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Published: September 28, 2009
As the second-largest provider of electricity to
the United States, Constellation Energy Group Inc. (NYSE: CEG)
has tremendous upside. At least, it would if the economy were
growing strongly.
Unfortunately, that’s not the case. And that means Constellation
will have to clear a number of hurdles if it’s going to fulfill
its long-term promise. Last year, the company bet big on higher
energy prices and paid the price dearly when the economy
collapsed.
Constellation’s very high level of debt, with large bond
maturities in 2009 and 2012 at that time meant they were
flirting with financial disaster. That forced the company into a
deal with Électricité de France SA (EDF), in which the European
energy giant agreed to inject $4.5 billion into Constellation in
exchange for almost 50% ownership of its nuclear plants.
That includes a brand new plant, Calvert Cliffs 3, that’s still
subject to pending regulatory approval. Maryland Gov. Martin
O’Malley has convinced the Public Service Commission to hold
open, public hearings to determine if this new deal is in the
public’s best interest.
One of the main points of contention is the two energy
companies’ demand to access the cash at distributing subsidiary
Baltimore Gas & Electric Co. (BGE).
“We know that BGE is a cash cow for Constellation Energy,” said
Gov. O’Malley. “We know that BGE pays more than half of all
dividends paid into Constellation Energy and has a huge impact
on Constellation’s bottom line. We also know that Constellation
Energy has had a tumultuous history over these last few years.”
The Maryland governor also noted that Constellation last year
lost -80% of its stock value and was just hours away from
bankruptcy before EDF stepped in.
Potential construction costs associated with the new nuclear
plant are another large uncertainty. Nuclear plants have the
tendency to run over budget, and that means the utilities then
come back to regulators asking for rate increases in order to
fund the cost overruns.
On the other hand, EDF Vice President John Morris recently
testified to the Public Service Commission that "a decision
denying EDF’s application or imposing conditions on the approval
of the application that cause it to fail, would bring an end to
the development” of the project.
And the company’s Chairman and Chief Executive Officer, Pierre
Gadonneix, told French lawmakers that EDF expects to get all the
necessary approvals for this transaction by the end of the year.
The approval would generate strong economic gains for the state
of Maryland, where EDF’s U.S. headquarters are based.
Électricité de France, a firm
owned 84% by the French government,
has its own challenges. Having
bought British Energy Group PLC and
embarked in other growth-oriented
investments, it too got caught with
too much debt. Like Constellation,
EDF is in debt-reduction mode. The
company is rumored to be pondering
the sale of another 20% stake in
British Energy, a swap of
electricity assets with German
utility E.On AG and the possible
float of another 14% of its own
stock.
We must also factor in the
possibility that destructive
protectionism will affect the deal.
The Obama administration recently
levied special import duties on
Chinese tires. When governments are
forced to confront the tough
realities of high unemployment, the
likelihood that they resort to
protectionism to boost local
employment is high. And this always
conspires against efficiency and
global growth.
Fortunately, there is no evidence of
any such pressure playing a role
yet.
In addition to the many
uncertainties about the EDF deal and
the Calvert Cliffs plant, we have to
deal with regulatory uncertainties
that are plaguing the industry.
Evolving environmental regulations
will require large increases in
capital investments. These
eventually are passed on to
consumers, reducing demand. In the
months and years ahead, we might see
so-called “cap-and-trade”
legislation, smart grid systems and
renewable portfolio standards that
will complicate things even more in
unpredictable ways.
The cap-and-trade legislation,
should it pass, could benefit
Constellation greatly. If the United
States made a stronger commitment to
reducing carbon emissions, nuclear
would have to be a big part of the
equation. And Constellation already
is well positioned to take advantage
of this. But while such regulation
would be good for the company in the
long run, right now it is just
another uncertainty.
We also need to remember that a new
nuclear power plant in the United
States hasn’t been built in 20
years, so a new labor force and
supply chain is needed. And despite
the fact that with the support of
EDF, Constellation is the largest
nuclear operator in the world, these
challenges cannot be achieved
overnight.
We are not going to go into the
Constellation results in detail.
Demand was down in the United States
in general, the summer was mild, and
industrial demand -- which is down
between -3% and -7% in different
regions -- is not coming back yet.
Constellation has indeed taken steps
to reduce its trading and other
risks and divested several
non-profitable operations. The vast
majority of Constellation’s June 30
earnings were due to special items
that boosted GAAP (Generally
Accepted Accounting Principles)
earnings. The special one-time items
from divested earnings accounted for
about 60% of the strong upside
adjustment. But they are not likely
to recur, and in this complex
business, some other one-time items
have the unfortunate trait of
appearing out of nowhere -- just
when it is least convenient to
shareholders.
I love Constellation’s strong
operating performance, its strong
position in nuclear energy, and its
focus on growing alternative energy.
These strengths are likely to play
out well over the long term, and
could even lead this company to
superior profits down the line. But
there are too many uncertainties
weighing on an already damaged
balance sheet, which makes the risk
for this company too large to bear
in the short term.
If Constellation is hit by any one
of these risks, another big hit to
the stock could lead to another
equity infusion. And the traditional
argument for buying utility stocks
as an income investment does not
work well either, given its low
dividend yield and the company’s
need to conserve cash.
So, with so much left to chance, I
would not buy Constellation at this
time. But there is enough long-term
potential, that if I already owned
Constellation stock, I would hold it
for a while to see if those
uncertainties are resolved. But be
aware that holding the stock is an
overly speculative position that
needs to be monitored constantly for
the developments that we outlined
above.
-- Horacio Marquez
Contributing Editor
Money Morning |
