Last week, Exelon (EXC) surprised investors by announcing its intention to buy Pepco Holdings (POM). Intentions are one thing, and execution is another. I believe the odds of Exelon's deal closing are less than 50%.
Many investors think of Exelon as a play on deregulated nuclear power. There is a good reason. Exelon operates 23 nuclear generating units at 14 locations in Illinois, Pennsylvania, Nebraska, New York, New Jersey and Maryland. The 23 units have the capability to generate 22,000 megawatts of nuclear power, which is far more than any other investor-owned utility.
While Exelon is a nuclear utility, it is also a local distribution company and a world-class energy services company. It owns and operates three separate local distribution utilities in Illinois, Pennsylvania and Maryland. These subsidiaries are fully regulated, and each earns a government-guaranteed return.
- ComEd is a regulated electric distribution company, and it is one of Illinois' largest utilities. It owns more than 70,000 miles of electric transmission and distribution systems. It serves 3.8 million electric customers.
- PECO is a regulated gas and electric distribution company, and it is one of Pennsylvania's largest utilities. It owns more than 29,000 miles of electric transmission and distribution systems. It also owns 6,600 gas lines. It serves 1.6 million electric and 490,000 natural gas customers.
- BGE is a regulated gas and electric distribution company, and it is Maryland's largest utility. It owns more than 26,000 miles of electric transmission and distribution systems. It also owns 7,100 gas lines. It serves 1.2 million electric customers and 655,000 natural gas customers.
Combining ComEd, PECO and BGE provides Exelon with a large footprint in the regulated utility business. Considering that Exelon previously announced plans to retire several of its 23 nuclear units, the company's investment profile would change to that of a predominantly regulated utility. Buying Pepco Holdings would cement that change, and if the deal is successful, it would diminish Exelon's exposure to the merchant nuclear power business.
On the surface, it makes sense. Exelon appears to be following the lead set by Dominion Resources (D) and Duke Energy (DUK); they appear to be dumping merchant assets and running for regulatory cover.
Pepco Holdings is a relatively simple enterprise. It has limited exposure to merchant power. It owns three separate local distribution companies and a small energy service company.
- Pepco is a regulated electric distribution company. Its franchise covers the District of Columbia and portions of Maryland.
- Delmarva Power and Light is a regulated gas and electric distribution company. Its franchise covers the portions of Maryland and Delaware.
- Atlantic City Electric is a regulated electric distribution company. Its franchise covers southern New Jersey.
- On a combined basis, transmission and distribution systems owned by Pepco Holdings consists of about 4,600 circuit miles of transmission, 35,000 circuit miles of distribution, a liquefied natural gas facility, 100 pipeline miles of natural gas transmission mains, 1,800 pipeline miles of natural gas distribution mains and 1,300 pipeline miles of natural gas service lines.
Here is the interesting part. All three of Pepco Holdings' regulated utilities operate adjacent to two of Exelon's regulated utilities: PECO and BGE.
On the surface, it seems like a marriage made in heaven. Pepco Holdings' footprint snuggles neatly into Exelon's service area like pieces in a puzzle. That presents the opportunity and the hurdle for Exelon.
However, for this merger to close, a long chain of approvals is required. Included are shareholder approvals from both companies, federal approval and states' approvals. As Entergy (ETR) and ITC Holdings (ITC) learned, any single failure in that chain would prevent the deal from closing.
If you think you have seen this movie before, you are right. When Exelon acquired BGE's parent company in 2012, the state of Maryland threatened to disapprove unless Exelon paid a heavy price.
However, that is not the original screenplay. Pepco tried to merge with BGE in 1995. That merger failed. Again, Maryland was the problem. As The Baltimore Sun reported, "BGE and Pepco claimed that the corporate marriage would save $1.3 billion, savings that they hoped to split evenly between customers and shareholders. [Maryland] Regulators, however, ordered BGE and Pepco to give customers 75 percent of the savings." Because Maryland attempted to harvest most of the merger's benefits, BGE and Pepco called their deal off.
In addition, Pepco Holding' financials are chronically weak. Cash flow from operations has been declining. The company's payout ratio has been chronically unhealthy. Its only unregulated subsidiary, Pepco Energy Services, has a decade-long disappointment.
Pepco Holdings' prospects for improving its financial condition are slight. State regulators hold most of the keys to the company's financial health, and they have been unwilling to rubber-stamp rate increases.
What is striking is Exelon's timing. It has been warning about the health of its nuclear fleet, saying that it could be retiring perfectly good nuclear plants because those plants cannot achieve earnings. At the same time that Exelon warns of potentially massive write-downs in its nuclear business, it announce its intentions to buy Pepco.
It seems that Pepco Holdings shareholders might want to exit now. The Exelon-Pepco deal is not going to get any better. In fact, the tough news has yet to arrive. This merger is not a slam-dunk.