversification of geographic and regulatory risk, and complementary expertise in nuclear operations (EXC) and competitive markets (PEG).
“In addition, potential restructuring of PEG’s merchant plants and international assets could provide further benefit. From a financial perspective, earnings accretion and the dividend hike are key attractions.”
However, Fleishman noted that one major hurdle stands in the way of this deal: market power in the PJM Interconnection. That “could be a risk in securing FERC approval,” he said.
The companies highlighted the strengths of their combined generation portfolio, the bulk of which is located within PJM. That situation may end up being a major sticking point, noted Christine Tezak, an analyst with Stanford Washington Research Group. “We believe that this large merger is likely to fail the FERC’s preliminary merger screens.”
However, Tezak said the solid RTO structure of the PJM Interconnection will go a long way toward mitigating any market power. “The fact that both parties to this potential transaction are operating within a FERC-approved RTO structure may ameliorate concerns about anticompetitive behavior through the existence of a structure that appears to significantly impede the ability of the filers to exert horizontal and vertical market power. We expect that the FERC can ultimately approve the potential transaction.”
Tezak also believes that the merger will pass Hart-Scott Rodino antitrust review by the Department of Justice and Federal Trade Commission because of PJM’s oversight of the companies’ transmission, and power marketing activities.
In addition, Tezak noted that because retail choice is in place in each of the utilities’ service territories — Commonwealth Edison, PECO and PSE&G — there may be far less trouble winning state regulatory approvals.
About half of the combined company’s earnings and cash flow will come from its three regulated utilities and half from the unregulated generation business. The companies said that by operating in multiple states and geographic regions their risks will be diversified and their earnings will be more consistent. They also will have a more diverse generation platform. This balanced strategy is expected to enable the new company to prosper through changing energy markets and regulatory conditions.
While Exelon and PSEG said they expect solid investment grade ratings following the closing, Standard & Poor’s Ratings put Exelon on Ratings Watch Negative and put PSEG on CreditWatch with developing implications. Exelon and PSEG together have about $20 billion in debt outstanding.
“The ratings for the several Exelon companies had already borne negative outlooks prior to the announcement of the merger transaction because of concerns related to its ongoing pursuit of growth initiatives that can heighten financial and operating risk,” S&P said. “Regulatory uncertainties facing Commonwealth Edison Co. were also factored into the negative outlook.
“The merger with Enterprise [PSEG] is emblematic of Exelon’s pursuit of growth initiatives and will likely place pressure on financial margins in the near term because of the operational challenges that have been plaguing Enterprise’s nuclear fleet in the past year and that are expected to continue at least through 2005. The combination will also lead to a larger trading and marketing operation, which could heighten risk. Consequently, these factors mandated a negative CreditWatch listing for Exelon.”
Standard & Poor’s credit analyst David Bodek said the credit quality of PSEG and its subsidiaries “should benefit from anticipated synergies and from the company’s incorporation into a larger entity with a stronger credit profile.”
However, S&P added that if the merger isn’t completed or is “perceived to be failing, or there is further degradation in the performance at PSEG Power’s nuclear assets in the interim, credit ratings at the Enterprise companies are likely to be lowered to reflect the financial consequences of such performance, the dispatch and cost implications of ongoing transmission constraints, and expectations that trading revenues may not be as robust as anticipated.”
The corporate credit ratings assigned to the Enterprise family of companies, other than PSEG Energy Holdings LLC, would be lowered to ‘BBB-‘ and the outlook would remain negative, S&P said, because of the “substantial impact that poor stewardship of nuclear operations and other operational issues have had on financial performance.”
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