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October 29, 2001 


Energy Company Values Sink
In Response to Changing Times 



By Robert C. Bellemare
Vice President 


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Constellation Energy's (NYSE:CEG) shares fell nearly 11 percent on Friday in response to announcements that the company is cutting its earnings' projections, shelving plans to split the company into two parts, and severing its ties with investment bank Goldman Sachs (NYSE:GS) which would have been a minority partner in its energy-trading operation if the spin-off had gone ahead. 

Analysis: Constellation Energy's stock value dropped to its lowest level in seven years-down nearly 11 percent in one day, and down over 45 percent since May 1, 2001. But perhaps what is most important about Constellation is its shift in business strategy as it becomes the second company of the week to announce it is withdrawing plans to split its company into two parts. Earlier in the week Allegheny Energy (NYSE:AYE) announced it would hold off on its planned initial public offering (IPO) of Allegheny Energy Supply Company, its unregulated power generation and trading subsidiary, until market conditions improve. 

The dramatic shift in company strategy appears to be driven by the same forces. Constellation sited falling energy prices, the changing nature of the California power crisis and weak economic conditions as the main reasons for dropping its company-separation plans. The company said it would now focus on using its "single" status to leverage its balance sheet to participate in the consolidation of the wholesale electricity industry in the United States. "What seems to matter now is size and stability and we think that comes from being a single company ? What has changed (in the last one year) is the significant change in the immediate growth rate we are seeing for new power plants ? the reasons are simple and profound. The world has changed,'' Constellation Energy Chairman Christian Poindexter said in a conference call with the media. 

The change in Constellation's strategy will be costly. The company will pay Goldman Sachs about $355 million to terminate their power-marketing agreement, $159 million which Goldman had previously put in the business, and $196 million in future income Goldman would have earned had the business continued. Constellation expects the Goldman Sachs business termination will cause the company to record a $200-million special expense in the fourth quarter. The company said that its split-up with Goldman Sachs was amicable. Goldman's relationship with Constellation started in the mid-nineties when the investment bank was looking for a partner to help it break into the energy trading and marketing business. In 1999 Goldman agreed it would take a 17.5-percent stake in Constellation's trading business when the state of Maryland deregulated the power industry and Constellation decided to make a separate trading company. Poindexter indicated that Goldman did not want to be part of a situation where energy trading and generation would remain together.

It certainly has been an active week for Constellation as it has made other significant announcements concerning its future plans. Mayo A. Shattuck III was elected to the position of president and CEO effective Nov. 1, 2001. Shattuck recently resigned his position as chairman and CEO of Deutsche Banc. Alex Brown and has served on Constellation's board of directors for the past seven years. On Oct. 24, the New York Public Service Commission said it would approve the sale of Niagara Mohawk's Nine Mile nuclear generating station in New York to Constellation Nuclear for $780 million. Constellation Nuclear is a unit of the Constellation Energy Group. As part of the sale, Constellation has agreed to sell 90 percent of Nine Mile's output at fixed prices for 10 years, or through August 2009 if the operating license of Nine Mile 1 is not extended. 

The unregulated generation and trading activities continue to drive the bulk of earnings for both Constellation and Allegheny. Constellation's domestic merchant energy business contributed $0.89 of their $1.00 earnings per share of common stock for the quarter ending Sept. 30, 2001, slightly higher than last year when the business contributed $0.87 of the $0.98 per share in earnings for the same quarter. Allegheny Energy reported that their third-quarter profits more than doubled on increased generation capacity and the acquisition of a trading and marketing unit. Allegheny's third-quarter earnings were $1.33 per share, compared with $0.69 per share one year ago, and beating analysts' earnings of $1.10 to $1.28 per share. Allegheny is confident that its year-end earnings will be within its guidance range of $3.80 to $4.10 per share. 

Despite the strong earnings, Allegheny's stock price has dropped over 30 percent since May, and over 5 percent in the past 10 trading days. The drop in energy stock value appears to be driven by softening wholesale power prices. Earlier in the month Lehman Brothers lowered its estimate of Allegheny's 2002 earnings by 12 cents, to $4.03, citing reduced forward power price assumptions. 

The high-flying days of the recent past, where energy companies' price-to-earnings (P/E) multiples were exceeding 50 in certain cases, appear to be over. Many power producers are returning to their roots-scrapping plans for splitting operations and questioning whether more risky overseas operations can be supported by lower prices brought on by a slowing economy and softening wholesale market prices. Paul Patterson, an energy analyst with ABN Amro, said there are common themes affecting the industry: "One is lower power prices and the margins that are associated with them. And two is lower stock prices and the ability to finance more asset driven growth." 

AES Corp. (NYSE:AES ), apparently agrees. Its earnings fell for a second consecutive quarter on poor results from operations in Brazil and Britain and said last Thursday it would revamp its organization and did not rule out selling off assets. AES' Chief Executive Officer Dennis Bakke indicated AES was placing a renewed emphasis on the traditionally profitable, long-term contract generation business. By placing generating capacity into long-term contracts a company is able to provide profit stability during times of flat growth. Just one year ago physical reserve margins in power markets were very low, allowing generation companies to achieve high profits for their product. But with the slowing economy, mild weather and consumer response to the higher prices, power demand for 2001 is flat or even down from one year ago in many parts of the country. 

The recent actions of Constellation, Allegheny and AES likely indicate a fundamental shift in the electric business. Their actions are, in some respects, a return to the past-companies striving for predictability and reliability in their power supply costs, profits and operations. Perhaps most significantly, companies are once again rethinking their strategy in regard to whether or not they will continue to be an integrated business. As Constellation concluded, one way to achieve and maintain a critical mass of business is to remain an integrated company. We would not be surprised if others come to the same conclusion. 


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