Constellation Energy Group: Reasons Behind the Sell-Off

The TSX being halted for virtually a full day was interesting (and scary), but it gave me a lot of time to think about US positions. Constellation Energy Group (CEG), of which we own shares, did exactly what we thought it would do and rejected MidAmerican’s (MDPWK.PK) buyout offer ($26.50 per share plus assumption of debt) in favor of the EDF offer of $4.5 billion (no assumption of debt) for 50% of CEG’s nuclear assets.

What happened wasn’t what we expected: the stock sold off by over 20% down to $3 below the MidAmerican deal price. It goes to show you that a degree in psychology would be more useful in predicting the markets than a degree in economics or business. It is becoming increasingly apparent that not only do you need to predict the future (what earnings will be, what events will happen, etc) but you need to predict the reaction to those events in order to make money in these markets. So while it may be possible to accurately predict the future (say 70-75% of the time), if you can only correctly predict the reaction 50% of the time, then your overall success ratio will still only be 50/50.

It’s important though to remember what Warren Buffett says, in the short term the market is a voting machine, but in the longer term it’s a weighing machine. Simply put, people can react to news incorrectly in the short term, but those inefficiencies will be removed over the longer term.

So the question is… what does CEG weigh after this EDF deal? What Warren Buffett offered for CEG was effectively $26.50 per share PLUS assumption of net debt (let’s call that $7 billion to use round numbers). This put the total value of the transaction at around $11.6 billion (assuming we give no value to the positive working capital, ex-cash, of about $2 billion, which would reduce this figure to $9.6 billion).

The EDF transaction is way more complicated, in that EDF cannot purchase the entire company outright, as there are restrictions on foreign ownership of nuclear assets in the US. So they are buying 49.99% of the nuclear assets (3,831MW) for $4.5 billion, or around $2.3mm per MW (new plants are estimated to cost between $3mm and $7mm per MW with the wide margin attributed to the current weakness in commodity prices). They also gave CEG a put option on 2,257 MW of their non nuclear generating capacity for up to $2 billion. CEG would have an additional 2,961 MW of non nuclear generating capacity if they were to sell all of those assets to EDF. In addition CEG would continue to be the sole owner of Baltimore Gas and Electric (the distribution utility for 1.1 million homes in the Baltimore area) and they would maintain their commodity and electric wholesaling business (which let’s just say are worthless).

So what does all that total up to? That values the nuclear generating assets at $9 billion, part of the non nuclear at $2 billion (the 2,257MW), and using the same cost per MW for the remainder (2,961MW at $0.88mm per MW) $2.6 billion. Baltimore Gas and Electric is harder to value since it’s hard to know what all those miles of grid are worth, but it is a fairly stable business that in normal times should generate between $100 and $140 million in net income. As a transmission service I don’t think it would be unfair to apply a 10x-20x multiple to that business.

So the value of BG&E is let’s say between $1 billion and $2.8 billion. Using these values the sum of the EDF offer is approximately $14.6 billion to $16.4 billion. Of course you could make an argument that the markets are bad and the remainder of the assets not covered by the put option are worth less than the assets that are covered by it. BG&E probably wouldn’t attract a premium price in this market either, so let’s use the low end of that range. The total value of the EDF offer then is conservatively $13.95 billion.

Of course, there is a break fee with MidAmerican of about $435 million in cash which means the net debt of CEG increases to about $7.435 million and there was issuance of shares to MidAmerican (9.9%). So the EDF offer leaves CEG shareholders with $32.75 per share in assets in the scenario outlined above. There appears like there may be some additional tax consequences (which could be substantial) and some additional regulatory hurdles, which may be why you saw the huge sell-off.

