Exelon Corp (EXC) is suffering through a dry earnings spell because of low natural gas prices. A combination of slow growth in electricity demand, competitively priced natural gas and programs encouraging renewable fuel use are causing this. Lower prices for energy are reflected in the company's margins that haven't been this low in the last 10 years that I looked at:
Exelon Business Summary
From its 10-K: "Exelon, incorporated in Pennsylvania, in February 1999. It is a utility services holding company engaged, through its principal subsidiary, [Exelon] Generation, in the energy generation business, and through its principal subsidiaries ComEd, PECO and BGE, in the energy delivery businesses."
Outlook On Energy Prices
The outlook on energy prices is not extremely favorable in the short term. I downloaded a 2013-2014 chart on estimated total retail energy prices (including industrial and commercial) based on data by the U.S Energy Administration. The forecast is that prices rise slowly:
If the short-term outlook for prices were decisively positive, the current opportunity would not exist. There is no great encouragement from the short-term data but given history I like the chances of unexpected price increases over the mid- to long-term.
Why Invest in Exelon?
Exelon has a few very attractive qualities that make it stand out from its competitors. Most notably, it is the largest nuclear power generator in the United States. The company owns 11 nuclear plants with a total of 34 gigawatts of generation capacity. The company produces 22% of U.S. nuclear power. Almost half of its total power output is generated by nuclear power. Generating nuclear power has disadvantages and advantages. To start with the advantages:
The company has very low operating costs because that is the nature of nuclear power generation. It produces nuclear waste but in terms of fuel, costs are very low. Usually this would not result in a true competitive advantage as competitors would just match your investment in plants - read Greenwald on competitive advantages - and drive down excess returns.
But nuclear plants require massive upfront investments - costing many billions of dollars - that will only pay off many years into the future. They take many years to construct and it is impossible to know what will have happened to energy prices by that time or to the regulatory framework. Not to mention the possibility of breakthrough technology turning your investment obsolete.
In addition before construction can start there is usually also a ton of resistance from local communities. There are very few people who are delighted with the prospect of a nuclear plant in their backyard. All these factors add up to a significant barrier to entry. That's why Exelon will be able to sustain its competitive advantage of producing at below industry average cost.
Well positioned from environmental perspective
Nuclear plants have very low greenhouse gas emissions. In an environment of tightening regulations - the Environmental Protection Agency has more or less stopped coal plants from being feasible - this is a valuable advantage. Competition may be hit by regulation while Exelon is relatively safe. Nuclear disasters can quickly turn the tide against the company though.
Exelon pays a nice dividend
Exelon recently decreased its dividend because of the challenging conditions but it still pays out a healthy 5.4% a year. As do many investors, I favor dividend payers by some degree over companies that don't pay a dividend. Mainly because it's not as likely large companies can reinvest capital and achieve high RoC but also because it sets a bar for CEOs. They have to come up with that dividend and if they want to continue growth, they have to work hard to get the cash flow together.
A company with earnings that are depressed from "normal" values is hard to value but that also makes it worth the effort. I used a discounted cash flow model to estimate the true value of Exelon.
In my earlier article on Exelon I also valued the company by DCF. Since that article I've worked to improve my model. One of the improvements is that I standardized my approach. This makes it harder to tune the calculation to the conclusion you, subconsciously, would like to arrive at.
This time I based my valuation on 10 years of historic free cash flow. Because the current cash flow of the company is so far below that historic average I adjusted it upwards to 50% of operating cash flow. A number that has historically been easily achievable.
I've lengthened the horizon over which I modeled cash flow according to my current standard practice, when valuing a company that has a significant competitive advantage. Exelon does, because it's so hard to enter the market of nuclear generated power.
I don't expect Exelon to be able to grow much but the company will, at least, be able to match inflation. Based on my updated calculation the net present value of a share of Exelon is worth $37.52. In my last article I arrived at a value of $39 per share (read my thought process here), when the stock was trading at $29. It's now trading at $27. This is a 38% discount to intrinsic value.
Counting on reversion of the mean I expect natural gas prices to ultimately reach higher levels. When that will happen it will catapult Exelon's free cash flow and the market will discover the attractive asset base of the nuclear power generator. The fact that there is no clear catalyst is the only reason the stock is actually undervalued. If it were obvious when natural gas prices would tick up again, everyone would realize the powerful effect it would have, and buy the stock. The stock is about 38% undervalued and with the great yield you get paid while waiting for a catalyst to come along.