We have been publishing our analysis and research on Exelon Corporation (EXC) since June in the wake of the Wisconsin recall elections. Our thesis is that the two states where Exelon (Illinois) and Wisconsin Energy (WEC) are headquartered will be seeing different potential long-term economic growth rates as the two states have pursued two vastly different macroeconomic models since 2010. In 2010, the people of Wisconsin created an electoral groundswell by electing a fiscally prudent Governor, Lieutenant Governor and State Legislature while the people of Illinois voted to double-down on more taxes and government spending. Because of this, we expected to see the Wisconsin economy grow at a faster rate than the Illinois economy and in our October interview with Wisconsin Energy CEO Gale Klappa; he confirmed for us that the Southeastern pocket of the State of Wisconsin has seen healthy population growth.
We attribute this to the 2011 tax increases passed by the solons of the Illinois Legislature which have served to increase the already high cost of living for residents of the Chicagoland metropolitan area and forced them to join Fat Wallet in moving forward with their lives in Wisconsin. We don't believe that investors should rely on Exelon in their portfolio because we can't rely on Exelon to maintain its dividend. Exelon is based in Chicago and based on a story in Crain's Chicago Business, we can see that Chicagoland electricity customers can't rely on Exelon to deliver electricity service reliably.
Although Exelon's dividend yield of 6.75% is more than double that of Wisconsin Energy's 3.33%, we believe that Exelon investors need to consider more than the dividend yields posted on CNBC.com before considering Exelon over Wisconsin Energy. Our series has shown beyond a reasonable doubt that Exelon is a poor choice for dividend seeking investors in relation to WEC because of Exelon's poor financial performance, the fact that it is bogged down integrating a complex merger with another broken growth company in the utility industry, it has frozen its dividend since Q4 2008 and it is considering cutting its dividend. Also, investors need to realize that not all utilities are the same. We'd consider Exelon's PECO regulated utility subsidiary if we could get the 6.75% yield that Exelon is offering. However, that yield wouldn't be sufficient for its weakest utility subsidiaries (Commonwealth Edison and Baltimore Gas and Electric). Finally, Exelon's biggest subsidiary is its Exelon Generation LLC wholesale merchant power producing subsidiary and that is much more exposed to macroeconomic factors than its three regulated utility subsidiaries.
We have received such a strong feedback that many former Exelon bulls have had second thoughts with regards to their Exelon investment. Here are important pieces of information that are worth repeating from our earlier report installments in our critically acclaimed "Replace Exelon with Wisconsin Energy" series.
- Wisconsin scored higher for business friendliness than Illinois, Maryland and Pennsylvania
- Wisconsin Energy (a "less-fashionable, less well-known" regulated utility) had a comparable profit margin to Exelon's well-known, high-potential power generation subsidiary
- Wisconsin Energy enjoyed significantly higher profit margins than Exelon's regulated utilities
- WEC generated more profit in Q1 2012 than all of EXC's regulated utilities combined
- Even during the 2002-2008 multiyear boom in natural gas prices, WEC's cumulative EPS growth of 111% during that time period exceeded the 86% growth that EXC enjoyed.
- Let us repeat that, even with the benefit of ridiculously high and rising natural gas prices, the well-known power generator EXC's cumulative EPS growth was less than the less well-known regulated utility.
Here we will analyze the recent performance of the business operations of these companies. We see that Wisconsin Energy smashed through the $.57 EPS consensus estimates by Wall Street and racked up $.67 in Q3 2012. Although Exelon beat the $.72 adjusted EPS consensus estimates by $.05 and generated $.77 during the period, EXC's management put a damper on the mood of Exelon's investors by hinting at cutting its dividend. EXC's reported earnings were even more atrocious than the "adjusted results", as EXC's GAAP EPS during the quarter was $.35 versus $.90 in Q3 2011. "Non-recurring charges" at its Exelon Generation LLC unit accounted for nearly all of the 55% difference between EXC's adjusted EPS and its GAAP EPS. But the real concern was that its adjusted EPS of $.77 was a 31% decline from the $1.12 in adjusted EPS in Q3 2011. Or was the real concern the fact that adjustments to EPS increased to $.42 in Q3 2012 versus $.28 in Q2 2012, $.22 in Q3 2011 and $.12 in Q2 2011. Or that adjusted EPS for FY 2013 are expected to decline by at least 10% versus FY 2012 after declining by 33% in FY 2012 versus FY 2011?
