Driven to merge

In the end, Potomac Electric Power Co.'s future was determined largely by its size.

Surrounded by behemoths such as Virginia Power Co., Pepco's relatively limited area and small customer base made the Washington-based power company a likely target for a takeover in an industry that is aggressively moving toward competitiveness.


But by agreeing last month to merge with Baltimore Gas and Electric Co. to form the nation's ninth-largest utility, nearly 100-year-old Pepco ensures both that it will be in the vanguard of industry trends and to a certain extent control its destiny.

"BGE puts us in a position where we can be at the table with much larger utility companies, that neither Pepco nor BGE could do alone," said John M. Derrick Jr., Pepco's president and chief operating officer and the person designated to hold that title in the merged company. "Neither of us was particularly comfortable with the sea of big guys around us."


Indeed, industry experts and analysts say that sweeping changes being mandated by the federal government will result in tremendous consolidation, making Pepco -- and players like it, with fewer than 1 million customers -- vulnerable despite its nearly $7 billion in assets and a prosperous but limited geographic territory including Washington and its Maryland suburbs.

The industry's survivors, the analysts contend, will be the industry Goliaths that control vast geography and can generate savings through size, allowing them both to compete and to fend off hostile raiders. Pepco, with a shrinking urban core and mature suburbs, was unlikely to sustain any measurable growth in the coming years.

"There is a strong view out there that as competition becomes prevalent, bigger is better," said Bruce G. Humphrey, director of research for Cambridge Energy Research Associates, a Massachusetts-based industry consulting firm.

But the reasons for the pending corporate marriage go far beyond the fact that Pepco's 640-square-mile territory borders BGE's. More important to the fit are the shared management styles, corporate cultures and philosophies of the two utilities -- and the desire by Pepco to be proactive regarding pending industry changes.

"They just fit exceedingly well," said Doug Kimmelman, a Goldman, Sachs & Co. vice president and head of the investment banking firm's utility department who advised BGE in the merger talks. "Most importantly, they share a vision of the changes that are taking place in the industry, and the need to drive costs down. I think there are a lot of synergies to be gained."

Pepco's need to merge to survive has become the subject of intense debate within the industry since the strategic alliance with BGE was announced. Despite its small customer base of 670,000, Pepco had prospered for years through efficient management and adherence to conservative financial principles.

"When I was in the Massachusetts Public Service Commission, we used to use Pepco as the comparable utility and a model for a well-run company," said Lawrence D. Crocker, acting general counsel for the Washington Public Service Commission.

It also benefited from the Washington area's explosive growth as suburbs mushroomed in Prince George's, Montgomery and Charles counties, posting a historically solid financial performance. Today, more of Pepco's residential customers live in the suburbs than in the city of Washington.


But Pepco's performance has slipped of late. Last year, Pepco reported its net income fell 6 percent from 1993, to $227 million, on revenues of $1.8 billion. It also posted losses in the first two quarters of this year, the result of a more than $100 million after-tax charge Pepco took to eliminate an airplane leasing subsidiary -- one of the company's few daring ventures.

Stock slipped, dividend held

The stumble hurt the company's stock, which slipped from its 1994 high of more than $26 in January to $18.375 by the end of the year, and the stock continued to trade under $20 until merger rumors pushed it higher in the late spring.

Still, Pepco maintained its $1.66 per share dividend last year, despite criticism from some analysts who worried that the high payout ratio would eventually strain Pepco's ability to pay.

"Financially, there's nothing present now that would raise red flags, but a couple of years from now they could have faced real problems because of their dividend," said Alex Hart, a utility analyst with Ferris, Baker Watts Inc., in Baltimore.

"Pepco will be the larger beneficiary, at least in the short term, because they could have faced cash-flow pressures in the future. So the combination brings them some much-needed financial flexibility."


As have other utilities, Pepco has embarked on an intense cost-cutting campaign that has partially offset its earnings slump. Since 1989, the company has eliminated more than 700 employees, or more than 15 percent, of its work force, which now numbers 4,500.

Other expenses have been trimmed as well. Pepco shaved $555 million from its construction budget in the past two years and refinanced $1.1 billion in debt since interest rates began to dip three years ago.

But what has really differentiated Pepco from other East Coast power concerns is its ability to produce electricity at a lower cost than most competitors. Pepco's six fossil-fuel generating plants, scattered throughout Prince George's, Montgomery and Charles counties and Washington, consistently rank among the top 10 generating facilities in the country for efficiency.

"Pepco is a better low-cost provider of power than BGE is right now," said Ronald S. Tanner, a utility industry analyst with Legg Mason Wood Walker Inc., the Baltimore investment firm. "I can't believe the merged company won't adopt some of their techniques to save money."

In addition, Pepco is set apart by its highly residential/commercial customer base and its unique No. 1 customer -- Uncle Sam. The federal government accounts for 20 percent of the utility's business -- a fact that is both a blessing and a curse, analysts say.

The blessing is that the government has been not only a stable but also an expanding customer for years; the curse is that such a big chunk of its revenue is threatened by the Republican-dominated Congress' stated goal of shrinking government.


And Pepco courts the federal government assiduously, with accommodations such as free energy audits, $4 million in rebates since 1991 for upgrades to more energy-efficient equipment and other studies aimed at saving the feds money.

"They treat us like the big customer that we are," said Steven R. Williford, chief of maintenance and energy for the U.S. General Services Administration region, which includes Washington. "They always try to accommodate us."

The primary reason for the doting service is to protect Pepco's largest customer from other utilities anxious to take advantage of changing laws through long-term, wholesale contracts. Pepco, in fact, is negotiating its own long-term deal to secure the GSA, Mr. Williford said.

