Constellation Energy Group, In CEG
October 30, 2008 - 8:57am EST by
nauset323
2008 2009
Price: 24.24 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 4,320 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Constellation Energy; $23.29 as of 10/28/08
Summary:
Unstable market conditions and fear over further credit problems have presented an opportunity to own Constellation Energy Group at a discount to an existing takeover bid with limited downside risk and potential upside beyond the takeover price. Due to short-term liquidity needs and a series of credit rating downgrades, CEG was forced to sell itself to MidAmerican Energy Holdings, a subsidiary of Berkshire Hathaway, in order to raise short-term liquidity and avoid potential bankruptcy.
Over the past year, the stock price has fallen approximately 75%, and it traded at over $100 per share as early as January 2008.  The current stock price offers an attractive ROI over the next 6 – 9 months from the convergence to the deal price ($26.50) along with two or more $.478 dividend payments (8% annual yield).  There is also the potential for further upside if the pending takeover falls through and another bid appears.  My worst case scenario is the takeover falls through, no other bidder appears, and you are left owning a very solid energy business that trades at less than 5x earnings and yields 8%.
Background:
Constellation Energy Group, Inc. (“CEG” or the “company”) is an energy company that operates in two main business segments: Merchant Energy and a regulated electric and gas public utility in Maryland.  The company generated over $21 billion of revenue over the trailing 12 months.  The Merchant Energy operation is a competitive provider of energy solutions that owns electricity generation assets located in the Northeast (NY), Mid-Atlantic (MD/PA), and Western states (CA/NV/UT).  Merchant Energy provides the vast majority of revenues and operating income (83% of both in 2007).  Baltimore Gas & Electric (“BGE”), the regulated electric and gas utility, provides utility services to Baltimore and 10 surrounding counties.  The company controls 12,359 MW of electrical capacity and owns roughly 71% of that.
The company’s electricity generation plants are fueled by a mix of nuclear, coal, gas, hydro, solar, geothermal, and biomass, with the vast majority of output coming from nuclear (61%) and coal (35%).
As part of the company’s daily operations, Constellation operates a large Global Commodities trading business.  This business is primarily used to hedge the company’s ongoing operations and help manage commodity price risks within energy contracts.  The trading portfolio is focused on power in N. America, natural gas in N. America, and coal and freight globally. 
Due to rapidly rising commodity prices throughout the first half of 2008 (power up 33%, natural gas up 44%, crude oil up 55%, and coal up 153%), higher margin requirements in its trading portfolio impacted not only CEG but panicked trading partners like Lehman Brothers, Morgan Stanley, and Goldman Sachs as well.
As 2008 progressed, Constellation faced increasing liquidity needs to meet collateral requirements as part of its derivatives exposure.  The company also faced worsening counterparty credit exposure as many utilities were impacted by higher commodity prices and imperfect hedging.  The impact of mark-to-market accounting on the company’s derivatives portfolio and additional margin requirements soared into the hundreds of millions of dollars, and risked being in the billions if the firm’s credit rating dropped below investment grade.
In the second quarter of 2008, CEG added $1.1 billion in credit facilities, which resulted in the issuance of an additional $1.75 billion in letters of credit to support their risk management and hedging activities.  In order to further help meet its additional collateral posting requirements and avoid multi-notch credit downgrades, the company also entered into a $2.0 billion credit facility with UBS Loan Finance LLC and RBS Securities Corp. in August.  This credit facility was expected to be in place by October 2008, but much would happen before then.
During the 2008 Q2 conference call on July 31, 2008, CEO Mayo Shattuck stated the following:  “While we’re pleased with the overall operating performance of the company, we understand that the recent performance of our stock does not reflect the underlying value of our assets.  While some of this is directly related to the tough economic and market environment, we believe that our current stock price significantly undervalues the company and we intend to take strategic steps to address this valuation gap.”  The stock closed that day at $83.16.
