The U.S. utility sector offers low risk, stable earnings and a high dividend yield, which is why it has remained a popular choice for income-seeking investors. However, lately, the sector has been facing several headwinds because of depressed gas and power prices, and soft electric demand growth. Exelon Corp. (EXC) has significant exposure to merchant power assets, and earnings of the business are negatively affected by weak power prices. The company's management has been proactive in taking measures to support its earnings and navigate through the prevalent tough times, but weak gas and power prices continue to take their toll on the stock price. Because of weak forward power prices, I am downgrading EXC from 'buy' to 'hold', and believe that gas and power prices remain key drivers in the future.
Nuclear Plant Shutdown
Difficult power market conditions have had a negative impact on the company's earnings. The company's management, during the recent EEI conference, indicated that in the prevailing weak power market conditions, it will evaluate its cost structure and possibly opt for the shutdown of some of its existing nuclear plants. As the management is evaluating gas and power market weakness and plant economies, it may opt to shut down one or more of its nuclear assets. I believe it is highly likely that EXC will announce to shut down one or more of its nuclear assets, as difficult conditions persist in upcoming months. Among the options available with the company to choose which nuclear plant to shut down, I believe Quad City, Clinton and Ginna seem to be on top of the list. Quad City and Clinton are among the plants that have been unprofitable in recent times, which is why they have high probability of closure in response to tough power market conditions. The possible shutdown of any of the unprofitable plants will help the company support its earnings, as its costs will decrease and help navigate through difficult power market conditions.
Maintaining Investment Grade Credit Rating
In the ongoing difficult conditions for power markets, EXC is committed to maintaining its investment grade credit rating. Maintaining the investment grade credit rating seems to be among the top priorities for the company; EXC announced a dividend cut of 41% earlier this year. Now the company has been aiming to reduce its debt in order to maintain the investment grade credit rating. EXC plans to retire $615 million of ExGen debt in 2014 using proceeds from the recent Continental Wind LLC project issuance and using internally generated cash flows. It is important for the company to maintain its investment grade credit rating, as this will help the business participate in commercial business opportunities, improve cost efficiency and provide reliable access to the capital market, reduce collateral requirements and increase business financial flexibility. The following table shows the credit ratings assigned to EXC by different credit rating agencies.
During the recent EEI conference, EXC introduced credit metric target ranges under both market and stress conditions to stay intact with its investment grade credit rating. Following are the credit metric targets introduced by EXC:
- FFO/Debt > 30% in base case and 27% in stress case
- RCF/Debt > 20%
- Positive Moody's Free Cash Flow
As discussed earlier, a continuous weakness in gas and power prices has been having a negative impact on the margins and stock price. Recently, the company introduced its total gross margin guidance of $7.4 billion for 2016, as compared to $7.6 billion for 2015. The management expects $2-$4 of upside in the competitive power markets/forward power prices moving in 2014 and 2015, which I believe is an optimistic projection by the company. I recommend investors keep an eye on a recovery in forward power prices, which remain a key performance driver for EXC in the future. The following table shows the total gross margin guidance from 2013 to 2016.
Total Gross Margin
Source: EEI Conference Presentation Slides
The company's financial performance has been negatively affected by challenging power market conditions; however, I believe the management remains proactive in responding to prevailing conditions. To lower its cost curve and support its future earnings, EXC might announce to shutdown one or more of its nuclear plants. Also, maintenance of the investment grade credit rating will boost investor confidence and improve financial flexibility for EXC. However, difficult power market conditions will have a negative impact on EXC's future revenues and earnings; therefore, I am downgrading the stock rating from 'buy' to 'hold.'