Constellation Energy: Lots of Spark
By Craig Shere, CFA
Shares of electricity supplier Constellation Energy Group (CEG; recent price, $38.00) haven't generated much of a return for investors thus far in 2004, with the stock down 3.2% through June 18. We at Standard & Poor's Equity Research Services 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 EPS growth.
Constellation has been unfairly tainted by these concerns, in our view. We believe that it has a low-cost position in unregulated wholesale electricity generation, enjoys a stronger credit rating than most competitors, seeks to fully hedge its commodity price risks, and has positive free cash flow after capital expenditures and uses of working capital. Based on its below-average valuation multiples and above-average EPS growth rate, we've assigned the stock our highest investment recommendation of 5 STARS, or buy.
Alternative investment choices in the energy-merchant segment are limited, in our view. 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.
ADVANTAGES IN COMBINATION.
Constellation has three main interrelated business segments: regulated utility operations, conducted through Baltimore Gas & Electric; unregulated electric generation; and competitive wholesale (Power Source) and retail energy supply (NewEnergy). Unregulated electric generation and competitive supply are reported together as Merchant Energy, which contributed 67% of 2003 segment operating income. BG&E served almost 1.18 million electric customers and 617,500 gas customers at the end of 2003.
Important synergistic relationships exist among Constellation's three primary segments, in our opinion. Power Source and NewEnergy meet their 2004 contracted customer load-serving requirements of 27,300 megawatts through the use of the company's 12,500-Mw unregulated generating portfolio and third-party supply contracts. In turn, the generating portfolio is able to make strategic acquisitions of power plants (replacing third-party supply) where Power Source and NewEnergy have signed long-term contracts, knowing that the price of electricity from new plants is already hedged.
Meanwhile, BG&E obtains fixed-price power from Merchant Energy's Mid-Atlantic generating fleet (i.e., operating power plants) for customers that have not switched to competitive suppliers. The Mid-Atlantic fleet's location and types of fuel provide competitive cost advantages for serving BG&E's load requirements and the needs of Baltimore area customers selecting competitive suppliers.
BG&E's fixed-price service (which is below current market prices for electricity) will transition to competitively bid market pricing in July, 2004, for commercial and industrial (C&I) customers and in July, 2006, for residential customers. We see expanding profit margins for Energy Merchant's power supply sold in the BG&E service area as customers move from fixed-rate pricing. These gains should at least offset, in our opinion, declining competitive transition charges (expiring in 2007), which the utility is collecting from ratepayers.
A major factor in our estimated 10%+ EPS growth rate for Constellation is its success at gaining share in the expanding market for competitive 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.
We attribute Constellation's weak year-to-date performance and below-average price-earnings ratio, price-to-book, and price-to-cash-flow multiples to investor uncertainty about expanding energy-merchant operations and the company's ability to sustain EPS growth. Underscoring these concerns, Standard & Poor's Ratings Services downgraded Constellation's long-term corporate rating to BBB+, from A-, in late March, 2004. In an Apr. 15 report, S&P Ratings explained that the company's "Financial measures have improved and the improvement is expected to continue," but that "it is difficult for energy merchants to achieve a rating in the A category" because of inherent business risk. But we see its business model as fundamentally safer than historical energy-merchant models.
We think it is understandable that equity investors and rating agencies would take a cautious view toward Constellation's initial success. If we are correct, investor concerns should fade over time, as it continues to generate steady earnings and cash-flow growth.
We look for an expanding economy and the retirement of less-efficient and more heavily polluting power plants to lead to widening power margins. 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.
Prospects for increased power margins relate primarily to the profitability of gas-fired energy-merchant plants. However, as of the end of 2003, 51% of Constellation's generating fleet was comprised of low-cost nuclear and coal facilities. During 2003, 86% of the electricity produced by Constellation was created by its nuclear and coal plants. By Craig Shere, CFA
HOW PRICING WORKS.
We look for output from Constellation's nuclear facilities to increase annually through 2008, due to the June, 2004, acquisition of the 495-Mw Ginna nuclear power plant for $408 million, as well as investments to increase the capacity of Constellation's three nuclear facilities by another 276 megawatts by 2007.
Since they are the last plants to be called on to run, natural gas-fired facilities generally set the price for market power prices in many regions of the U.S. Accordingly, nuclear and coal plants tend to enjoy higher margins during periods of increased natural gas prices. We expect Constellation to continue to benefit from historically high natural gas prices at least until 2007, when new liquefied natural-gas import facilities enter operation. It is also able to manage commodity-price changes better than many competitors, with more than 30% of its nonnuclear fleet capable of running on more than one fuel.