On August 13, 2008, S&P downgraded CEG’s credit rating from BBB+ to BBB.  Fitch soon followed with a downgrade on August 19, 2008.  Then on August 20, 2008, Moody’s announced that CEG’s ratings were under review.
On September 12, Constellation was considering an investment by France’s Electricite de France International (“EdF”), one of CEG’s largest existing shareholders.  EdF owned 4.9% of Constellation’s outstanding shares and was a joint venture partner with Constellation in a nuclear power business.  EdF increased their ownership of CEG to 9.5% by purchasing shares throughout August and early September.
Events occurring during the week of September 15 caused further problems for CEG.  First, Lehman Brothers filed a voluntary bankruptcy petition.  Then Merrill Lynch announced that it had agreed to be acquired by Bank of America.  There were also concerns about AIG’s solvency.  These events impacted CEG’s stock price (down 18% on 9/15/08) as rumors emerged that UBS and RBS would withdraw the company’s pending credit line.
On September 16, 2008, the stock fell to an intra-day low of $13.00 and trading was temporarily halted by the NYSE.  It ended the day down 36% (at $30.76) due to further speculation about credit exposure to Lehman Brothers and rumors that certain counterparties had stopped trading with Constellation or wanted more collateral.
Constellation quickly met with Morgan Stanley to discuss strategic alternatives and tried to persuade EdF to invest up to $500 million.  Later in the day, CEG received an unsolicited call from David Sokol, the Chairman of MidAmerican Energy Holdings (“MEH”).  Shortly thereafter, the company received two additional unsolicited calls from other firms expressing interest.  Wanting to prevent a death spiral from further downgrades, the company discussed the MidAmerican offer with MidAmerican’s management.
The MEH offer proposed a $1 billion immediate investment in Series A Convertible Preferred stock which would provide much needed liquidity.  Upon execution of the agreement, CEG would pay MidAmerican a $25 million fee.  The offer further proposed an all-cash merger agreement for $26.50 per share of Constellation stock.
The offer allowed for several escapes if, upon conducting a 14-day due diligence period, MEH found material adverse issues with Constellation’s business.  The two main reasons why MEH could walk away from the deal included if Constellation’s retail or wholesale businesses or assets had deteriorated in value by $100 million or more from 6/30/08, or if CEG incurred net aggregate decreases in value in its trading portfolio of more than $200 million since 6/30/08.  CEG could also not incur any additional credit downgrades. 
On September 17, S&P placed Constellation on “CreditWatch,” and indicated that immediate resolution was required.  This resolution included the sustained availability of the $2 billion credit line, a near-term cash infusion of $750 million to $1 billion, and the completion of asset sales or an outright sale of the company.  If these conditions were not met, a multiple-notch downgrade was likely.
Later that same day, Moody’s completed a credit review and was prepared to announce a 2-notch ratings decrease to Baa3.
Constellation management strongly believed that the $26.50 offer price was too low, but it was the only realistic option available to prevent an immediate ratings downgrade and likely bankruptcy.  On the evening of September 17, CEG announced that it had signed a letter of intent with MidAmerican.
On September 19, 2008, the company received an unsolicited competing takeover proposal from a group that included EdF, Kohlberg Kravis Roberts, and TPG Capital.  This new offer proposed a $1 billion investment (convertible into a 16% ownership interest and $750 mm of senior notes) and, if Constellation was interested, ongoing negotiations to acquire CEG at $35.00 per share.  CEG and Morgan Stanley discussed this new offer given the premium price, but determined that the proposal lacked clarity in terms of financing and structure.  Given the timing (it was now late in the afternoon on Friday), the pending downgrade, and the expiration of the MEH offer at 5:00 PM, the company knew it needed to act quickly.  Despite the higher offer on the table, Constellation and MidAmerican signed a definitive agreement and issued a joint press release by the end of the day announcing their intention to merge.
