Exelon (EXC) owns and operates the largest merchant power fleet in the U.S. It owns solar, hydro, wind, oil and gas fired power plants but the largest proportion of installed capacity is from nuclear power stations (19 GW out of 35 GW), which makes it the largest owner and operator of nuclear power in the country. The company also owns three regulated distribution companies serving Chicago, Baltimore and Philadelphia. Despite declining contribution in the past few years, the majority of earnings still come from Exelon Generation, the power plant side of the corporation.
Exelon Generation has an industry-leading safety record as well as the highest capacity factor for its nuclear units. A high capacity factor means the company is able to keep downtime for planned and unplanned maintenance and refueling at a minimum. Perhaps most important, it also has the lowest nuclear production cost (just below $18/Mwh vs. $20-$26/Mwh 5-year average from competitors according to this recent investor presentation). Operational excellence has been a key driver of past returns, as the commercial strategy employed by the company is to sell energy production in spot markets. In recent years, however, this strategy has produced declining earnings due to depressed spot energy prices. In an effort to diversify its generation portfolio, EXC has been acquiring and developing large wind (404MWs of capacity addition in 2012) and solar (230 MW under construction) projects. These are all going to sell under long-term power purchase agreements, which should reduce gross margin volatility, and management has indicated it is focusing on developing contracted renewable projects. Over time, this effort will likely continue, however, the nuclear portion is still by far the main source of gross margin.
The "regulated utility" side of the business provides regulated earning base that should be relatively stable due to the risk transfer nature of regulated assets. Management has shifted long-term capex plans away from its nuclear up-rates program (upgrades to auxiliary equipment and systems to improve net plant output by reducing parasitic load and other losses) and into growing its regulated asset base. This will also contribute to decreasing reliance on merchant power and reducing volatility in earnings going forward.
The low variable cost and the size of this operator´s nuclear fleet is one of its biggest competitive advantages, but the commercial decision of avoiding long-term contracts has exposed the company to earning headwinds from depressed power prices. EXC compensates partially through a very large and disciplined hedging program that covers all expected generation in the current year, roughly 2/3 of expected generation in the second year and 1/4 in the third year.
The program is effective in reducing short and medium-term downside risk but gross margin remains exposed to a long period of depressed power prices as expiring hedges are rolled over. Power prices, largely driven by gas units, have been trending lower and remain depressed due to the large increase in volume from unconventional gas production in the US, very flat demand growth, and the resulting drop in gas prices. After going below $2/mmbtu in 2012, prices of gas have recovered to above $4/mmbtu as winter demand and some production curtailment (caused by the low price) starts taking effect.
Management expects power prices, and therefore gross margins from the generation portfolio, to recover in the medium term driven by two factors. First, the large number of announced coal power station decommissioning in the coming years and second, less efficient (higher heat rate) gas units coming online due to the coal retirements. In the medium term, and in an effort to adjust to current market conditions, EXC has announced reductions and delays in planned capex, especially around nuclear uprates and in February of 2013 reduced its dividend as well, in order to avoid potential credit rating downgrades. Management considers investment grade rating a priority and has recently used project financing (for the wind portfolio) in order to raise cash without affecting credit ratios.
The dividend level now in place is considered, in management´s view, robust enough to withstand a stress scenario in which gas prices stay at $3/mmbtu. Please see the Q&A Exchange on Feb 2013 earnings release between a Deutsche Bank analyst and the EXC CFO. This level seems conservative enough given the commodity curve is in contango and the company is able to hedge 2014 natural gas at about $4.5/mmbtu and 2015 gas even higher. A further reduction in dividend seems very unlikely during 2014.
For an investor with a long-term horizon, EXC can prove to be a solid investment, as a combination of factors, reasonably expected to take place in the next few years, helps the company regain earning capacity. Some of these factors could be: the US economy returning to normal growth (stimulating industrial & commercial power demand), natural gas price recovering due to demand adjustment to current prices (for example, heavy transportation fleets gradually switch from liquids to gas, LNG export capacity build up, etc.) and environmental regulation continuing to gradually cause carbon intensive power plants to be retired.
But the most interesting finding in analyzing Exelon is the deep discount the market is imposing on the power generation fleet. Using rule-of-thumb numbers from the industry, new power plants can cost from $2,000/KW for a natural gas combined cycle to $4,500/KW for nuclear. But the Exelon Generation fleet is valued at less than $200/KW. Using some very simple back of the envelope numbers:
The Exelon market cap is $23Bln (end of 2013); we can use a regulated utility forward Price-to-earnings like Duke Energy (DUK) as a proxy and see it trades for about 16 times 2014 earnings. EXC Utility-only Earnings are $1.20 per share (using management´s top end of guidance range for 2013). Using these numbers, we can calculate the implied market cap for the "regulated utilities business" of Exelon as $16.1Bln ($1.20 times 16 equals $19, about 70% of $27 share price and $16.1 Bln is 70% of $23Bln). Implied market cap for generation is then $6.9Bln, which we can divide by installed power capacity of 35Gw and arrive at the value of $197 per installed KW. This is an extremely undervalued level for such a large, diversified and well-operated power generation fleet.
This analysis ignores the value of other margin sources that the company has in its small E&P portfolio and its large marketing organization, Constellation. A positive value for these businesses would imply an even lower valuation on the power fleet. The analysis also assumes away any ExGen specific debt, and corporate debt (all debt not related to utilities). There is about $5Bln in non-utility debt on the balance sheet, which would bring the market implied value of the fleet to $340/KW, still a very deep discount.
The main risk with an investment in EXC is the low probability but high impact risk of an industry (or company) nuclear accident severe enough that it causes restrictions for future operation and permitting of nuclear power plants.
I initiated a long position in EXC a few weeks ago and intend to keep for the long term.