Our Comparative Evaluation of Company Business Segments
Power Generation: We previously discussed how Exelon is primarily a merchant power generation company and the largest merchant power generator in the US through ExGen. We are aware that the results of this division are heavily influenced by natural gas prices. We think that EXC's former CEO John Rowe overestimated the bullish period for natural gas prices and we think that Exelon stakeholders believe that the natural gas prices will once again reach the unsustainable highs reached in 2008. Even Travis Miller, an Exelon Bull at Chicago based Investment Research Firm Morningstar admitted that he doesn't expect to see Exelon and ExGen reach its trough earnings period until 2014. Miller has reduced his fair value estimates twice in the last year by a total of $10 per share and by $36/share since 2008. We think Travis Miller is a bit too optimistic about Exelon and ExGen's prospects, even if the EPA was to severely regulate or ban fracking. ExGen reported a 42% increase in Q3 2012 revenues versus Q3 2011 levels. This was due to the acquisition of Constellation Energy and the merger of ExGen with CEG's non-regulated energy generation and marketing businesses. Despite the combination of these two companies, the new ExGen saw its adjusted segment net income decline by 12% year-over-year, due to natural gas prices that were 30% lower than the prior year's period.
Source: Morningstar Direct
We were surprised that natural gas prices have snapped back so fast from the April 2012 lows of less than $2/MCF and now October 2012 gas prices were 3% higher than October 2011 gas prices. We saw no fundamental reason for the snapback in gas prices since Europe is in the grips of a severe economic crisis, the emerging markets are seeing slowing economic growth, the US is facing a potential recession and natural gas production continues to expand even while the number of drilling rigs devoted to natural gas production continues to decline. One reason why natural gas production has not collapsed is because the drilling rigs have been redirected to explore and produce oil, which has generated natural gas production as a byproduct of oil production. The other reason we can think of with regards explaining why natural gas production continues its steady climb is due to hydraulic-fracturing (fracking), which has revolutionized the supply-demand relationship for energy commodities in general and natural gas in particular.
Source: Bloomberg LP
Wisconsin Energy has two power generation facilities in its W.E. Power LLC power generation business, Port Washington and Oak Creek. Each facility has two power generation units and collectively saw revenue attributed to this segment decrease by 35bp and its operating income grew by nearly 1.9% in Q3 2012 versus Q3 2011. Operating income increased due to reduced operations and maintenance costs as well as depreciation and amortization. On a year-to-date basis, W.E. Power generated 1.44% revenue growth and 3.25% operating income growth. Because ExGen is a merchant power producer while W.E. Power is an in-house power generator, we are not trying to say one power subsidiary performed better than the other because each subsidiary serves a different purpose.
Source: Exelon's 2000-2011 Annual Reports and Our Estimates
Utility Subsidiaries: We see that Wisconsin Energy is a stronger performer in this segment versus Exelon. While Exelon is bigger than WEC in the regulated utility business due to its ownership of three large utility subsidiaries versus WEC's unitary We Energies subsidiary, we find that the performance of WEC and We Energies is electrifying and illuminating in comparison to the dim performance of Exelon's utility operations.
Commonwealth Edison generated $1.5B in revenues in Q3 2012, down 16.8% from Q3 2011. ComEd saw its adjusted business segment net income decline by 20.35% due to increased local taxes and depreciation/amortization expenses, which were partially offset by lower operating costs and purchased power costs. ComEd's Q3 2012 and FY 2012 profit margin was well below that of Wisconsin Energy because although ComEd had higher revenues than Wisconsin Energy, Wisconsin Energy continues to earn higher profits than ComEd.
PECO Energy saw its revenue net of purchased power and fuel decline by 0.4% in Q3 2012 versus Q3 2011 but benefitted from a 11.3% reduction in operating costs and this caused its adjusted operating income to increase by nearly 20% for the period versus last year's levels. PECO benefitted from a 6% reduction in interest, which was offset by increased income tax expense and this allowed its quarterly segment adjusted net income to only decline by 1.2% versus the comparable period last year. Wisconsin Energy's FY 2011, YTD 2012 and Q3 2012 profit margins continued to equal and exceed PECO's. Wisconsin Energy continues to generate more revenue and profit than PECO even though PECO's service area is more densely populated than WEC's areas.
