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On September 30, Jim Cramer commented favorably on electric utility Exelon (EXC), after the stock closed at 49.62.

I was not listening (a little bit goes a long way) but according to Miriam Metzinger, he said that the cap-and-trade bill should benefit Exelon, which has nuclear power exposure. Investors have a good entry point because the "stock is way off."

I mentioned Exelon as a recent portfolio addition on September 1 without providing any analysis of the individual stock, since my focus at the time was on strategy and positioning. Now would be a good time to go over the basics on the company and assess the possible implications of cap-and-trade for its future earnings and stock price.

Overview

From the 10-K:

Exelon, a utility services holding company, operates through its principal subsidiaries—Generation, ComEd and PECO.... Generation’s business consists of its owned and contracted electric generating facilities, its wholesale energy marketing operations and its competitive retail supply operations. ComEd’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of distribution and transmission services to retail customers in northern Illinois, including the City of Chicago. PECO’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of transmission and distribution services to retail customers in southeastern Pennsylvania, including the City of Philadelphia, as well as the purchase and regulated retail sale of natural gas and the provision of distribution services to retail customers in the Pennsylvania counties surrounding the City of Philadelphia.

Generation produces 68% of the power it generates from nuclear plants, 25% from fossil fuels, and the remainder from hydroelectric. They generate 80% of their power, the rest is purchased under long term contracts. Here is a link to their most recent presentation, which provides a good understanding of their operation and strategy.

Cap-and-Trade

Legislation has been passed by the house and a Senate bill is under review. Exelon is on the record as supporting this legislation and has adopted a plan of compliance and begun implementation. The act, if it becomes law, will create another layer of regulation for an already heavily-regulated industry.

My take: global warming caused by green house gases is scientific fact, something has to be done, and cap-and trade is a start. Now, who is going to pay for this?

Logically, the beneficiaries of any environmentally harmful activity should pay the costs of remediation. In the case of electricity generation, that would be rate-payers. Politically rate-payers are tax-payers and voters, leading to the conclusion that attempts to place the cost elsewhere will pressure utility earnings and harm shareholders. Exelon, due to its large nuclear fleet and preemptive adoption of various actions to reduce its carbon footprint, has distanced itself from the fray.

The legislation under consideration calls for a 17% reduction of green house gases by 2020. Large utilities will be required to produce 20% of their energy from renewable sources by 2020. The actual effects on earnings of any utility are many quarters away, and passage is not guaranteed. As Cramer's bullish remarks demonstrate, the positive perceptions of a low carbon foot-print can come up any time cap-and-trade is in the news. Very possibly the poor 2009 market performance of the utility sector reflects concerns for the harmful effects of new legislation.

Capex

Exelon does have one new nuclear plant on the drawing board, to be located in Victoria, Texas. Because the approval process is so slow, this is strictly a back-burner project.

The company is systematically availing itself of the opportunity to uprate its nuclear plants, a schedule is included in their recent presentations. The net result will be the addition of 1,300 to 1,500 MW of capacity, roughly the equivalent of a new nuclear plant. This type of capex is predictable and low risk. The process of securing regulatory approval, where needed, has been proceeding successfully. Expansions from this source are approximately 5% of total capacity.

They have been successful in extending the operating licenses, originally issued for 40 years, by means of 20 year increments. A schedule of expirations is included in the presentation.

Regulation

Exelon is regulated by numerous State and Federal authorities. Profits have been steady, suggesting that rate regulation has not been hurting them. There is no indication they have got on the wrong side of any of their regulators.

Energy Trading

Energy trading is an unregulated activity performed by the power team within the generation company. Their positions are hedged by various derivatives, leading to counter-party risks and potential exposure to collateral posting requirements and liquidity issues in the event of a credit downgrade of sufficient severity.

In discussing the company's repurchase plan, CEO John Rowe mentioned that there would be little activity on that front, just being prudent to stay on the right side of the rating agencies.

Energy trading has in the past created difficulties for electric utilities: Allegheny (AYE) comes to mind, it was a while ago. There was also Enron, a very bad mix of predatory trading and accounting fraud. Exelon describes their limits and controls on this activity as stringent, backed by a Risk Management Committee. My impression is that trading is pursued in a manner that is supportive of primary activities - generation and distribution.

Valuation

EXC is another situation where a 5 year average EPS makes sense. Over the past five years, the stock has traded in a range of 12.8 to 30.9 on that metric, with the mid point coming in at 20. Projecting to the end of 2010, 3.72 X 20 equals 74 as a target price within the next two years. It reached a high of 92.13 during 2008, when the market seemed to perceive it as a growth utility, something of an oxymoron.

It is indeed “way off” that price; however, that price was “way out.” A historical average line of reasoning applied to book value or revenue produces 66 and 55, respectively. Net income as a percentage of revenue has been consistently high in recent years, and may not be sustainable.

The dividend at 2.10 yields 4.2% with shares trading just under 50.

Taking all of this together, I plan to invest on the basis that shares will be fairly valued at 66. If that target is achieved within two years, annualized returns will be 15%, excellent for a low risk situation.

Investment Strategy

EXC is a defensive stock, suitable for buy-and-hold or dividend investing. It has been mentioned twice in Seeking Alpha in articles on safe dividend stocks. Those who prefer something with a little more pop could consider substituting LEAPs for share ownership. The Jan11 35 calls make sense to me, the time premiums are not excessive and the sale of shorter expiration calls at 55 could provide current income and an exit point at a conservative valuation.

In addition to the perennial attraction of cheap leverage, the options would have the benefit of limiting the downside in the unlikely event of a nuclear accident or rogue trader incident.

Disclosure: Long VFRAG, EXC Jan11 35 calls, short EXCAK, EXC Jan10 55 calls, no position in AYE

Source: Exelon: Defensive Dividend Utility Stock