As we stand today, the merger is expected to conclude by the end of Q2 2009, pending regulatory and shareholder approval.  Constellation would become a wholly-owned subsidiary of MidAmerican Energy Holdings.  CEG’s stock price is currently below $23.00/share, despite the $26.50 offer price.  There is nothing obvious on the regulatory or financing side (especially given MidAmerican’s strong reputation) that would indicate any major problem in completing the takeover.  MEH completed their due diligence process on Constellation and had no concerns over the quality of CEG’s business.
Constellation’s emergency “fire sale” was driven by a shutdown of the credit markets and rapidly increasing counterparty risk.  It was not based on fundamental changes in CEG’s underlying business or asset values.  The company’s core business has been growing steadily over the past several years, and revenues have doubled since 2003.  Management forecasts earnings growth of 15 – 20% over 2008 and five year forward earnings growth of more than 10%, and the company has declared a $.478/share dividend for shareholders of record as of 12/10/08 payable on 1/2/09.
Valuation:
CEG appears to be cheap on both an absolute basis and relative to its peers.
Constellation’s EV/Revenue is a fraction of its peers, ay 0.42 versus an average of 2.37.  The firm is also the cheapest of its peers when looked at on an EV/MW basis, with significantly higher Net Income per MW than most of the industry.
·        Current EV of $9 billion, with an EV/EBIDTA of approximately 4.7x (electric utility sector trades at an average EV/EBITDA closer to 9.5x)
·        Trailing P/E of 5x and a forward P/E of 4.2x:  the company has reiterated its 2008 full-year EPS guidance of $5.25 - $5.75
·        For comparative purposes, Exelon Corp. recently bid $6.2 billion to buy NRG, a valuation at roughly 10x P/E and 7.5x EV/EBITDA.
·        The company is trading below its tangible book value with $10.4 billion of net property on its balance sheet versus an enterprise value of less than $9 billion.
·        Based on replacement cost estimates from World Nuclear Association and other sources, the company’s nuclear assets alone are worth close to $25/share.  (This assumes a cost of $2,500/kW and is adjusted for each plant’s estimated remaining useful life). 
·        Constellation also owns or co-owns 74 more generating plants, 248 substations, nearly 25,000 miles of distribution lines, 1,300 miles of transmission lines, and several gas plants and distribution pieces.
Catalysts:
·        Completion of current $26.50/share takeover by MidAmerican – this appears to be a low-risk way to achieve roughly 10% of stock price appreciation in 6 – 9 months (plus at least one quarterly dividend payment).  Note: The stock price has been fairly volatile over the past month, so there are often opportunities to buy at an even steeper discount.
·        Shareholder rejection of current takeover bid and subsequent bid at higher price (EdF bid $35.00/share shortly after the MidAmerican offer)
·        Current dividend yield of more than 8% pays you to wait for an event to unlock additional value
·        Improving company fundamentals within the merchant energy operations, as below market contracts roll off and are replaced with higher-margin, market-based contracts could result in longer-term appreciation without a deal
Risks:

      ·     MidAmerican takeover falls through and no other bidders come forth. Utilities are often owned by shareholders    seeking predictable dividends, so there is a chance that the takeover will be rejected.

·        Short-term liquidity needs intensify due to volatile commodity prices and a deteriorating credit environment.
·        Further credit downgrades

Catalyst

· Completion of current $26.50/share takeover by MidAmerican – this appears to be a low-risk way to achieve roughly 10% of stock price appreciation in 6 – 9 months (plus at least one quarterly dividend payment). Note: The stock price has been fairly volatile over the past month, so there are often opportunities to buy at an even steeper discount.
