Exelon Revisited

 |  About: Exelon Corporation (EXC)
by: Anthony Grossi

About two years ago I wrote a lengthy piece recommending Exelon (NYSE:EXC), and I was disastrously wrong. Not only has the stock price been in a never ending nose dive, but they had to cut the dividend, which seriously undermines the purpose of owning a utility in the first place. I thought it would make for a worthwhile exercise to revisit that article and see if I could learn anything from my mistake.

My original thesis was pretty straightforward. Exelon is a regional monopoly that owns critical infrastructure assets that provide essential services to their customers. Secondly, share prices were depressed due to weak power prices, caused by a glut of natural gas supply. Finally, any rebound in power prices or new regulatory restraints regarding clean fuel sources would immediately benefit the company.

What I love most about revisiting my old article is how little has changed. Exelon is still battling weak power prices. In the name of redundancy, the key here is that Exelon is really a bet on power prices. So if demand goes up, Exelon benefits. To the extent that environmental regulations shut down coal plants, Exelon benefits. And to the extent that natural gas prices rise, that also benefits Exelon. And of course, none of that happened, so Exelon shares went down. And they were over-leveraged, so they had to cut the dividend when pricing didn't improve.

So what was my big mistake? Not accurately guessing the future path of power prices? No, future spot prices are unknowable and if I did know I would bet using futures contracts instead of owning a boring utility company.

So what was my big mistake? I didn't understand the financial underpinnings of the business. Exelon still has a great set of assets. But it is entirely plausible that between cheap natural gas supply and improving alternatives, like hydro, wind and solar, that the spot price for electricity once adjusted for inflation will be the same or lower in ten years. And that possibility, whatever odds you care to put on it, makes Exelon a potentially dangerous stock to own. I didn't understand how Exelon's hedging program and leverage (debt) put the dividend at risk if prices continued to fall. In short, I was right about a bunch of stuff that didn't even matter and ignorant of the one thing that mattered most, downside risk.

What about the company going forward? After all, the price is much more attractive today than it was two years ago. Would I recommend the stock today?

After the merger with Constellation, Exelon has two businesses, one a regulated utility and one an un-regulated utility. Utility regulation aims to fix customer rates at levels that allow the utility to earn a fair return on their investment while keeping customer costs as low as possible. The upside to this arrangement is that it ensures that the utility company will at least earn their cost of capital. The downside (for the company, not the customer) is that it prevents the company from earning windfall profits.

The big threat for Exelon today is re-regulation. Imagine a perfect world for Exelon shareholders. New regulations close down all dirty coal plants, natural gas supplies tighten and power prices rise. Exelon benefits from an earnings windfall selling cheap, clean energy in the competitive market. Such a scenario could happen, and if it did it would most likely lead politicians to purse price caps. If there were a push to re-regulate power markets to protect customers from rising energy prices, Exelon loses its raison d'etre.

In conclusion, I still think Exelon's nuclear power fleet is a great set of assets. I still think the company is uniquely positioned to benefit from a rise in power prices or new environmental regulations. The company has already cut its dividend, so there's not much else they can do but wait for a rebound in pricing, or expand their regulated fleet. I have to believe that expanding their regulated fleet is a huge disservice to investors as it robs them of participating in the wholesale power market, and thus of any upside in share price.

So they simply have to wait. Which would be all well and good in its own right. After all, a difference in opinion is what makes a market, and investors are free to choose to own or avoid the stock. My new concern, in the interest of downside protection, is what if everything goes right for shareholders and still doesn't matter because a rise in power prices is met by a wave of re-regulation?

I think Exelon is a very interesting stock and would buy it at tangible book (about $22.50) because I don't think any utility can be worth less than tangible book for very long, it will either go bust or regulators will step in to guarantee that they at least earn their cost of capital. But I now know that Exelon is a potentially dangerous stock for investors to own. Power prices could struggle to keep pace with inflation or regulators could change the rules of the game. There are easier stocks to own than this one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.