Ken Silverstein EnergyBiz Insider Editor-in-Chief

The transaction marks another step of creating a group of eight or more major energy/utility companies in this country with market capitalizations of around $30 billion or greater. The models of the merged companies will vary somewhat, but they will generally be a blend of regulated and unregulated assets, will have a broad variety of power sources, and will serve multiple geographic markets. These mergers are occurring because companies with high fixed costs can benefit earnings through sharing and reducing variable costs across their combined operations.

"There should be several other mergers like this, creating a group of major utilities of $30-45 billion in market cap, over the next two years," says James Halloran, Wall Street analyst for National City Bank in Cleveland. "The interesting thing to watch will be when these large utilities try to go to the next level, through another round of mergers and acquisitions, to get to $50 billion and beyond."

Halloran goes on to say the high cost of energy will spawn some public reaction -- and necessitate regulation of these "new breed of large utilities." He expects energy prices to remain above the norm. Utilities will therefore be required to share the cost savings and forego some ability to pass through their costs -- all to ease price shock on consumers. The deregulated side of these merged companies will feel pressure just as thoroughly as the regulated side.

The new FPL-Constellation entity, to be called Constellation Energy, would be the nation's largest competitive energy business. This would be a nice complement to FPL's large generation portfolio that it seeks to market to other utilities and large industrials. All told, the combined company would have 45,000 megawatts of capacity. It would also be the nation's third largest nuclear operation and own a total of seven such plants. Executives of the would-be Constellation Energy, which would serve 5.5 million customers in Maryland and Florida, say that they expect federal and state regulators to give final approval to the deal in the next 12 months.

"This historic transaction will create growth potential for the combined enterprise that exceeds what our two companies could have achieved separately," says Lewis Hay, who would be CEO of the combined company. "It brings together two strong, successful industry leaders with extensive and complementary assets and skill sets, combining the best of the regulated utility and competitive energy sectors. We also will have the second-largest and one of the fastest-growing electric utility businesses in the nation. All of this will be supported by the strongest balance sheet among our industry peers."

Active Year

2005 was an active year for the utility sector. Thomson Financial says that 169 mergers were announced that were valued at $66 billion. That's second only to the year 2000, which saw 184 deals valued at $77 billion. Some of the bigger ones: Duke Energy's $9 billion bid for Cinergy, NRG's $6 billion offer for Texas Genco and Berkshire Hathaway's $5 billion buy of PacifiCorp.

Both FPL Group and Constellation Energy have delivered shareholder value outpacing both the Dow Jones Electric Index and the S&P 500 since year-end 2001. FPL Group has provided total shareholder returns of about 77 percent since year-end 2001, and Constellation Energy has provided total returns of more than 160 percent over the same period. Mayo Shattuck, who led Constellation and who would be chairman of the new company says that each company has maintained strong balance sheets and even during the industry's darkest years. Constellation, a huge energy trader, was able to stay above the fray because it took a conservative approach, he says.

Traditionally, mergers and acquisitions in all segments of the economy have stumbled, largely because the expected synergies didn't pay off and the corporate cultures didn't mesh as well as expected. But corporate officers say that they have learned from past mistakes and have incorporated such tough lessons into their pre-merger thinking. Ditto for utilities, which have high fixed capital costs that might be better managed if they are spread over a broader geographical base.

Reduced Debt Levels

Utilities have hunkered down and have reduced their debt levels, largely by selling troubled assets and participating in a low interest rate environment. The efforts have paid off: The Dow Jones utilities index grew by 23 percent in 2003 and by 25 percent in 2004. In 2005, the index was up more than 20 percent -- a trend that could be buoyed by higher electricity prices and new investments in transmission reliability and renewable energy technologies. The market, in fact, is putting pressure once again on utilities to grow their earnings and dividends. And one way is through acquisitions that can create economies of scale and potential cost savings.

Shareholders are pressuring the utilities with the most resources to grow their earnings beyond the 2-4 percent they have typically gotten. The valuations now being placed on assets are much more realistic than they were at the height of the previous merger boom in the 1990s. Companies, furthermore, are buying assets to win new efficiencies and to reduce operating costs.

Barry Abramson, a Wall Street analyst with Gabelli Asset Management says that FPL and Constellation are a good fit because their respective strengths -- trading and generation -- are complementary. He acknowledges that oftentimes companies pay too much to acquire others and therefore end up with too much debt. But, FPL is buying Constellation by issuing stock and will end up preserving its strong balance sheet, he says.

"This deal is another indication that the industry is back on its feet," says Abramson. "Other mergers will follow."

Needless-to-say, the utility industry is more cautious than it was during the hey-day of the 1990s. And companies say that their approach to merging is more thoughtful, all with the aim of realizing expected future benefits such as cost savings and complementary features. It's up to the market, though, to determine if bigger is ultimately better.

For far more extensive news on the energy/power visit:  http://www.energycentral.com .

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