· Shareholder rejection of current takeover bid and subsequent bid at higher price (EdF bid $35.00/share shortly after the MidAmerican offer)
· Current dividend yield of more than 8% pays you to wait for an event to unlock additional value
· Improving company fundamentals within the merchant energy operations, as below market contracts roll off and are replaced with higher-margin, market-based contracts could result in longer-term appreciation without a deal
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    Description

    Constellation Energy; $23.29 as of 10/28/08
    Summary:
    Unstable market conditions and fear over further credit problems have presented an opportunity to own Constellation Energy Group at a discount to an existing takeover bid with limited downside risk and potential upside beyond the takeover price. Due to short-term liquidity needs and a series of credit rating downgrades, CEG was forced to sell itself to MidAmerican Energy Holdings, a subsidiary of Berkshire Hathaway, in order to raise short-term liquidity and avoid potential bankruptcy.
    Over the past year, the stock price has fallen approximately 75%, and it traded at over $100 per share as early as January 2008.  The current stock price offers an attractive ROI over the next 6 – 9 months from the convergence to the deal price ($26.50) along with two or more $.478 dividend payments (8% annual yield).  There is also the potential for further upside if the pending takeover falls through and another bid appears.  My worst case scenario is the takeover falls through, no other bidder appears, and you are left owning a very solid energy business that trades at less than 5x earnings and yields 8%.
    Background:
    Constellation Energy Group, Inc. (“CEG” or the “company”) is an energy company that operates in two main business segments: Merchant Energy and a regulated electric and gas public utility in Maryland.  The company generated over $21 billion of revenue over the trailing 12 months.  The Merchant Energy operation is a competitive provider of energy solutions that owns electricity generation assets located in the Northeast (NY), Mid-Atlantic (MD/PA), and Western states (CA/NV/UT).  Merchant Energy provides the vast majority of revenues and operating income (83% of both in 2007).  Baltimore Gas & Electric (“BGE”), the regulated electric and gas utility, provides utility services to Baltimore and 10 surrounding counties.  The company controls 12,359 MW of electrical capacity and owns roughly 71% of that.
    The company’s electricity generation plants are fueled by a mix of nuclear, coal, gas, hydro, solar, geothermal, and biomass, with the vast majority of output coming from nuclear (61%) and coal (35%).
    As part of the company’s daily operations, Constellation operates a large Global Commodities trading business.  This business is primarily used to hedge the company’s ongoing operations and help manage commodity price risks within energy contracts.  The trading portfolio is focused on power in N. America, natural gas in N. America, and coal and freight globally. 
    Due to rapidly rising commodity prices throughout the first half of 2008 (power up 33%, natural gas up 44%, crude oil up 55%, and coal up 153%), higher margin requirements in its trading portfolio impacted not only CEG but panicked trading partners like Lehman Brothers, Morgan Stanley, and Goldman Sachs as well.
    As 2008 progressed, Constellation faced increasing liquidity needs to meet collateral requirements as part of its derivatives exposure.  The company also faced worsening counterparty credit exposure as many utilities were impacted by higher commodity prices and imperfect hedging.  The impact of mark-to-market accounting on the company’s derivatives portfolio and additional margin requirements soared into the hundreds of millions of dollars, and risked being in the billions if the firm’s credit rating dropped below investment grade.
    In the second quarter of 2008, CEG added $1.1 billion in credit facilities, which resulted in the issuance of an additional $1.75 billion in letters of credit to support their risk management and hedging activities.  In order to further help meet its additional collateral posting requirements and avoid multi-notch credit downgrades, the company also entered into a $2.0 billion credit facility with UBS Loan Finance LLC and RBS Securities Corp. in August.  This credit facility was expected to be in place by October 2008, but much would happen before then.
    During the 2008 Q2 conference call on July 31, 2008, CEO Mayo Shattuck stated the following:  “While we’re pleased with the overall operating performance of the company, we understand that the recent performance of our stock does not reflect the underlying value of our assets.  While some of this is directly related to the tough economic and market environment, we believe that our current stock price significantly undervalues the company and we intend to take strategic steps to address this valuation gap.”  The stock closed that day at $83.16.
    On August 13, 2008, S&P downgraded CEG’s credit rating from BBB+ to BBB.  Fitch soon followed with a downgrade on August 19, 2008.  Then on August 20, 2008, Moody’s announced that CEG’s ratings were under review.
