Exelon Corp's (NYSE: EXC) plan to acquire Washington, DC-based Pepco Holdings Inc (NYSE: POM), a regulated, wires-only utility, would reduce Exelon's earnings volatility, while offering improved economies of scale to both firms, which operate in neighboring Northeast service territories (See Chart A).
Pepco is one of the largest energy delivery companies in the Mid-Atlantic region, serving about 2 million customers in the District of Columbia, Maryland, Delaware and New Jersey.
Exelon, a diversified energy firm, with both regulated and unregulated divisions, is more than five times larger than Pepco based on market capitalization just prior to the deal's announcement–$31 billion vs. $5.7 billion.
Exelon has operations and business activities in 47 states, the District of Columbia, and Canada. The company has 35,000 megawatts of owned capacity, one of the nation's largest. Exelon’s regulated utilities deliver electricity and natural gas to more than 6.6 million customers.
Chart A: Exelon/Pepco Would Achieve Significant Economies of Scale
Source: Lazard
In its announcement last week, Exelon stated that the all-cash transaction is based on a $27.25 share price that represents a 24.7 percent premium to Pepco Holdings' closing price of $21.85 on April 25. That would value the deal at about $6.8 billion based on the number of outstanding shares reported in Pepco's most recent securities filing.
The deal has been approved by the boards of directors at both companies, but must still be endorsed by Pepco's shareholders. Exelon also agreed to provide up to $100 million–or about $50 per customer–to give Pepco's customers benefits such as rate credits, assistance for low-income c! ustomers and energy-efficiency measures. For a pre- and post-merger breakdown analysis of the firms conducted by investment bank Lazard, which advised Pepco, please see Chart B.
The combination of these two firms would build on strengthening earnings trends for Pepco and give Exelon much-needed regulated earnings support in what has been a very volatile market environment. Exelon stunned investors in early 2013 with a 40 percent dividend cut as a result of weak power demand, low natural gas prices, and greater competition from renewables, the combination of which have been eroding the firm's margins.
Exelon CEO Christopher M. Crane, whose firm's large investment in nuclear power is being undermined by competition from renewable technologies, had promised some major changes last year at the Edison Electric Institute Financial Conference, an annual conference also attended by bankers and analysts.
Mr. Crane said he would be exploring various approaches, including lobbying to remove renewables subsidies, and possibly shutting down non-performing power plants, in what he described as a "shrink to grow" strategy.
In addition to shoring up the firm's finances, this merger is a clear move by Exelon's senior team to mend fences with income investors still seething from last year's dividend cut and the stock's subsequent selloff, as well as to appease other investors who have been demanding immediate strategic action.
Chart B: Exelon-Pepco Combined
Source: Lazard
With Pepco, Exelon will be getting a regulated utility that has been steadily improving its finances in a back-to-basics strategy over the last year, after some unfortunate drags on earnings from non-core businesses with which Pepco's management has already dealt.
With moderate growth in kilowatt-hour sales expected! for the ! remainder of 2014, along with more favorable regulatory decisions and lower operations and maintenance (O&M) expenses, Pepco is on track to generate full-year 2014 earnings per share (EPS) of $1.25, which would be in the upper half of management’s guidance range.
In fact, with regard to kilowatt-hour sales to industrial customers, the regional economy in the company’s primary service area (the District of Columbia, Maryland and Delaware) is stronger than in many other parts of the US, and the new owners would likely be an early beneficiary as the US economy continues to improve. Additionally, a more strategic combination between the regulated Northeast operations of Exelon and Pepco should drive down costs while boosting earnings.
Meanwhile, management has repeatedly said the transaction would provide a "better ability" to fund the existing dividend and that the board would likely be more constructive when looking at the dividend going forward. In other words, this is the usual noncommittal committal that's intended to show that management believes there's a possibility of future dividend growth. Still, these statements are relevant, as management has been silent on this score for several quarters.
Exelon's management also affirmed that post-merger the merchant and utility cash flows will support holding company debt, while the utility would shoulder more debt.
Ultimately, the merger should create more of a 50/50 split between Exelon's regulated and unregulated operations.
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