A rescue fueled by back-to-basics

THE BALTIMORE SUN

On the day that Mayo Shattuck arrived to straighten out the floundering operations of Constellation Energy Group Inc., the former banking executive thought he had joined the energy industry.

He had no idea that he had also become a shipping executive - the proud owner of a 41,500-ton transport tanker. He knew nothing of the Boeing 747 he now controlled either, one of the many peculiar investments that the utility had made over the past two decades.

By the time the former Deutsche Banc Alex. Brown executive was hired in November 2001 to rein in Baltimore's largest energy company, the troubled utility had strayed so far from its core energy business that Shattuck found himself sitting astride a major real estate portfolio, a lucrative nursing home business and $5 billion in debt.

Wasting little time, Shattuck replaced almost the entire management team, killed major power plant construction projects, trimmed the work force 10 percent and eliminated nearly all assets not related to the energy business. He sold the ship to the Navy; re-leased the jumbo jet to an airline. Millions of dollars in real estate holdings were unloaded, the senior-living business abandoned.

That was the easy part.

In the ensuing 15 months, the refocused Constellation Energy Group has accomplished what most other energy companies can only envy: It has exceeded earnings guidance for five consecutive quarters and projects 10 percent earnings growth for several years, acquired four energy businesses and resolved a potentially thorny dispute with California over accusations that it illegally took advantage of the state's power crisis by inflating energy prices.

And analysts say it might not have been possible without Shattuck, an outsider who wandered into an industry littered with the wreckage of an energy crisis that included the Enron Corp. bankruptcy, accounting and trading scandals and a weak economy. It was his financial acumen, analysts say, that may have turned Baltimore's 187-year-old utility around.

"With Mayo at the helm, there is a level of understanding that he understands the capital markets and understands what investors value," said Jeffrey Gildersleeve, a utilities analyst for Argus Research in New York. "He's an expert on financing. He's improving the quality of earnings. There is a building confidence in Mayo and his team."

A messy situation

Mayo A. Shattuck III knew on Oct. 26, 2001, that he was stepping into a messy situation. He just didn't know how messy.

That was the day Constellation made its stunning announcement that it was scrapping a yearlong plan to split into two independent businesses, one a high-growth, high-risk company that would produce and sell power nationwide, and the other a slow-growth regional distribution company that would include BGE.

The backtracking forced the company to pay Goldman Sachs Group Inc. $355 million to end a partnership in Constellation's energy trading business. The architect of the separation plan, Chief Executive Christian H. Poindexter, also stepped aside and was replaced by Shattuck, who had recently left his job as chairman at Deutsche Banc.

The market responded to the news by driving down Constellation's stock almost 11 percent, closing at $23.41 - less than half of its 52-week high.

Investors, already angered by the company's 71 percent dividend cut, threatened to dump the stock. Bewildered employees blamed company leaders for squandering Constellation's fortunes on an unsound strategy and for lacking a detailed plan for the future.

Wall Street analysts immediately downgraded the stock.

Constellation's credibility had already taken a huge hit that year. The company had lowered its earnings forecasts twice, failed to sell power for future use from its Midwestern plants and botched negotiations for new coal contracts.

But, Shattuck said, he neither anticipated the troubles that pounded the energy industry throughout the next year nor the depth of Constellation's problems until he began work that November.

In pursuit of aggressive strategies that promised triple-digit earnings growth, many companies like Constellation focused on producing and trading power. The stodgy business of delivering power to customers was not glamorous or profitable enough.

The California energy crisis, Enron bankruptcy, accounting and trading scandals, and the weak economy soon showed that premise was wrong.

"I certainly didn't know how bad the industry was when I took over," Shattuck said. "I was negatively surprised by Enron and all the fallout from that. I was surprised by the lack of a centralized risk-management structure. And I was surprised by the implications of how long it would take to work out of these things."

Slow reactions

At the time, Shattuck was dealing with an energy company that was still operating like a regulated utility. Top-level executives were slow in reacting to changes in the volatile industry. Constellation's debt was too high. The company had no one monitoring the daily risks it could encounter in the market. And Constellation had taken on too many projects and businesses that had nothing to do with energy.

