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As the second-largest provider of electricity to the United States, Constellation Energy Group Inc. (NYSE: CEG) has a 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 (PSC) 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 PSC 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.
Shares of Constellation Energy closed Friday down 1.45%, or 47 cents, at $31.84. The stock earlier this month hit a 52-week high of $33.37 after falling to a 52-week low of $15 in March.
Recommendation: Hold Constellation Energy Group Inc. (NYSE: CEG) (**).
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in Constellation Energy Group Inc.
[Editor's Note: Veteran Wall Streeter Horacio Marquez is the author of Money Morning's hugely popular "Buy, Sell or Hold" series, and is also the editor of the longstanding "Money Moves Alert" trading service.
In a new free report, Marquez has identified a category of stocks he has labeled "rocket stocks," which display key characteristics hinting that they're ready to move. One such characteristic: Heavy insider buying. In fact, one particular sector right now is seeing especially heavy insider buying – and many investors will be surprised to discover just what sector it is, and what companies top executives are buying into. For a free report that details these "rocket stock" plays, and that outlines this torrent of insider buying, please click here.]
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