Exelon Corp. (EXC) is among the leading electric utility companies in the U.S., serving more than 6.5 million customers. The company has significant exposure to unregulated power generation operations, whose performance is highly sensitive to forward power and natural gas prices. In the last two years, EXC has been in the news, certainly not for good reasons, at first due to balance sheet concerns and now due to weak forward prices and low natural gas prices, which have taken a toll on the stock price. The balance sheet concerns have faded away, as EXC addressed them by cutting dividends. Now low natural gas prices and weak forward power prices remain headwinds for the company, which I believe will further affect the company's margins and stock price. The following is the stock price graph for EXC for the last two years.
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Source: Yahoo Finance
EXC has significant unregulated and merchant power operations, whose fundamentals stay weak due to difficult business conditions. Almost two quarters of the company's equity value and earnings are exposed to unregulated operations. I am bearish on EXC, as forward power prices remain weak and business environment for merchant power operators remains tough. Also, a lack of heat rate expansion, excess power supply in PJM power market, weak spark/dark spreads and low natural prices do not paint an attractive picture for EXC. Additionally, low power prices have resulted in increased competition in EXC's retail business, which has pressurized its margins to the bottom-end of the targeted margin range of $2-$4/MWh. It seems that the merchant power market has lost its allure, and there has been a structural change in the market.
Also, as the merchant power market fundamentals stay weak, the risk of nuclear plants shutdowns remains high for merchant power producers. EXC's merchant nuclear plants are also adversely affected by high fixed costs associated with regulatory inspection of aging plants and contracting of quark spread. The company's Quad Cities Nuclear Plant, in PJM, is facing weak margins due to wide pricing differentials. Moreover, EXC's management has highlighted that margins and economics of several of its nuclear plants, including Quad Cities, Clinton, Oyster Creek, and R.E. Ginna, stay weak, and it could opt to shutdown some of its nuclear plants in the coming quarters.
Low natural gas prices and excess power supply have forced PJM power prices into backwardation as 2017 prices are below the 2014 prices; I do not expect this to improve in the near term. Consistent with weak market conditions, EXC recently introduced the 2016 gross margin, which is $200 million less than 2015's gross margin. The following table shows the gross margin trend for the company's merchant operations.
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Source: Presentation Slides
As merchant power operations continue to be weak, the company aims for regulated operations growth, which will drive its consolidated earnings growth. The company is targeting to achieve a 6% rate base growth and 7%-8% EPS growth through 2017; I will recommend investors to watch for additional information in the coming quarters regarding the road map and rate base growth strategy for regulated operations. However, I believe that regulated operations growth will be masked by the continuous weakness in the merchant operations.
I have a bearish stance on EXC due to the difficult business environment for its merchant power operations, and believe growth in regulated operations will also be masked by the sluggish merchant power market. Merchant power markets for EXC are not expected to improve in the near term as power supply remains excessive, limiting a power price recovery. As the company has been surrounded by problems in recent years, it has led to multiple contraction for EXC, as shown below, which I believe will continue in the near term due to difficult conditions for merchant power operations. Therefore, I recommend a 'sell' rating for the stock.
Price/ Cash Flows