As panic spreads, Buffett strikes
The billionaire investor plays the financial crisis to his advantage with a deal to buy Constellation Energy.
NEW YORK (Fortune) -- There's nothing like a good financial panic to lure Warren Buffett off the sidelines.
The billionaire investor and CEO of Berkshire Hathaway sprang into action Thursday with a $4.7 billion plan to acquire Constellation Energy (CEG, Fortune 500), the Baltimore-based energy wholesaler and utility operator whose shares have plunged this week as the company ran short on cash.
Under the deal, Constellation - which runs the Baltimore Gas & Electric utility and operates 83 electric generators around the country - will be folded into Berkshire's MidAmerican Energy unit.
Berkshire will pay $26.50 a share for Constellation - just a third of what the shares were worth at the end of July, when CEO Mayo Shattuck declared the company "underappreciated" in the marketplace, and a quarter of Constellation's market value a year ago.
Shattuck, a former investment banker at Alex. Brown & Sons whose wife was until recently a cheerleader for the NFL's Baltimore Ravens, noted in Thursday's sale announcement that "the financial services sector and energy commodity markets have witnessed unprecedented volatility."
While that's inarguably true, it fails to explain how Constellation found itself striking a deal at a price Shattuck would surely have scorned only last week.
MidAmerican chief Gregory Abel says in an interview Thursday that MidAmerican had been eyeing Constellation for some time, due to its "respect for the assets and the people there," but adds that talks over a deal began only in the last 48 hours.
Buffett was able to swoop in and pay a bargain price for Constellation because the energy firm - like so many of the big financial houses that have cratered this year - was in large part a complex trading business that depended on cheap short-term market financing.
While the company's best-known holding is the regulated BG&E, most of Constellation's $21 billion in annual revenue comes from unregulated energy and commodities trading.
That strategy worked in the early part of this decade and well into this year. At their late 2007 peak, Constellation shares had risen fivefold since Shattuck took over in November 2001.
But with financial firms reducing their lending as they try to recover from billions of mortgage-related losses, investors have grown unwilling to back businesses that are less than transparent.
"Equity investors have - from our perspective - never seen the value" of Constellation's commodities trading business, Citi analyst Greg Gordon wrote earlier this week. "This is because of their perceived lack of recurring earnings, inherent volatility, credit intensity, complex accounting and lack of consistent cash flow."
The chronic questions about the quality of Constellation's earnings became acute this week. First came Monday's collapse of Lehman Brothers, a major trading firm whose demise made other traders even more skittish about committing their capital.
Then, ratings agencies threatened to downgrade Constellation's debt - which at triple-B already sat at the low end of the investment-grade spectrum. A downgrade could have forced Constellation to produce more than $3 billion in cash collateral on its trading positions - cash the company didn't have.
"Constellation is facing an acute crisis of confidence," Standard & Poor's analyst Aneesh Prabhu wrote Wednesday. "Constellation's large global commodities operations rely heavily on sustained counterparty confidence, and curtailment of business by these counterparties has the potential to impair Constellation's ability to conduct its commodities operations."
In an illustration of just how desperate Constellation has become for funds, Berkshire - whose $31 billion cash hoard has been the subject of much speculation on Wall Street, what with the financial sector in desperate need of capital - agreed as part of Thursday's deal to provide $1 billion in preferred-equity financing to Constellation by Monday.
Abel says MidAmerican is "very excited" about the chance to add Constellation's BG&E, power-generation and energy-trading businesses. He says it's likely that under MidAmerican's stewardship, Constellation will be "ramping down a little bit" on its commodity-trading activities, and likely to do an orderly wind-down in coming years of its derivatives dealings.
Constellation shares rose fractionally in afternoon trading Thursday to around $25.
The role of the cash-hungry trading businesses in scaring investors away from Constellation - and laying the groundwork for the lowball offer from Buffett - is hard to overstate. Energy stocks have fallen sharply since the commodity bubble popped earlier this summer. But utility companies such as Entergy (ETR, Fortune 500) and Florida Power & Light (FPL, Fortune 500) have seen their shares tumble much less than Constellation.
Constellation didn't exactly shore up confidence in its prospects when it admitted in a regulatory filing last month that it had miscalculated the amount of cash it would need to produce in the event of a ratings downgrade. The company, after saying a downgrade to junk status would force it to post $1.6 billion in cash collateral, said in August that the true figure was twice as large.
A Constellation spokesman says the issue of whether Shattuck will continue with Constellation after Mid-America completes the deal "has not even been discussed" at this point. Abel says MidAmerican's assumption on doing a deal is that people at an acquired company will stay in place, but he adds that "people have to make their own decisions."
One factor that may enter into Shattuck's thinking is the size of his paycheck, which under the no-nonsense Berkshire regime stands to shrink a good bit. Shattuck made $13.9 million in total compensation and $20.1 million in 2006, including at least $1 million in salary each year. Buffett, for his part, makes $100,000.
That said, Abel says the stability of working for a company with a bulletproof balance sheet offers its own rewards.