By Rich Heidorn Jr. and Ted Caddell

Exelon CEO Christopher Crane said Wednesday the company’s $6.8 billion acquisition of Pepco Holdings Inc. is “the right deal [at] the right time” for Exelon shareholders.

But some analysts aren’t convinced, questioning the purchase price and potential regulatory challenges. They said it also raises questions about the strength of the recent rally in the generation sector.

Exelon will pay $27.25 a share for Pepco, a 27% premium over last Friday’s close, before word of a possible deal boosted Pepco shares Monday.

Exelon said the deal will create “the leading Mid-Atlantic electric and gas utility,” boosting its customer count to almost 9.8 million from 7.8 million (+25%) while increasing its rate base to almost $26 billion from $19 billion (+37%).

At a conference call Wednesday, Exelon executives said the deal would increase the company’s reliable regulated utility cash flow and earnings while preserving the upside from a rebound in power prices. Going forward, the company will get 60% to 65% of its earnings from regulated operations, up from the current 55% to 60%.

Half of the deal will be financed through debt, with the remainder a mix of common stock, mandatory convertibles and cash from $1 billion in sales of “non-core” fossil generation.

The purchase will be “highly accretive,” they said, increasing earnings by 15 to 20 cents per share by 2017.

Synergies

Exelon said the merger will generate $250 million in net “synergies” over five years, of which it will retain one-third and return the remainder to ratepayers. Officials said the synergies are a “very small element” of the accretion, higher leverage being a bigger factor.

Debt rating agencies look at Exelon’s regulated and merchant generation operations in total, Exelon Chief Financial Officer Jack Thayer said. Increasing the reliance on regulated earnings will provide “incremental leverage at the holding company that absent this transaction we wouldn’t be able to do.”

Thayer said Exelon’s projections on the deal assume Pepco returns on equity “very much akin” to those Pepco presented to analysts recently. State regulators would have allowed Pepco to earn as much as 9.6% last year but the company’s infrastructure spending limited its earnings to 7%, according to The Wall Street Journal.

Other Options

In response to analysts’ questions, Crane said alternative investments in conventional or renewable generation would have offered comparatively paltry returns. A combustion turbine costing $750 million to $1 billion would have added “a couple pennies at best” in earnings, he said, versus “15 to 20 cents [for Pepco]. It’s powerful.”

Crane said the purchase would not “deter or distract us from any opportunities on the power side.”

The regulated utilities will provide sufficient cash flow to service debt and the company’s dividend, leaving the company flexibility to grow on the generation side, officials said.

Crane said there was no “ideal” mix of regulated and merchant business. “What we learned in the last downturn in the commodity cycle was our commitments need to be sized to be sustainable … so both sides of the business can stand on their own.”

Analysts’ Doubts

Some analysts expressed doubts about the wisdom of the purchase. In the The Journal’’s Heard on the Street, columnist Liam Denning noted that Exelon is paying 22 times Pepco’s estimated 2014 earnings — a higher multiple than Google commands.

“This is despite the risks presented by a long regulatory review process in tough jurisdictions such as Maryland,” Denning wrote. “Exelon choosing to pay anyway reflects, in part, reasonable hopes it can find efficiencies in Pepco’s business. But it likely owes more to that rally in Exelon’s stock price, which will allow it to fund a large part of the deal by issuing new stock.”

First-Quarter Earnings

Exelon stock has risen about 30% since Jan. 1, thanks to a rebound in power and natural gas prices over the winter. The company Wednesday announced first-quarter earnings of $90 million, or 10 cents a share, compared to a loss of $4 million, or 1 cent a share, for the same period last year. Revenue shot up to $7.24 billion from $6.08 billion last year.

Denning said the rally in Exelon shares was based on the idea that the company’s generation fleet would benefit enough from rising electricity prices to overcome trends flattening demand growth. “That the company has taken the opportunity to buy a pricey hedge in the form of more regulated assets suggests it doesn’t wholly share that view,” he said.

UBS analysts also had questions. “While we appreciate the accretive nature of the transaction, the all-cash deal (in lieu of shares) is unusual and potentially emphasizes a lack of confidence on the combined outlook on behalf of PHI,” they wrote.

“We think the deal could take some wind out of the nascent power recovery, seeing management’s willingness to deploy its newfound currency.”

Too Good to Pass Up

But Crane said the low cost of debt and the flexibility the company retains to make future acquisitions made the deal too good to pass up.

“You have to be opportunistic. You have to be able to create value,” he said. “When you can create value with accretion like this, the right time is anytime it becomes available.”

See related stories:

•  States, not FERC, will be Challenge for Exelon-Pepco
• Pepco to Lose its PJM Voice; Consumers Lose Frequent Ally