Electricity prices had fallen since a glut of new generators came on line, so Shattuck canceled power plant projects in Texas, Florida and Massachusetts.

He created the position of chief risk officer. While regulated companies may not have needed a risk officer in the days when they could depend on a guaranteed return and profit from investments, deregulation had changed all that. Shattuck filled the position with longtime BGE employee John Collins, who became responsible for examining the financial health of the company's trading partners, the operational status of its power plants and the volatility of the fuel markets.

"I was stunned that we didn't already do this," Shattuck said. "I was stunned that there was no regulatory oversight in the industry for a power trading environment. We needed to self-regulate. We need that, what with the dramatic changes we've seen over the past couple years.

"There is a back-to-basics strategy," Shattuck added. "Strangely enough, it's going way back, way before the industry entered into a perverse stage of regulated utilities that had excess cash to randomly invest into quirky things like a Navy ship. We've changed this company. We're a national company now that's reinvesting our money into a business we know something about. That business is energy."

Canceling the plan to split into two businesses also meant pulling the company - already well along in separating functions and personnel - back together and cutting about 900 people through early retirement and layoffs.

Those moves convinced longtime workers that Shattuck was prepping the company for sale - an accusation he adamantly denies. After all, Shattuck had cemented his reputation as a dealmaker by selling Alex. Brown twice.

Longtime employees also say Shattuck shares the blame for Constellation's troubles because he sat on its board of directors for seven years. They say cutbacks have left fewer workers in the field and hurt morale.

"They've decimated what we had," said a 20-year veteran field worker who asked not to be identified. "They want one man to do the work of five. We were hired back then with the understanding that you work hard for us and you'll be rewarded with a job for life. Now they're walking into meetings telling us, 'There is no such thing as a long-term career employee here anymore.'"

Shattuck concedes that Constellation is not the same company anymore. He also knows that the changes have been painful for many.

"A lot of people, when they joined the company, the covenant was different then," Shattuck said. "You had lifetime employment and a pension. We still have a pension, but we don't have lifetime employment anymore and that scares people. It's painful, but it's necessary. We have to face reality. In the end, I think employees will see that it's better to be on the platform of a healthy company."

A key decision to building a healthy company, Shattuck said, was changing a top-down management culture to one with a team of leaders who would make decisions and be held accountable for the results. The only high-level executive retained was BGE President Frank O. Heintz, who reported the best year for system reliability and locking in wholesale power contracts at the utility even while the rest of the company was stumbling.

Lack of empowerment

"I was on the critical path for every little decision, from individual employment issues to whether or not we'd invest a relatively small amount of money into some particular operation," Shattuck said. "People didn't feel empowered. They felt they didn't have the authority. The incentive to move fast and make tough decisions wasn't there.

"I recognized right away how important it was to change the vast majority of the management team right away," Shattuck said. "People understood very quickly that I didn't have any tolerance for excessive deliberation. We make decisions. We get things done."

Get things done, they did.

Besides selling off assets unrelated to energy, Shattuck and Chief Financial Officer E. Follin Smith focused on the company's balance sheet. Constellation was carrying about $5 billion in debt at the end of 2001.

"Some questioned why we were appearing as conservative as we were," Shattuck said. "I had a world-class CFO who was very focused on our balance sheet. And after 20 years as a banker, one of the first things I examine is a company's financial position.

"In taking over Constellation, I saw that we had taken on much larger volumes of debt over the past three years without an increase in earnings," he added. "That was a telltale sign that something was awry. It signaled that the economy had fallen into that trap of excessive expectations in a market that really couldn't absorb what people were throwing at it."

Early last year, Constellation executives argued their case with the ratings agencies to make sure that, despite its problems, the utility would still maintain a high credit rating. Over and over, Constellation promised Standard & Poor's and Moody's Investment that "We'll deliver. We'll deliver," CFO Smith recalled.

When Moody's downgraded Constellation's senior debt by one notch from A3 to Baa1, Smith moved.

