Exelon's Future Performance Relies On Executing Plans To Diversify Operations

Jul.15.14 | About: Exelon Corporation (EXC)

Summary

Weak natural gas and forward power prices adversely affected company’s margins and overall business performance in the past.

EXC experienced valuation contraction as a result of weak and volatile forward prices.

Efforts to diversify operations portends well for stock performance and help the company address risks being faced by the utility sector.

In the first half of 2014, the utility sector outperformed the broader market. The utility sector ETF (NYSEARCA:XLU) has gained 13% year-to-date, as compared to a 6.8% gain for the S&P 500. The outperformance of the utility sector can be attributed to a better sales trend of utility companies, a decline in treasury yields and an improvement in competitive power markets.

However, the utility sector is exposed to the risk of a rise in treasury yields, which could limit the sector's upside in the second half of 2014. Also, an increase in investor risk taking ability and rotation out of defensive sectors could limit capital gains for the sector. Therefore, I believe the utility sector could underperform the broader market in the remaining half of the year. As the above mentioned risks could adversely affect the utility sector's performance, Exelon Corp. (NYSE:EXC) has been making efforts to improve its business operations, as the company's performance is highly sensitive to natural gas prices and forward power prices. To diversify its business operations and improve its risk profile, EXC has intentions to acquire Pepco Holdings (NYSE:POM). Also, last week, EXC acquired Annova LNG, a company which plans to export natural gas. Moreover, the company is making investments in renewable energy projects to keep up with the Obama Administration's plans to curb carbon emissions.

Diversifying Business Model

As the company's operations are highly sensitive to natural gas prices and volatile forward power prices, EXC has been taking measures to diversify its business operations to address instability. EXC has planned to acquire POM for $6.8 billion in cash. The acquisition will make EXC the largest electric and natural gas utility company in the Mid-Atlantic region. The combined company will have a rate base of $26 billion and serve approximately 10 million customers. U.S. power utility companies have been active with merger and acquisition activities in the recent past to diversify business operations and lower costs through larger operational scale. According to Bloomberg data, acquisitions by U.S. power utilities have totaled $14.9 billion in the past one year. The acquisition will increase EXC's regulated operations and result in annual cost savings of $80 million a year.

Moreover, to diversify business operations, EXC last week acquired a 96% stake in Annova LNG, a company that plans to export natural gas. Annova LNG is a startup company and is in early stages of constructing a $1.3 billion LNG export terminal in Brownsville, Texas. Annova LNG is in the process of constructing facilities that store and refrigerate gas that will be shipped overseas through tankers. Annova LNG will sell LNG by targeting customers that lack facilities to manage larger tankers. The acquisition will help EXC strengthen its business operations and will portend well for the stock price.

Also, EXC signed a contract to develop and install solar plants. EXC will own the solar plants and sell the output through long-term purchase agreements. The company intends to provide electricity to municipalities and schools based in California. The power purchase agreements will provide stability to the company's revenue base. Moreover, the initiative will allow the company to expand its renewable portfolio and meet regulatory requirements to curb carbon emissions by 30% by 2030. The company plans to invest $260 million on renewable energy projects in 2014, which will increase electricity generation from renewable sources; currently, 10% of EXC's total electricity is generated from renewable source.

Conclusion

EXC's performance is highly sensitive to natural gas prices and forward power prices. Due to weak natural gas and forward power prices in the past, the company's margins and overall business performance were adversely affected. Also, the company experienced valuation contraction as a result of weak and volatile forward prices, as shown in the table below. EXC's efforts to diversify its operations will portend well for the stock performance and help the company address the risks being faced by the utility sector. However, the efficient execution of the company's plans to diversify operations remains critical for the company's future performance.

Price/Sales

Price/B.V.

Price/Cash flows

2011

1.5x

2x

5.9x

2012

1x

1.2x

4x

2013

0.9x

1.1x

4x

Click to enlarge

Source: Morningstar.com

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