    On September 12, Constellation was considering an investment by France’s Electricite de France International (“EdF”), one of CEG’s largest existing shareholders.  EdF owned 4.9% of Constellation’s outstanding shares and was a joint venture partner with Constellation in a nuclear power business.  EdF increased their ownership of CEG to 9.5% by purchasing shares throughout August and early September.
    Events occurring during the week of September 15 caused further problems for CEG.  First, Lehman Brothers filed a voluntary bankruptcy petition.  Then Merrill Lynch announced that it had agreed to be acquired by Bank of America.  There were also concerns about AIG’s solvency.  These events impacted CEG’s stock price (down 18% on 9/15/08) as rumors emerged that UBS and RBS would withdraw the company’s pending credit line.
    On September 16, 2008, the stock fell to an intra-day low of $13.00 and trading was temporarily halted by the NYSE.  It ended the day down 36% (at $30.76) due to further speculation about credit exposure to Lehman Brothers and rumors that certain counterparties had stopped trading with Constellation or wanted more collateral.
    Constellation quickly met with Morgan Stanley to discuss strategic alternatives and tried to persuade EdF to invest up to $500 million.  Later in the day, CEG received an unsolicited call from David Sokol, the Chairman of MidAmerican Energy Holdings (“MEH”).  Shortly thereafter, the company received two additional unsolicited calls from other firms expressing interest.  Wanting to prevent a death spiral from further downgrades, the company discussed the MidAmerican offer with MidAmerican’s management.
    The MEH offer proposed a $1 billion immediate investment in Series A Convertible Preferred stock which would provide much needed liquidity.  Upon execution of the agreement, CEG would pay MidAmerican a $25 million fee.  The offer further proposed an all-cash merger agreement for $26.50 per share of Constellation stock.
    The offer allowed for several escapes if, upon conducting a 14-day due diligence period, MEH found material adverse issues with Constellation’s business.  The two main reasons why MEH could walk away from the deal included if Constellation’s retail or wholesale businesses or assets had deteriorated in value by $100 million or more from 6/30/08, or if CEG incurred net aggregate decreases in value in its trading portfolio of more than $200 million since 6/30/08.  CEG could also not incur any additional credit downgrades. 
    On September 17, S&P placed Constellation on “CreditWatch,” and indicated that immediate resolution was required.  This resolution included the sustained availability of the $2 billion credit line, a near-term cash infusion of $750 million to $1 billion, and the completion of asset sales or an outright sale of the company.  If these conditions were not met, a multiple-notch downgrade was likely.
    Later that same day, Moody’s completed a credit review and was prepared to announce a 2-notch ratings decrease to Baa3.
    Constellation management strongly believed that the $26.50 offer price was too low, but it was the only realistic option available to prevent an immediate ratings downgrade and likely bankruptcy.  On the evening of September 17, CEG announced that it had signed a letter of intent with MidAmerican.
    On September 19, 2008, the company received an unsolicited competing takeover proposal from a group that included EdF, Kohlberg Kravis Roberts, and TPG Capital.  This new offer proposed a $1 billion investment (convertible into a 16% ownership interest and $750 mm of senior notes) and, if Constellation was interested, ongoing negotiations to acquire CEG at $35.00 per share.  CEG and Morgan Stanley discussed this new offer given the premium price, but determined that the proposal lacked clarity in terms of financing and structure.  Given the timing (it was now late in the afternoon on Friday), the pending downgrade, and the expiration of the MEH offer at 5:00 PM, the company knew it needed to act quickly.  Despite the higher offer on the table, Constellation and MidAmerican signed a definitive agreement and issued a joint press release by the end of the day announcing their intention to merge.