Smith began holding elaborate presentations for banks to obtain commitments for a $1.7 billion line of credit to tap. In addition, carefully timing her moves in the capital market, Smith began refinancing $2.5 billion of debt due this year, spreading it over 30 years.

She also started keeping $500 million cash in the bank to bulk up the company's position.

"The urgency was incredibly important because the world began to melt down around us," Smith said. "Things were going to get bad and we needed lots of ready liquidity. We were fortunate in our timing."

Those financial moves were prescient.

Companies including El Paso Corp. in Texas, Aquila Inc. in Missouri and Constellation's neighbor in Hagerstown, Allegheny Energy Inc., have been rocked by credit-rating cuts and liquidity crises. Many are desperately selling off assets at a loss to raise cash as they try to avoid bankruptcy.

Constellation, on the other hand, is poised to benefit from industry misery.

In September, Constellation purchased a commercial and industrial energy business that added 3,000 large electricity customers to its client list. On Jan. 2, it snapped up two energy businesses from Allegheny, making Constellation the nation's largest competitive supplier of energy to large commercial and industrial customers. Three weeks later, it purchased another energy business in Alberta to add 65 clients and expand into Canada.

Future acquisitions will build on the company's strategy of focusing exclusively on producing, selling, delivering and providing services for customers' energy needs.

Concentrating on those key points has helped Shattuck regain the confidence of Wall Street.

"Frankly, Shattuck has done a phenomenal job in a short period of time," said Mark Levin, a utilities analyst at Davenport & Co. in Richmond, Va. "They obviously went through a period of difficulty. He has been able to bring a fresh approach to this company, and this is an industry that needs a fresh approach."

Gildersleeve added, "Constellation has faced the music. They've cleaned up some ruffled areas of the business, sold off non-core assets and worked to create a stable company. It's coming across very clearly from management what direction they want to take the company. They are refocusing on their expertise."

Praise from S&P;

Standard & Poor's recently praised Constellation in a credit report for aligning its merchant energy company with its regulated utility, BGE. Recognizing the company's strong cash flow, the agency maintained Constellation's consolidated corporate rating of A-.

Constellation's stock price has held in the mid- to high $20s, closing at $26.03 on Friday, while many of its counterparts have fallen into the single digits. And as many companies are cutting or suspending their annual dividend, Constellation boosted its dividend at the beginning of 2001 and again in January to pay out $1.04 per share. That's still a net loss of 64 cents per share when compared with dividends before the plan to split.

"Mayo really knew the financial markets at a time when energy industries find themselves in unexpected tumult," said Heintz. "He understood Day 1 the importance of a good balance sheet, the importance of focus, the importance of communicating with Wall Street."

Most analysts agree that the tough choices Shattuck made early on may have been painful to Constellation for a spell, but were crucial to the company enduring industry instability. Those difficult choices could also be key to Constellation's survival.

Constellation predicts earnings of $2.65 to $2.85 per share this year, but some analysts say those numbers are overly optimistic.

Last week, Thomas Hamlin of Wachovia Securities downgraded Constellation's rating to "market perform" from "outperform," and reduced his earnings estimate for the year to $2.50 from $2.65. Earnings from Constellation's energy trading business will be less predictable in the future, Hamlin warned.

But while Constellation remains under the same pressures "from low commodity prices and dormant trading market," analyst Steven I. Fleishman at Merrill Lynch Global Securities Research said, "we believe that the company's exposure is minimized given the solid balance sheet, stable investment grade credit, heavily hedged position and built-in growth drivers."

As testament to that, Shattuck points to the company's new headquarters located above an electricity substation that overlooks the Inner Harbor. The sound of construction crews pounding, drilling and sawing into the Pratt Street building is Constellation making room for 250 workers who will move in as a result of its September acquisition of AES NewEnergy.

"Thank God we did not separate," Shattuck said, reflecting on the past year. "We were vulnerable, and we were perceived as vulnerable when I first got here. A year later, we're one of the stronger players out there today. We are now in control of our destiny."

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