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Wednesday, September 24, 2008

Buffett buys Constellation

(Source: Constellation Energy Group 2007 Annual Report)

No, it's not AIG even though there were talks that it could be, but Constellation Energy Group (CEG). In its website (http://www.constellation.com/) CEG describes itself as "A Fortune 125 competitive energy company based in Baltimore", "The nation’s largest supplier of competitive electricity to large commercial and industrial customers", "The nation’s largest wholesale power seller", "A major generator of electricity with a diversified fleet of power plants strategically located throughout the United States", etc., and 2007 highlights include "Provided a 52 percent total return to shareholders, assuming reinvestment of dividends", etc. In essence, a very large, apparently very profitable utility stock in the S&P500, and yet the share price got whacked hugely from a 52 week high of $107.97 on Jan 8, to a low of $13 on Sep 16, before Buffett steps in on Sep 19. Des Moines, Iowa-based MidAmerican which is owned by Buffett will pay $26.50 per share in cash for Baltimore-based Constellation. This puts the deal at $4.7 billion and MidAmerican has also given CEG an immediate $1 billion infusion after shares of the nation's largest wholesale power seller plummeted and until then, liquidity concerns had analysts worried it would go out of business.

On the surface, $26.50 isn't the best deal. The French electricity giant Electricitie de France's (EDF) has revealed that last week it teamed with the private equity firms Kohlberg Kravis Roberts and TPG Capital to make a bid of $35 a share for Constellation. That's $8.50 more than the $26.50 Constellation agreed quickly with Buffett. Apparently, the EDF's bid is "still valid.", since despite Buffett's $1 Billion injection last Friday, the deal isn't a completely done deal. According to a source, "In the end, it'll be up to (Constellation) shareholders to decide. EDF hopes they'll opt for the best price." Whilst the boards of both MidAmerican and CEG have approved the deal, the shareholders and regulators have yet to sign off. The transaction is expected to close within nine months.

The capitulation on CEG's share price happened on Tuesday, Sep 16, when the stock plummeted more than 50 percent before recovering somewhat in the afternoon. Analyst reports were out like vultures as usual. The next day, Standard & Poor's Ratings Services placed Constellation's investment-grade "BBB" debt ratings on CreditWatch "developing," meaning they may be revised higher or lower, or maintained. S&P said Constellation needed to shore up its balance sheet in the face of a broad loss of market confidence by closing a $2 billion credit facility, getting an infusion of $750 million to $1 billion of new equity, and selling assets -- or by selling the company outright. S&P said the inability to execute on a transaction or a series of transactions in the very near term would cause a downgrade to sub-investment grade. That would force the company to post an additional $3.3 billion in collateral, which is beyond the company's current available liquidity. That would put the company out of business. Citi Investment Research analyst Greg Gordon said in a report Wednesday that Constellation would have to settle for the best deal it could even though it may be less than the company's intrinsic value, much like Merrill Lynch & Co. did when it agreed to be bought by Bank of America Corp. recently.

So, why didn't CEG accepts EDF's offer when it plans to pay higher at $35 bearing in mind, EDF already owns almost 10 percent of Constellation and is a joint venture partner in the construction of four new nuclear power plants? The answer seems to boil down to 3 things. First, Buffett is a fast mover and a lot less bureaucratic than everyone else - he can make a major decision for Berkshire in less than 5 minutes. Second, he can immediately inject $1 Billion into any entity without the red tapes that everybody else has to go through. Third, there simply isn't any white knight stronger or as reputable as Buffett. Constellation Chairman & CEO Mayo Shattuck called the MidAmerican deal "the best overall solution for all our stakeholders." and added "Regardless of how you might interpret the various sources of a billion dollars of equity, there was no question in our minds that the billion dollars of equity coming from this source (Berkshire), with this backing and this history, meant a lot more than it would have in some other cases." The WSJ's Deal Journal calls it the "power of Buffett. Nothing soothes like Buffett's involvement. In a volatile world, he is as close to a sure thing as the finance world sees."

However, it will not be plain sailing for CEG and Buffett from here onwards. Everything that Buffett does "looks easy" but in reality is fraught with great danger, unless you really and absolutely know what you are doing. A shareholder lawsuit filed Tuesday calls into question the $4.7 billion sale to MidAmerican. “The price isn’t right and the process isn’t fair,” said John Isbister, an attorney with Baltimore-based Tydings and Rosenberg, the law firm that filed the suit. The action came as at least four other lawsuits were filed opposing the deal, and state lawmakers continued ratcheting up the rhetoric, calling for state regulators to reject the union with the Warren Buffett-owned company. Yes, Buffett may have bought at close to rock bottom prices which some say are perhaps only a quarter of its intrinsic value, but he buys when everyone is completely afraid (see the obvious 50% capitulation in price in one day in the chart above), and even then, it's still not plain sailing from here onwards. But in typical Buffett deal, he has nothing to lose - either he gets Constellation or he gets a $200m payment if he has to walk away. The desperation to secure a quickfix at Constellation was such that the company agreed to pay Mr Buffett a break fee of $175m plus another $25m for any fees and expenses incurred.

So if EDF's higher bid finally wins the day - and the French have until the Constellation shareholder meeting in December to convince the board - then Mr Buffett will get $200m and will have made a 20 per cent return on the $1bn cash injection he has paid into Constellation's account.

And what did yours truly did last night? He dipped his little toe in and followed Buffett by buying a small amount of CEG at $26.30. The stock price fell a little last night, to close at $26.11. Shucks. Never mind - no one can consistently buy at the bottom, especially when I simply haven't heard of CEG until recently, and simply don't monitor the US markets on intra-day basis (which is really intra-night and intra-morning here in Malaysia). And in the extremely unlikely scenario that should CEG reject both Buffett and EDF, then, I'm "hoping" the share price will at least go up higher than my cost **grin**. If I close both eyes (ignore the 20% factor and the time value of money), I can console myself that I did buy slightly cheaper than Buffett at $26.30 vs his $26.50! **grin**

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