Rate requests criticized

But if Pepco bends over backwards for the government, that's often not the case with consumers, critics say.

Residential customers and the D.C. People's Counsel -- a government-sponsored citizens advocate -- have reportedly hammered Pepco for seeking what they consider exorbitant rate increases.


Most recently, the D.C. Public Service Commission in late June awarded Pepco a 4 percent rate increase, shy of the 9 percent the company sought but worth $28 million a year.

"They rarely get everything they want," said Mr. Crockett, the D.C. PSC official. "Rate increases are an emotional issue, though, and it's the nature of a litigious atmosphere like a rate case that attracts strong feelings by opponents."

To illustrate the point, between 1991 and 1994 Pepco received approval for rate increases of $83 million, a fraction of the total amount requested.

Elizabeth A. Noel, People's Counsel for the District, declined to comment on her feelings about Pepco, other than to say she has "concerns about the implications of the merger in regards to depriving rather than suppling District residents with alternatives for electricity."

To dissipate the acrimony caused by rate cases, Pepco has donated time, energy and money to the community. As BGE does in Baltimore, Pepco represents one of the largest charitable contributors to various Washington organizations, including the YMCA, the United Way and area schools such as Washington's Dunbar High, a pre-engineering school where Pepco provides scholarships and directs mentoring programs.

Help for poorer customers


Additionally, Pepco implemented a program in 1982 to discount a portion of low-income residents' electric bills by 25 percent. Some 14,000 Pepco customers now participate, said Nancy S. Moses, a Pepco vice president and spokeswoman.

Pepco's biggest philanthropic contribution, however, began in 1987, when it created a group known as Action to Rehabilitate Community Housing. Since then, the nonprofit group has bought dozens of houses and upgraded them with other charities, and weatherized nearly 20,000 homes.

ARCH, which Pepco spun off last year but continues to fund with a $1 million annual donation, also has trained more than 600 unskilled adults to rehabilitate housing.

Although there are plans to shift the headquarters to the Annapolis area when the $2.9 billion merger with BGE is completed by March 1997, Mr. Derrick insists that Pepco will continue to be a strong member of the Washington establishment.

Pepco has also managed to patch up past differences with its work force.

"We have a very problem-solving-oriented relationship," said Jim Hunter, president of the International Brotherhood of Electrical Workers Local 1900, which represents Pepco employees. "If there's a problem, we sit down and talk about it, and they give business reasons for why the view it as a problem. We both


realize it's to everyone's advantage to work toward a common goal."

Labor difficulties

It wasn't always that way, though. As late as 1989, IBEW members threatened to strike Pepco, as they had four years earlier, because of strained relations. Mr. Hunter credited a change in union leadership and Mr. Derrick's promotion to president with changing attitudes on both sides.

And in March 1993, Pepco paid $38.4 million to settle a discrimination suit brought by black and female workers and applicants. The case, which drew national attention, also forced the utility to alter its hiring and personnel procedures.

Company executives say that after the merger the combined work force will be given the opportunity to decide whether to be represented in the future. BGE, traditionally nonunion, is expected to resist any efforts at organizing.

In addition to having to contend with labor problems, Pepco has had other setbacks, namely with its unregulated subsidiaries.


In May, Pepco took a $124 million charge against earnings to divest itself of a money-losing airplane-leasing business run under the umbrella of its Potomac Capital Investment Corp., a nonregulated subsidiary. Last year, the leasing activities caused Pepco's subsidiary to generate a disappointing 7 percent return on equity.

"Pepco has made some real mistakes with its nonregulated subsidiaries, but they're working to correct them," said Gary F. Hovis, a utility analyst with Argus Research, in New York. "But of the 98 publicly held utilities in the U.S., I'd still rank Pepco in the top 10 percent in terms of management. They have experience, as well as depth."

By March 1997, Pepco intends to sell 13 aircraft and end its involvement in the subsidiary, in which it has invested $700 million.

Although various analysts have pointed to Pepco's failure in the airline leasing business and its subsequent drain on earnings as a motive for its merger with BGE, Mr. Derrick dismisses the notion.

"Both of us focus on the fundamentals of the business," Mr. Derrick said. "The things we could see and feel were clearly compatible."

Through the merger with BGE, Mr. Derrick said, Pepco will immediately benefit from its partner's advanced customer service system.


Large commercial customers such as Giant Food Inc. that deal with both utilities say BGE currently has the edge on Pepco when it comes to providing the highest level of service.

Pepco also is expected to attempt to compete in the natural gas business, a new area for Pepco, using BGE's experience to battle Washington Gas Light Co. for customers.

Conversely, Mr. Derrick believes BGE will gain from Pepco's added territory, where it will have the ability to expand its retail and home products divisions, as well as the development of energy control techniques that contribute to Pepco's generating efficiency.

"We were faced with a decision," said Edward F. Mitchell, Pepco's chairman and chief executive, at the BGE merger announcement.

"Do you remain small, or do you look aggressively for alternatives?"

Potomac Electric Power Co.


Headquarters: Washington

Employees: 4,500

Chief executive: Edward F. Mitchell

Businesses: Power generation and supply, investment in marketable securities, airplane leasing, solar energy development, real estate holdings, energy management services, wireless data communications.

Commercial electric customers: 70,737

Residential electric customers: 601,400


1994 Revenues: $1.8 billion

1994 Earnings: $227.1 million

Power plants: Benning Generating Station, Washington; Buzzard Point, Washington; Chalk Point, Prince George's County; Dickerson, Montgomery County; Morgantown, Charles County; Potomac River, Alexandria, Va.

Stock symbol: POM

Annual dividend: $1.66 per common share

Stock price: $24.375