Exelon (NYSE:EXC) is a merchant electricity generator powerhouse. The problem for investors lie in the fact the company is virtually all nuclear. Exelon’s business is split between merchant power (75% of operating earnings) and regulated electric utilities ComEd and PECO (25% of operating earnings). Review these statistics:
- EXC operates the largest fleet of nuclear power plants in the US with nineteen, eleven of which are in the Northeast and Mid-Atlantic.
- EXC generates 17% of all nuclear power supplied in the U.S.
- EXC generates 10% of total power in the 14 state Mid-Atlantic region.
- EXC generates 4% of total US electric generating capacity, inclusive of all fuel types.
There are four issues facing investors: the current crisis in Japan and potential impact on the nuclear industry in the U.S.; more stringent EPA regulations for competitive fuel emissions; market pricing; earnings visibility. These topics are as controversial as they are complex and a book could be written about each subject. These topics are also very much intertwined.
The events unfolding in Japan are too fluid to accurately access anything except the most general impacts on the nuclear power industry in the U.S. We should keep in mind the men and women in and around the Japanese power plant are most likely on suicide missions and to correct the situation may cost them their lives.
Unlike some European countries which are shutting down their nuclear generation capacity, the U.S. will take a more measured approach to existing facilities: more stringent regulations and more oversight.
The pace of construction of new nuclear facilities in the U.S. will surely go back into the deep freeze. The main reason for the growing interest in nuclear power generation is the historically lower cost compared to oil, natural gas, and coal. Nuclear power is almost unmatched in its production capacity. The cost of alternative energy from wind and solar are multiple times higher than nuclear, and capacity is limited. With a lack of competitive low cost, new nuclear capacity coming on stream, companies with a higher exposure to nuclear generation should be at an advantage. As the largest nuclear generator, both in capacity and leveraged exposure, EXC stands to gain the most.
There will be investigations and hearings and more regulations ahead for the industry, and these will increase capital expenditures and operating costs. It should not be unexpected that new regulation may cost EXC upwards of $1 billion, due to their numerous plants. Management has already budgeted $700 million for plant upgrades in 2011 and $5 billion over the next three years for maintenance and upgrades.
Due to its advantages of lower cost and higher capacity, nuclear power generated cash flow was coveted by investors. The main risk had been the impact of commodity electricity auction market pricing. However, due to the tragedy in Japan, event risk will become a larger factor, potentially depressing comparative cash flow multiples.
Re-licensing of nuclear power plants in the U.S. will become more costly and difficult. There are currently 20 plants that have filed for re-licensing and an additional 17 anticipated soon, and combined represent 35% of the 104 nuclear power plants in the U.S. While these facilities will be operating during the application and review process, their re-license now carries a slightly higher risk. EXC earliest re-license will be in 2016 and again in 2020.
Lost in the news cycle was the recent announcement by the EPA of higher emission standards for power plants. One key element of the new regulations is a 91% reduction in mercury emission with a 3 year compliance window. Mercury is one of the pollutants in coal-fired power generation. The EPS estimated compliance costs of $11 to $15 billion annually while the industry claims the installed costs are upwards of twice EPA’s estimates. Investors should be aware that the investor- owned utility sector earned $30 billion in all of 2010.
Coal-fired power plants will begin closing as it will be uneconomical to meet these new EPA regulations. It is estimated that 75 gigawatts of coal-fired generation, or 10% of total U.S. generating capacity, could be shut down this decade due to more stringent EPA regulations.
With insufficient new thermal power generating facilities being built today, and with the lack of alternative energy to generate this replacement capacity, it is logical to project constrained supplies. With constrained supplies should come higher prices.
With 75% of its operating earnings from power generation, EXC is very much at the mercy of commodity electricity pricing, also known as the "auction market." Currently, electricity demand is weak due to slow, but improving, economic activity. The well-documented low cost of natural gas has also depressed market pricing as these cost savings are passed on. However, the potential for higher natural gas pricing and higher demand is beginning to push future pricing up by around 15% to 30% out 4 years. Market prices last year for round-the-clock-service were around $40, with 2012 futures priced at around $46 and 2015 futures at around $53.
With a full-scale retreat of coal as a fuel source for electric generation, natural gas becomes the next best alternative in the traditional energy field. The U.S. has increased its use of natural gas from about 19 percent of electricity generation in 2005 to about 24 percent in 2010. The CEO of EXC made this point very clear at an industry conference last week:
"The economics have changed so much that natural gas really is going to play a much bigger role. Last year, the focus was on how much shale gas we have. This year, it's now how it's going to change the economics of the whole electric power business ... it will be the default fuel going forward."
EXC could be viewed as a play on higher natural gas pricing driving up the production cost of electricity, directly benefiting nuclear power generators.
A reduction in coal-fired power generation and an uptick in natural gas pricing, combined with better demand, should result in higher auction market prices over time. This will positively impact EXC’s earnings potential.
Earnings per share in 2010 were $4.08, and should be about flat in this year. With higher-priced hedges expiring this year and next, and with a lower-priced current auction market, EXC is expected to show an earnings decline to about $3.25 in 2012 and into 2013. As the auction market improves in a few years, EXC will be able to replace current low-priced hedges with higher priced one. However, that may not be until 2013, or 2 years from now. Higher auction pricing will translate into higher earnings. At the top of the next economic cycle, EXC has the potential to earn over $6.00.
EXC pays a dividend of $2.10 that is secure, but not anticipated to grow over the next 18 to 24 months. The 5.0% current yield is not overly compelling strictly as a no-growth income selection.
A 3-year price chart with 200 day and 50 day MA is below:
There is a lot to like and equally enough to dislike about Exelon. EXC’s share price has fallen about 10% over the past week, and briefly dropped below $40. Investors hate uncertainty and the nuclear power industry is fraught with uncertainty right now.
Share prices have held up better than I had anticipated. I initialed an average size long-term position in December and January, but knee-jerked a breakeven sale of half early last Monday, anticipating a big selloff. I’m looking to get back in either at a better price below $38 or at a replacement cost of $43. I am willing to bet EXC and the nuclear power industry will see weaker times ahead in the short-term, but don’t want to miss the long-term tide of increasing merchant power profits.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.
Disclosure: I am long EXC. Author has been a shareholder since 2010.