Constellation believes it's the nation's largest provider of competitive retail C&I energy services, with a 16% share in a highly fragmented market. By 2006, Constellation expects to achieve a 21% market share. This growing market leadership, in our opinion, will be compounded by growth in the underlying market. As of late 2003, about 30% of the C&I market that had the right to select competitive suppliers (rather than remain with the local utility) had done so. Over the four years ending in 2006, Constellation expects the switched C&I market for power to grow 50% and for natural gas to grow 16%. These forecasts imply a near doubling of Constellation's competitive C&I customer load from 2003 to 2006. Competitive pressures may lead to narrower margins, but these should be mitigated by high natural-gas prices and the absorption of excess generating capacity over time.
Two final competitive distinctions between Constellation and more traditional energy merchants worth noting: It has significant regulated electric and gas utility operations and retains a stable investment-grade credit rating.
AT A DISCOUNT.
The main difference between our 2004 operating EPS estimate of $3.25 and our Standard & Poor's Core Earnings estimate of $3.34 is the exclusion of 16 cents of synthetic fuel tax credits relating to previous periods. Constellation had postponed the recognition of tax credits for a synfuel plant purchased in 2003, pending a private letter ruling from the IRS. Contributions from the synfuel plant are partially offset by the full expensing of employee stock options under our Core EPS methodology. We project a narrowing of the differences between our operating and Core EPS estimates in 2005, under the assumption that employee stock options will begin to be expensed. Core EPS estimates reflect only minor net adjustments for pension and other post-employment benefit expenses in 2004 and 2005.
Constellation is priced at a significant discount to its peers. Based on price to trailing 12-month operating cash flow, the stock is trading at a multiple of 5.5 times, vs. diversified multi-utilities, at almost 6.4, and more regulated utility peers, at almost 8.6. Based on price-to-book, Constellation is valued at 1.5 times, versus more than a 1.7 average for both multi-utilities and more regulated peers. Its 2005 p-e multiple of 10.7 stands in sharp contrast to multi-utilities at 12.0 and more regulated peers at 13.8. Finally, its shares trade at a p-e to growth (PEG) ratio of about 1.2, versus PEGs of about 2.0 for the S&P 500 and nearly 3.0 for the more-regulated utility group.
Our discounted cash-flow analysis suggests that Constellation is trading about 13% below its current fair value. Compounding our fair value forward at our assumed 11.3% cost of equity less a 3% dividend yield, we arrive at a 12-month target price of $46, more than 20% above its current market price.
Assuming Constellation would be fairly valued at the current average 2005 diversified utility p-e of about 12.0 and that the stock should appreciate in line with EPS growth, we again arrive at a 12-month target price of $46.
Risks to our recommendation and target price include the company's need to hedge contracted electric-load obligations, increased competition in wholesale power and retail C&I energy markets, the successful implementation of plant upgrades and enhancements to boost generating output, and a possible long-term decline in power prices. If Constellation is unable to fully hedge its contractual customer commitments, and energy prices move against it, the company could be faced with significant short-term losses. While the inability to hedge prices for power from owned generation can lead to significant fluctuations in margins, we see limited exposure to losses from owned generation, due to the low variable cost structure of most of its generating fleet.
We believe the greatest risk that energy-merchant operations face is a "credit cliff," where counterparties no longer have confidence that an energy merchant will fulfill its bilateral contractual obligations. When such a crisis of confidence occurs, we think that counterparties are much less likely to do business with an energy merchant and much more likely to demand onerous collateral to secure existing agreements. Energy merchants experience such a crisis of confidence when significant losses are incurred from unhedged contractual commitments or generating assets. The impact of such operating difficulties are exacerbated if an ensuing crisis of confidence leads to lost market share and liquidity strains relating to collateral demands.
Solid investment-grade credit ratings are very important to energy merchants. A weakening credit rating can lead to a crisis of confidence or fuel already developing concerns about an energy merchant's sustainability. Investors should pay close attention to changes in short-term liquidity for companies engaged in unregulated energy-merchant operations.
SOOTHING THE MARKET.
The new energy-merchant model Constellation has developed is not easy to execute. However, we believe management has shown the capacity to navigate the most treacherous of terrains and that the market has overestimated probable long-term risks inherent in Constellation's business. We believe methodical operating growth over the next year or two will go a long way toward dispelling much of the market's concerns -- and boosting Constellation's share-price multiples.
Analyst Shere follows multi-utilities stocks for Standard & Poor's Equity Research Services