Exelon: A Safe Haven In This Market?

Apr.11.14 | About: Exelon Corporation (EXC)


Utilities have been among the best performers so far in 2014.

Have all the weak holders finally exited Exelon's stock following its dividend cut?

The company's Valuentum Buying Index score of 5 reflects stability, which may be all that is needed for outperformance in this high-flying market.

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Let's examine what we think Exelon (NYSE:EXC) is worth in this article and what we think its future potential may hold.

But first, a little background to help with some of the lingo in this piece. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.

If a company is undervalued both on a discounted cash flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Exelon posts a Valuentum Buying Index score of 5, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and neutral technicals.

The company is about as neutral as it gets with respect to how it scores on our process, and therefore we're expecting resilience from the company in this market environment. Its shares will likely hold up relatively well. We'd expect underperformance on firms that score a 1 or 2 on our scale, and outperformance on firms that register a 9 or 10 on our scale. Exelon falls within the big middle.

Our Report on Exelon

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Investment Considerations

Investment Highlights

• The recent merger of Exelon and Constellation Energy has created one of the lowest-cost power generation fleets in the US. The tie-up offers opportunities for O&M synergies, portfolio optimization, and overhead savings. More than half of the combined company's portfolio will be low-cost nuclear.

• Exelon has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 9.7% in coming years. Total debt-to-EBITDA was 3 last year, while debt-to-book capitalization stood at 47.5%.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

• Exelon recently slashed its dividend to a payout of $1.24 per year. We still don't think the firm has strong dividend growth prospects, but the weak holders may have already exited. This should prevent any income-related selling going forward, and reduce the firm's pricing action to any adverse events. To a large extent, its Valuentum Buying Index rating reflects this improved resiliency.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Exelon's 3-year historical return on invested capital (without goodwill) is 9.4%, which is above the estimate of its cost of capital of 7.5%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Exelon's free cash flow margin has averaged about 7.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Exelon, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.

Valuation Analysis

The estimated fair value of $37 per share represents a price-to-earnings (P/E) ratio of about 26.1 times last year's earnings and an implied EV/EBITDA multiple of about 7.9 times last year's EBITDA. This is roughly in line with the company's share price. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 10.7%. Our model reflects a 5-year projected average operating margin of 16.8%, which is below Exelon's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.4% for the next 15 years and 3% in perpetuity. For Exelon, we use a 7.5% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $37 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Exelon. We think the firm is attractive below $30 per share (the green line), but quite expensive above $44 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Exelon's fair value at this point in time to be about $37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Exelon's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $44 per share in Year 3 represents our existing fair value per share of $37 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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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.