    As we stand today, the merger is expected to conclude by the end of Q2 2009, pending regulatory and shareholder approval.  Constellation would become a wholly-owned subsidiary of MidAmerican Energy Holdings.  CEG’s stock price is currently below $23.00/share, despite the $26.50 offer price.  There is nothing obvious on the regulatory or financing side (especially given MidAmerican’s strong reputation) that would indicate any major problem in completing the takeover.  MEH completed their due diligence process on Constellation and had no concerns over the quality of CEG’s business.
    Constellation’s emergency “fire sale” was driven by a shutdown of the credit markets and rapidly increasing counterparty risk.  It was not based on fundamental changes in CEG’s underlying business or asset values.  The company’s core business has been growing steadily over the past several years, and revenues have doubled since 2003.  Management forecasts earnings growth of 15 – 20% over 2008 and five year forward earnings growth of more than 10%, and the company has declared a $.478/share dividend for shareholders of record as of 12/10/08 payable on 1/2/09.
    Valuation:
    CEG appears to be cheap on both an absolute basis and relative to its peers.
    Constellation’s EV/Revenue is a fraction of its peers, ay 0.42 versus an average of 2.37.  The firm is also the cheapest of its peers when looked at on an EV/MW basis, with significantly higher Net Income per MW than most of the industry.
    ·        Current EV of $9 billion, with an EV/EBIDTA of approximately 4.7x (electric utility sector trades at an average EV/EBITDA closer to 9.5x)
    ·        Trailing P/E of 5x and a forward P/E of 4.2x:  the company has reiterated its 2008 full-year EPS guidance of $5.25 - $5.75
    ·        For comparative purposes, Exelon Corp. recently bid $6.2 billion to buy NRG, a valuation at roughly 10x P/E and 7.5x EV/EBITDA.
    ·        The company is trading below its tangible book value with $10.4 billion of net property on its balance sheet versus an enterprise value of less than $9 billion.
    ·        Based on replacement cost estimates from World Nuclear Association and other sources, the company’s nuclear assets alone are worth close to $25/share.  (This assumes a cost of $2,500/kW and is adjusted for each plant’s estimated remaining useful life). 
    ·        Constellation also owns or co-owns 74 more generating plants, 248 substations, nearly 25,000 miles of distribution lines, 1,300 miles of transmission lines, and several gas plants and distribution pieces.
    Catalysts:
    ·        Completion of current $26.50/share takeover by MidAmerican – this appears to be a low-risk way to achieve roughly 10% of stock price appreciation in 6 – 9 months (plus at least one quarterly dividend payment).  Note: The stock price has been fairly volatile over the past month, so there are often opportunities to buy at an even steeper discount.
    ·        Shareholder rejection of current takeover bid and subsequent bid at higher price (EdF bid $35.00/share shortly after the MidAmerican offer)
    ·        Current dividend yield of more than 8% pays you to wait for an event to unlock additional value
    ·        Improving company fundamentals within the merchant energy operations, as below market contracts roll off and are replaced with higher-margin, market-based contracts could result in longer-term appreciation without a deal
    Risks:

          ·     MidAmerican takeover falls through and no other bidders come forth. Utilities are often owned by shareholders    seeking predictable dividends, so there is a chance that the takeover will be rejected.

    ·        Short-term liquidity needs intensify due to volatile commodity prices and a deteriorating credit environment.
    ·        Further credit downgrades

    Catalyst

    · Completion of current $26.50/share takeover by MidAmerican – this appears to be a low-risk way to achieve roughly 10% of stock price appreciation in 6 – 9 months (plus at least one quarterly dividend payment). Note: The stock price has been fairly volatile over the past month, so there are often opportunities to buy at an even steeper discount.
    · Shareholder rejection of current takeover bid and subsequent bid at higher price (EdF bid $35.00/share shortly after the MidAmerican offer)
    · Current dividend yield of more than 8% pays you to wait for an event to unlock additional value
    · Improving company fundamentals within the merchant energy operations, as below market contracts roll off and are replaced with higher-margin, market-based contracts could result in longer-term appreciation without a deal

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