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Summary

  • Natural gas prices depressed Exelon earnings.
  • When put in a historical perspective, Exelon's profit numbers are terrible.
  • When performing a DCF calculation taking into account normalized gas prices, Exelon is undervalued.
  • Exelon has a low beta and a sizeable but unreliable dividend.

Exelon Corp (NYSE: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:

EXC Operating Margin (NYSE:<a href='http://seekingalpha.com/symbol/ttm' title='Tata Motors Limited'>TTM</a>) Chart

EXC Operating Margin (TTM) data by YCharts

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 included 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 for prices changed because of the cold U.S. winter:

Cold weather also contributed to a new record-high withdrawal of natural gas from storage and a surge in natural gas spot prices. Natural gas working inventories on January 31 totaled 1.92 trillion cubic feet (Tcf), 0.78 Tcf below the level at the same time a year ago and 0.56 Tcf below the previous five-year average (2009-13). Henry Hub natural gas spot prices increased from $4.32 per million British thermal units (MMBtu) on January 2 to $5.66/MMBtu on January 27, before falling back to $5.04/MMBtu on January 31. EIA expects that the Henry Hub natural gas spot price, which averaged $3.73/MMBtu in 2013, will average $4.17/MMBtu in 2014, an increase of $0.27/MMBtu from last month's STEO. Residential natural gas prices are expected to average $10.16 per thousand cubic feet (NYSEMKT:MCF) this winter, an increase of $0.41/Mcf (4%) from last winter.

-Source: U.S Energy Information Administration

If the short-term outlook for prices were decisively positive, the current opportunity would not exist. 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. Let's start with the advantages.

Competitive Advantage

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 - of 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 by 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's dividend policy is unreliable

Exelon decreased its dividend because of the challenging conditions, and it stands at 4.1% a year. One understandable complaint I often hear from long-term Exelon investors, since writing about the company, is that its dividend policy is unreliable.

Like 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.

However Exelon is really a bet on natural gas prices returning to a higher level. An investment in Exelon is not a safe reliable dividend play in the first place.

Valuation

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.

Like the last time, I based my valuation on 10 years of historic free cash flow. The main difference with the last discounted cash flow calculation I performed is that I based it off the latest numbers.

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.

When you look at a chart of Enterprise Value to Revenues, you can clearly see what depressed profitability does to the valuation of a company. At the same time, the company has a P/E of 15. A number that doesn't make you think twice.

EXC EV to Revenues (<a href='http://seekingalpha.com/symbol/ttm' title='Tata Motors Limited'>TTM</a>) Chart

EXC EV to Revenues (TTM) data by YCharts

When valuing a company that has a significant competitive advantage, I model cash flow up to 10 years into the future. Exelon does have a solid competitive advantage, because it's so hard to enter the market of nuclear generated power and thus match Exelon's efficiency.

I don't expect Exelon to be able to grow much anytime soon. The company will most likely be able to keep up with inflation. Based on my updated calculation, the net present value of a share of Exelon is $39.67. In my last article, I arrived at a value of $39.52 per share when the stock was trading at $27. It's now trading at ~$30. This is still a ~33% discount to intrinsic value.

I don't rely on beta very much to make my investment articles work, but in this case, I think it deserves a mention. Exelon's beta of 0.17 puts the 33% in perspective. It's very hard to find stocks with this kind of beta that are undervalued as much.

Stock Price HistoryExelon
Beta:0.17
52-Week Change:-4.84%
S&P500 52-Week Change:21.34%
52-Week High (Apr 30, 2013):37.80
52-Week Low (Jan 3, 2014):26.45
Data: Yahoo Finance

Conclusion

Counting on reversion to the mean, I expect natural gas prices to ultimately reach higher levels. I don't live in the United States, but in the Netherlands. In this case, it might as well be in a parallel universe, because the six o' clock news over here is showing RWE (OTCPK:RWEOY) shutting down gas burning power plants en-masse because natural gas is too expensive.

If natural gas would rise, this will catapult Exelon's free cash flow and the market will discover the attractive asset base of the nuclear power generator. The fact that is that there is no clear catalyst. If it were obvious when natural gas prices would return to historical averages, everyone would realize the powerful effect it would have, and buy the stock. The stock is about 33% undervalued, and with the sizeable yet admittedly unreliable yield, you receive some compensation while waiting for natural gas prices to return to normal levels.

Source: Exelon: Moving In The Right Direction, But Still 33% Undervalued