Exelon (EXC) share prices have not traded this low since Feb 2003. According to Morningstar.com, a $10,000 investment in EXC Jan 2003 would be worth a bit more than $15,000 compared to about $25,000 for a similar investment in SPY and a bit less than $30,000 for Diversified-Utilities. On a total return basis, EXC has generated a 3.76% return annually over the past 10 years versus 8.3% for Diversified-Utilities and 7.6% for the S&P 500. However, for investors that are more recent, the rewards have been substantially worse with 5-yr total annual returns of -7.5% vs. 6.6% and 18.1% respectively. A $10,000 investment 5 years ago would be worth $6,990 today. To say EXC has been a good investment would be a bit far-fetched.
However, there can be a case made for the contrary opinion that the reasons EXC has fallen out of favor are the same that will turn the company into a potential winner. But there must be three elements for a turn in fortunes: an improvement in natural gas pricing that will positively affect electricity pricing, sustainable economic growth in the Northeast and Midwest, and patience for higher prices and increasing demand to turn into additional profitability for EXC.
As presented by the following graphs, electricity pricing in EXC's geography has been weak since 2008. Below are pricing charts for electricity in the Mid-Atlantic PJM region from 2001 to 2013 and the ISO-New England Region from 2005 to 2013, as reported by sriverconsulting.com here (pdf) and here (pdf):
Electricity Forward Market Report as offered by ENERNOC for ISO New England and PJM Western Hub:
As shown, in both producing areas price fell from $60 in June 2011 to just below $40 by Feb 2012. However, the New England area has recovered while the PJM Western hub has not. It should be noted that the peak in electricity in 2008 at roughly 2.5 to 3.0 times current prices also coincided with EXC stock selling in the high $80s.
Demand for power has not fully recovered to pre-2009 levels, pressuring prices downwards Additional competitive pricing pressures have come from subsidized renewable sources, such as wind. Depressed natural gas pricing is also reflected in lower power prices.
There is a correlation between the price of natural gas and the price of electricity. Below is a graph of the correlation of New England Hub electricity pricing with NYMEX 12-month strip natural gas.
1-year Regression Analysis Forward Gas vs. Forward Electricity
Below are two graphs also outlining the correlation between natural gas pricing and power pricing between 2001 and 2012. Avalon Energy Services, LLC offers these graphs on their blog:
As shown, as natural gas prices moves higher, there is a reflection of that movement in the price of electricity. The impact of higher electricity pricing will positively influence the merchant power business at EXC.
Exelon sales are split between merchant power revenues from their ExGen subsidiary that are greatly influenced by a rolling 3-year auction process and regulated electricity revenues that are controlled by state PUCs. Utilities usually generate large depreciation allowances, and review of operating cash flow OCF by operating segment may provide better insight than reported EPS. Below is a table of selected Exelon annual operating financials for the periods from 2006 to 2008 and from 2010 to 2012.
Source: EXC 10-K
Over time, Exelon has added generating capacity to its ExGen subsidiary. Below is a table of generating MW capacity by fuel type in 2012 and 2008:
Long-Term Contract & CENG
Total Generating Resources
Source: EXC 10-K
In 2008, the ExGen segment created $4.445 billion in ocf from capacity of 31,292MW. In 2012, ExGen created $3.554 billion in ocf from capacity of 44,027MW. If pricing and cost structure return to peak 2008 levels, ExGen could create upwards of $6.25 billion in ocf from its current capacity. If prices and costs returned to 2007 prices, ExGen could create $4.213 billion in ocf from its current capacity.
If the regulated utilities did no better than 2012 ocf, company-wide ocf could then be between $6.9 billion and $8.9 billion and would equate to between $8.00 and $10.50 per share.
During the first nine months of 2013, net cash flows provided by operating activities were $4.4 billion versus $4.6 billion in the year-ago comparable period. Based on ocf, shares are currently trading about 3.5 times projected ocf for this year, and are less than the previous range of 4.9 to 5.9 times in 2010 and 5.5 to 9.2 times in 2008.
The reason EXC shares are trading at such a low valuation is the needed turn in electricity pricing is not "just around the corner." The PJM auction last May that covers electricity pricing going out to 2016/2017 points to continued weakness. From a recent SA article, below is the RPM Results Chart outlining pricing for various PJM regions, with the largest being RTO (blue line).
The two graphs below are estimates of the future of PJM pricing models from 2010 to 2030, as reported by Versar.com in their study titled "Long-Term Electricity Report" (pdf). The estimates are for a slow and steady climb in PJM pricing over the next two decades.
In addition to the steady climb in PJM pricing will be a steady climb in generating capacity that will be retired in the PJM service area. Below is a graph also offered by Avalon Energy Services that outlines the anticipated annual and cumulative retirement of power generating capacity in the Northeast and Midwest from 2010 to 2029. While alternative fuels are taking up some of the slack, wind and solar are not base-load comparable to coal, which is the largest fuel source being retired.
Exelon's hedging program involves hedging of the commodity risks for expected generation, typically on a ratable basis over a three-year period. The proportion of expected generation hedged as of Sept 30, 2013, is 97% - 100% for 2013, 84% - 87% for 2014, and 48% - 51% for 2015. In addition, about 29% for 2016 is hedged. This hedging helps in maintaining a predictable short-term cash flow and allows for commodity upside potential within just a few years. However, it will be in 2015 and beyond before a meaningful pricing uptrend is contributing to overall profitability due to a limiting of 50% of expected 2015 production is already pre-sold.
Exelon's capital expenditures were $3.9 billion during the first nine months of 2013 compared with $4.1 billion in the prior-year period. However, according to their latest investor presentation, management expects to reduce cap ex. The largest reductions will be in nuclear upgrades, investments in solar, and base cap ex. Below is a chart of anticipated cap ex out to 2016:
Source: EXC Investor Presentation
While this reduction in overall cap ex will contribute to higher free cash flow, it is also indicative of where management believes the best returns will be over the next few years - regulated over unregulated businesses.
It is interesting Morningstar.com ranks Exelon with 5 Stars and is the only utility with that rating. In addition, due to the strength of its nuclear power generating fleet, EXC carries a wide moat ranking as well. Morningstar analysis seem to side with management that the current share price is fundamentally cheap, pricing and demand support will return to the east coast power markets, and EXC will once again exceed most in electric utilities in creating above average return on invested capital.
Below is a 15-year graph of return on invested capital ROIC as reported by fastgraphs.com. EXC has historically generated above industry average ROIC. This outperformance drove share prices higher between 2005 to 2008 as ROIC increased from 4.5% to 12.3%. With the collapse in pricing and demand, ROIC has crumbled to between 3% and 4%, and is more in line with its peers.
The expansion into more regulated assets will help flatten out the earnings curve, but will not eliminate EXC's high exposure to ExGen and the merchant power business. While it is impossible to predict commodity-pricing years into the future, pricing related to PJM auctions will continue to be an important factor in EXC's profitability.
Analysts are not looking for a turnaround until after 2015. Most forecasts put EPS at $2.57 this year, with 5% to 10% declines each in 2014 and 2015. This may put earnings per share in the $2.30 to $2.40 range before a significant turn takes place.
Management and investors are making a huge bet that demand will increase, pricing will increase, and base-load capacity will decrease. Demand will increase with strengthening economic activity in the Northeast and Midwest. Pricing will pick up with a turn in natural gas pricing. Base-load capacity will decrease as coal-fired plants are retired and as more intermittent-load wind replaces investments in additional base-load capacity.
When these three events positively influence EXC's bottom line, share prices will be substantially above their current 10-year lows.
Author's Note: Please review important disclaimer in author's profile.