Michigan GREEN - Consolidation Coming

November 14, 2008

Exelon Corp. is eyeing NRG Energy. But NRG is playing hard to get and may be waiting for a more attractive suitor. Exelon, though, is determined and now says that it will take its $6.2 billion directly to the merchant power generator's shareholders, adding that it will sue NRG's management because it allegedly did not give the bid proper consideration.

A down economy generally leads to greater consolidation across the business spectrum. The utility industry is no different. During such times, those with the financial resources are well-positioned to make strategic acquisitions. Chicago-based Exelon, however, has been jilted before. Essentially, it likes Princeton, N.J.-based NRG because it owns a fleet of productive and unregulated generation assets that it says can immediately add shareholder value -- in a way that can avert a jaundiced look from state regulators.

State regulators previously thwarted Exelon's bid for New Jersey-based PSEG Inc. The authorities there said that deal would have given the combined company too much market power. For its part, Exelon owns unregulated power generation throughout the country, including the country's largest fleet of nuclear facilities. NRG has more than 24,000 megawatts comprised of market-based coal and natural gas generation located mostly in Texas and New England.

"An Exelon-NRG combination would result in a total enterprise value of approximately $60 billion with a generating capacity of around 47,000 megawatts, or enough electricity to serve nearly 45 million homes," says John Rowe, Exelon's CEO. "This combination would not only diversify Exelon's generation portfolio geographically, it would also create immediate earnings and cash flow accretion. We believe a combination of Exelon and NRG would represent an exceptional value for shareholders of both companies."

Rowe acknowledges that overcoming the scrutiny of state public utility commissions won't be easy. To do so, Exelon would have to shed some power generation to avoid the sharp criticism that it would then hold excessive market power. In any event, the combined power company would become the nation's largest.

NRG, however, has rebuked Exelon's offer. Exelon had offered $26.43 per share based on the Oct. 17 closing price. While that bid adds a 37 percent premium, it is still considerably less than NRG's 52-week high of $45 a share. NRG's board unanimously rejected the foray and called it "manifestly undervalued." It cited the company's "exceptional liquidity and cash flow generation" and saying it has "huge upside potential."

In making the offer, Rowe says that Exelon considered the discrepancy in NRG's share price over the last year. He prefers to emphasize NRG's rich opportunity -- to tap into Exelon's growth potential. While NRG says that its future as a stand alone company is excellent, it may be just posturing and holding out for a better price from either Exelon or another utility.

Short Generation

Unregulated power producers like NRG took a beating in the early part of the decade. They built too much power generation in the anticipation that energy demand would just keep rising. They then got in a bind when they were unable to recoup their costs. As a result, NRG spent seven months in bankruptcy in 2003.

Much of that group has emerged from those tough times. The demand for power eventually caught up with the amount of capacity, enabling these companies to retrieve fair values for their output. But as individual enterprises they lack the financial wherewithal and the size to increase productivity and efficiencies. That had been the main reason why NRG sought to buy Calpine Corp. earlier this year for nearly $10 billion -- a deal that Calpine struck down, saying the offer was "inadequate."

Through consolidation, independent power producers can achieve gains -- all within the context of expected generation shortages combined with projected upticks in demand. Risks still exist, however, as uncertain regulations, creeping construction costs and a serious credit crisis dampens the economy. Already such conditions have led to Warren Buffet's bid for Constellation Energy and to Reliant Energy putting all or a portion of itself on the auctioning block.

"Exelon's move toward the unregulated independents is not part of a trend but you will see more consolidation generally speaking," explains James Halloran, Wall Street analyst for National City Bank in Cleveland. "There will be a move toward bigger names."

The country is short generation, Halloran adds. And it is becoming increasingly difficult to build base-load generation that runs constantly, typically fossil-or-nuclear-fueled. That puts a premium on those facilities. Because NRG owns modern, unregulated and base-load facilities, it becomes a catch for any company with deep pockets. "Certainly, some others will be amenable to doing similar deals."

In the case of an Exelon-NRG combo, CEO Rowe says that the transaction would create synergies adding up to $3 billion in value. That would reflect annual cost-cutting measures that equate to 3-5 percent of the would-be entity's operating expenses. He says that the shareholders of both utilities would benefit from those economies of scale.

NRG disagrees that the shareholders of both companies would benefit, saying that the deal is one-sided while chastising Exelon for trying to negotiate in public. It says, however, that it believes in "consolidation" between willing buyers! and sellers. Exelon says that the potential merger would be the right deal and the right time, allowing each company to benefit from the other's strengths.

This saga will likely continue. Current economic conditions are helping to drive that offer. But so are market fundamentals that point to higher future demand and tougher regulatory standards. While the eventual outcome of this proposition is unknown, it does appear that the utility industry generally will merge.

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