In my opinion, the other reason you saw the huge sell-off is: cash is king. The Buffett deal offered shareholders cash, which is a certain thing. While power generation and distribution is about the closest you can get to a sure thing in this world, it isn’t cash… so the shareholders expecting to receive a nice whack of cash from EDF or Buffett are exiting the trade en masse. The other problem (unintended consequences) is in accepting this offer (by voicing their distaste for the Buffett offer), shareholders are seemingly stuck with the same management team that led them into this mess in the first place. The EDF deal carries execution risk in that CEG needs to delever in order to maintain its ratings above junk status. A falling share price won’t help matters much, as ratings agencies tend to use the share price as a barometer for the health of the company.

Since this is way too long already I’ll make my final point brief. The problem CEG had with its stock price was entirely due to management’s explanation of the deal on the conference call. The real sell-off didn’t start until the conference call was over. The reason is pretty straightforward: management did not do a good job explaining, in simple terms, why this deal was better.

I, unfortunately, listened to the entire call and they spent very little time talking about the value of the assets they had, but instead spent the entire time talking about being focusing on debt reduction to the point of being “myopic”. For the record, it is never good to describe yourself as myopic. In my opinion, if they want to restore shareholder confidence, they should create a very simple slideshow. It should list all of their assets, one by one, and detail the revenue, profit, and how they value each one internally. They should also disclose the pre-determined selling price of the 11 assets included in the put option EDF gave them. This would give the market better clarity and help to better explain why this makes their company worth more than $26.50 per share even after the significant dilution penalty of terminating the MidAmerican deal.

Incidentally (minus the termination fee part) this is exactly what the banks should do… unless, of course, Meredith Whitney is right and they are all bankrupt, in which case I think people would much rather not know.

Disclosure: Author holds a long position in CEG, no positions in the other stocks mentioned.

Comments

[eddybaby:]

Good Article Nick
I'd sold long dated puts at 25 some time ago, and got a real fright when the stock went down 20%!

It does look like there were a lot of traders exiting the play, and hopefully we'll see some sanity return to the price, which conservatively should be $30+

2008 Dec 19 08:47 AM

[reader:]

I think the board of CEG saw the handwriting on the wall and knew that the Buffet deal was going to be derailed by shareholders. I know that the divi will be greatly reduced so that the company can reduce debt, and I am alright with that since I am looking long term. Mayo and the board are a different question however. In the near future, after the deal is completed I would hope that shareholders will look to have this, group sooner if not later, replaced. I would also hope that when that occurs Mayo's golden parachute has a number of holes in it.

I am not, nor have I ever been a fan of these golden parachutes. As a stockholder in companies I am never asked how I feel about them when the are given away by the buddy, buddy boards.

2008 Dec 19 10:18 AM

[MILESCFA:]

"Me thinks you think too much." The deal with EDF was obviously NOT very appealing because the stock never really moved on it (and I'm not a bear on it; I was long and bought more).

I think CEG dropped because

1) Moody's/S&P downgraded the company.
2) CEG is looking to cut the 8% dividend 50-60%.

So what you're left with is a company with a management that screwed up in the first place. I don't know what it's worth, I don't know what to do with my stock, and this uncertainty is certainly another factor in the stock's drop (Wall Street hates uncertainty).

2008 Dec 19 11:25 AM

[investman:]

You failed to mention reduction of the dividend as a factor. Those who liked CEG in part for the hefty dividend may have left when the huge dividend cut was announced.

I hear that of the $4.5 billion, $1.5 billion would go to taxes, so that amount needs to be cut out to the value of the company.

I think the price is now in the priocess of stabilizing and will find its appropriate level.

Buffet had a steal if he closed and a nice margin of safety from the breakup, so he wins either way. Cash is definitely king in this market.

2008 Dec 19 11:26 AM

[an interest...:]

I think someday, in the not too distant future, traders and investors will look at managment groups like the one that currently runs CEG and target them as an outlet for all of the frustrations related to their collective disappearing investment values; just as they did at Tyco, Adelphia, etc. - then we can all watch the shareholder class action lawsuits really pile up....oh, to be a litigation lawyer in the next few years,,,,

2008 Dec 22 09:19 AM