Baltimore Gas & Electric BGE's Q3 2012 gross margin increased by 1.94% as a $2.9M decline in year-over-year revenues in Q3 2012 was more than offset by a $9.5M reduction in cost of fuel purchased. Operating expenses were flat for the year as a slight decrease in operating and maintenance costs were offset by increased local taxes and depreciation. BGE saw net division losses of $4M, down from a loss of $1.7M in the prior year period. That didn't stop WEC from continuing to generate higher profit margins than BGE during this time period, as well as higher revenues and profits than BGE as well. In fact, WEC's Q3 net income of 156.1M was 5.5 times as much as BGE's
Wisconsin Energy and We Energies: WEC has one consolidated utility reporting segment and brand name "We Energies", which consists of Wisconsin Electric and Wisconsin Gas. Wisconsin Energy saw its Q3 gross margin increase by 2.39% as a reduction in the cost of fuel and power purchased was partially offset by reduced revenues. Wisconsin Energy's gross margin growth was narrower than each of Exelon's utility businesses. WEC's operating income increased by 25% in Q3 2012 versus Q3 2011 and by 15% year-to-date due to the one year amortization holiday of certain regulatory assets. This agreement was reached between WEC and the Wisconsin PSC that allowed it to freeze base electric rates in 2012. We also like to point out that Mike Lapides of Goldman Sachs pointed out WEC's strong track record relative to its peers managing operations and maintenance expenses. Even if we include the $37M in quarterly deferred operations and maintenance amortization as an expense in WEC's operating income without adding a similar amount to revenue, it still generated a 8.6% increase in its operating income in Q3 2012 versus Q3 2011. WEC's Q3 2012 EPS grew by nearly 21.8% on a continuing operations basis versus Q3 2011 and its YTD 2012 EPS grew by 13.6% versus its YTD 2011 EPS.
While Exelon's previous CEO John Rowe was more visible than WEC's CEO Gale Klappa with regards to media exposure, Klappa's low-key management approach generated stronger returns for shareholders. Klappa shunned the bright lights of politicking and publicity seeking that Rowe engaged in and focused on the less glorious aspects of running a utility such as improving customer service, operational execution and capital asset management. Rowe led Exelon since its October 2000 merger combining PECO and Unicom and stepped down on March 12 when Exelon acquired Constellation. Under Rowe, EXC generated a 112% total return in his 11.5 years helming EXC. In comparison, Klappa generated over 300% total return since he assumed WEC's presidency in April 2003. We've listened to the conference calls for Exelon and Wisconsin Energy and we notice a big difference in the tones of the conference calls between WEC's management and EXC's management. WEC's management is calm, cool, charming, professional and at the same time upbeat and loose. EXC's management is monotoned, scripted and bewailing macroeconomic factors while WEC's management is proudly talking about power generation construction and distribution network upgrades.
In conclusion, despite the fact that natural gas prices jumped from $1.89/MMBtu in April to $3.34/MMBtu in November, EXC was not able to take advantage of this during the most recent quarter in order to substantially help the bottom line. Although the recent run-ups in natural gas prices have allowed Exelon to increase its management EPS guidance from $2.55-$2.85 in adjusted earnings as of June to $2.75-$2.95 as of November, this is a far cry from the $4.16 in adjusted EPS in 2011. Wisconsin Energy increased its adjusted EPS guidance from $2.24-$2.29 at the beginning of the year to $2.28-$2.32 after Q2 2012 and $2.31-$2.33 after Q3 2012. Then again, Wisconsin Energy's adjusted EPS guidance is the same as its actual EPS guidance, since it doesn't have to take an alphabet soup of adjustment footnotes in its financial performance releases. We were surprised that even with the recent run-up in natural gas prices Exelon's adjusted Q3 2012 EPS declined by $.35 year-over-year (31.25%). We compared that to Wisconsin Energy, which beat its consensus estimates of $.57 by $.10 (17.5%). Although we were surprised to see that PECO's profit margin reaching parity with WEC's profit margin in Q3 2012, WEC's profit margin was much higher than the rest of EXC's subsidiaries and that is why EXC shareholders are worried about dividend cuts, unlike WEC shareholders.
Disclosure: I am long WEC.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.