Go Long, Exelon
Exelon is a utility holding company which provides electricity generation to 3.8 million customers in Illinois and 1.6 million customers in southeastern Pennsylvania, and provides natural gas retail sales to 0.5 million customers in Pennsylvania. With the largest nuclear fleet of any U.S. utility, Exelon’s 11 nuclear plants in the midwest and mid-atlantic generate 17% of U.S. nuclear power and constitute 80% of Exelon’s generation output. Currently, Exelon trades at $42.29 and yields nearly 5%. In recent years shares in this utility exceeded $85 apiece. The share price fell due to a combination of weaker power prices, new rate regulations in Illinois and Pennsylvania, and Exelon’s expiring hedges on power generation, creating a good entry point for value investors.
As the lowest carbon emitter in its industry, Exelon stands to benefit from carbon cap and trade legislation and new “stealth” regulations by the EPA. In anticipation, Exelon expanded its clean energy footprint with the purchase of Deere’s wind energy business in a $900M deal in August, 2010. The company is readying for more emissions-free regulation as more states lower their tolerance for emissions in power generation. Exelon also continues to incrementally expand power output at its existing nuclear fleet with plans to add as much as 1,500 megawatts of new capacity to its current 25,000 output by 2017. Cap ex is predictable for this type of investment. With power prices around $40 per megawatt-hour and nuclear plants generating power for around $15 per megawatt-hour, Exelon gets the benefit of both low-cost and environmentally-friendly power output. Also, Exelon has one new nuclear plant hibernating in the permitting stages, to be located in Victoria, Texas.
Thus, as the lowest carbon emitter in the industry, Exelon will benefit from any carbon cap and trade legislation. Even if legislation is not forthcoming in the near future, the EPA and state power regulatory bodies continue to ratchet up emissions regulations. In 2009, Exelon carved out Exelon Transmission Co., now led by former Federal Energy Regulatory Commission chairman, Elizabeth Moler, to capitalize on nearly $50 billion in investments in “smart-grid” transmission upgrades over the next 10 years.
My fair value estimate for Exelon is $70.30 per share based on a discounted cash-flow analysis. The expiring price caps in Pennsylvania should yield $800 million in incremental margin in 2011. Further, the rate increase requested at ComEd, adding $396 million, and rate settlement at PECO, adding $245 million, will add to gross margin in 2011. Soft natural gas prices, the ultimate driver of lower power rates at present, are likely to halt their decline as the economy picks up. I assume continued 95% average nuclear capacity utilization, and use a $5 per mcfe natural gas price offset by Exelon’s wattage hedges, falling below 50% through 2013. The company’s gross margin is likely to stay north of 65% with free cash flow above $2 billion per year to permit resumption of increases in the dividend. With Exelon trading at current prices, the company shares offer a “free option” on increasing stealth regulation of emissions, cap and trade regulation, and a spike in power prices.
Risk is low with Exelon. The company is led by CEO John Rowe, and under his leadership Exelon has been recognized for its operational expertise. Exelon is regulated by numerous State and Federal authorities which are prone to implementing power rate caps which hurt profitability in the short run. Exelon is well-positioned to benefit from increasing regulation on the emissions front due to its nuclear fleet, and is likely to benefit from further regulatory developments due to the hire of FERC’s former chairman. In the long term, Exelon represents a sustainable opportunity for value investors with out-sized profit potential for the risks involved.