Citing gains in the large unregulated retail business and potential market improvements in wholesale power, analysts at Standard & Poor’s Equity Research gave Constellation Energy Group two thumbs up on Wednesday despite the one thumb down the company has been getting from investors lately with its stock off 3.2% year to date as of June 18.

S&P’s equity group said despite the market consensus the company has plenty going for it, including a low cost position in wholesale generation, a stronger credit rating than most competitors, an interest in fully hedging its price risk and positive free cash flow after operating expenditures.

“We…attribute its weak year-to-date performance and below-average valuation to investor uncertainty about its expanding energy merchant operations and its ability to sustain [earnings per share (EPS)] growth,” the S&P analysts said in a research note. “If we are correct, investor concerns should fade over time, as it continues to generate steady earnings and cash-flow growth.”

The S&P analysts are giving Constellation their highest investment recommendation of five stars, or buy. “Alternative investment choices in the energy-merchant segment are limited, in our view,” they said. “We see them as generally consisting of distressed pure-play unregulated companies with no dividends, or very large diversified utilities with EPS growth prospects in the low- to mid-single digits.

“In contrast, we expect Constellation to offer investors a dividend yielding 3% and an average annual EPS growth rate of more than 10% from 2003-2008. We see its dividend increasing in line with EPS growth, implying a 2008 dividend yield of almost 4.5% on shares bought at today’s prices.”

The S&P analysts said they expect significant operating efficiencies and synergies from the relationships among Constellation’s three business segments, utility operations, unregulated energy supply and power generation.

“A major factor in our estimated 10%+ EPS growth rate for Constellation is its success at gaining share in the expanding market for competitive [commercial and industrial (C&I)] energy supply. We think its industry-leading position in the C&I market has been built from several prescient acquisitions of distressed energy merchants and diversified utilities.” By 2006, Constellation expects to achieve a 21% market share in the competitive commercial and industrial sales market, which S&P expects to grow by 50% on the power side and by 16% on the gas side over the next three years

The analysts also pointed to the expanding domestic economy and the retirement of less-efficient and more heavily polluting power plants to benefit the company. “We see a return to balanced supply and demand beginning to take hold in two to five years, depending on the region of the country. The majority of CEG’s generating capacity is located in the Northeast and California, regions where supply and demand are more closely balanced than elsewhere in the U.S., in our view.”

The analysts also expect increased output from Constellation’s nuclear facilities and higher margins from its coal and nuclear plants because of continued high natural gas prices, which tend to set the market price for power.

“Our discounted cash-flow analysis suggests that Constellation is trading about 13% below its current fair value,” the analysts said predicting a 12-month target price for the company of $46, or more than 20% above its current market price. CEG shares closed up 11 cents on Wednesday to $38/share.

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