Record low interest rates combined with this year's earlier flight to safety have meant a banner year for regulated utilities such as Exelon (NYSE:EXC), Duke Energy (NYSE:DUK), Dominion Resources (NYSE:D), and Southern Company (NYSE:SO).
However, with shares of Exelon vastly outperforming its rivals, as well as the market in general, I feel the need to warn investors that Exelon's share price has far exceeded what its growth prospects justify over the next few years.
Latest earnings show continued struggles in turnaround
|Metric||Q2 2016||Q2 2015||YoY Change||YTD 2016||YTD 2015||YoY Change|
|Revenue||$4.5 billion||$4.3 billion||2.8%||$8.4 billion||$8.5 billion||-1.1%|
Exelon's overall results exemplify the struggles management has turning around the company since the company's wholesale energy division, which for years generated the majority of its revenues, started facing severe headwinds due to the shale gas revolution.
Specifically, Exelon's massive fleet of nuclear power plants, the largest in the nation, continues to face growing competition from natural gas fired power, as gas production booms, natural gas prices remain near all time lows, resulting in extremely low wholesale power prices. For example, this quarter the company's power generation segment reported an $8 million loss, compared to the same quarter last year, in which Exelon booked $398 million in profits.
Fortunately for investors, strong results from its PECO, and ComEd, thanks to higher rates, were able to offset most of the weakness in generation, as well as falling profits at BGE, where rate disallowances prevented the company from recovering on some capital expenditures in the form of higher rates.
This big, bold bet on nuclear, as well as large scale acquisitions of rivals such as its $7.9 billion purchase of Constellation Energy in 2012, and $5.4 billion buyout of Pepco in 2015 ($12 billion including debt), ended up creating an overly leveraged balance sheet. In fact, thanks to natural gas prices resulting in ongoing weakness in the wholesale energy markets, Exelon actually had to cut the dividend 41% in 2013, in order to preserve its credit rating. As consolation,Exelon has given relatively weak forward payout growth guidance of 2.5% a year through 2018, which, while better than nothing, still means that it will likely take decades for Exelon's dividend to reach its old highs.
The Bullish Case for Exelon
Management believe that the combination of higher base rates, most of which have already been secured, combined with finally getting costs under control through shutting of uneconomic plants, will lead to strong earnings growth in the coming years. In addition, a stronger focus on regulated utilities should mean stronger, and more consistent earnings going foreword. That's mainly because power generation will represent just 40% of sales going forward, compared to 80% in 2008.
Source: Exelon investor presentation.
How realistic are Exelon's rosy predictions? Well based on the company's poor overall margins, and returns on shareholder capital, there is certainly room for major improvement.
|Utility||Operating Margin||Net Margin||Return On Assets||Return On Equity||Return On Invested Capital|
That's especially true given that long-term coal and natural gas prices are expected to rise in the coming years thanks to numerous bankruptcies among coal producers. In addition, growing natural gas demand from a larger number of gas fired power plants, and LNG exports should cause natural gas prices to rise in the coming years.
Source: Kinder Morgan (NYSE:KMI) investor presentation.
In addition, thanks to more favorable regulatory environments regarding government support for low carbon power sources, several analysts, including Morningstar's Travis Miller, whom I consider one of the best long-term, buy and hold focused watchers of this industry, project that Exelon's regulated utility business can indeed grow at 8% annually through 2020.
Sufficient growth catalysts are certainly available to achieve those lofty targets, with management aiming for around $32 billion in capex investment over the next four years.
Then again, investors need to remember that Exelon will always have high regulatory risk that may limit management's ability to execute on its full growth potential. For example, in just the past few months, the failure of Illinois's legislature to pass a clean energy standard has resulted in the company announcing the early retirement of two major nuclear stations, the Clinton, Quad Cities, in 2017, 2018, respectively.
Dividend profile the weakest of its major rivals
|Utility||Yield||TTM Dividend Payout Ratio||10 Year Projected Dividend Growth||10 Year Projected Total Return|
Academic studies have shown that a good rule of thumb for anticipating long-term total returns is yield + dividend growth. And while management's 2.5% payout growth guidance through 2018 is hardly something to get excited about, nonetheless analysts expect dividend growth to accelerate slightly beyond that short-term time horizon.
Of course, the problem for investors looking to open a position in Exelon at today's prices, after the recent run up, is that the yield is lower than many of its large utility rivals; many which offer far better dividend growth prospects. For example, Dominion Resources expects its large expansion into natural gas to result in 8% dividend growth over the next few years.
Similarly, Duke Energy, whose management has once again shifted business models, this time away from wholesale power generation, and back to its core regulated business, is guiding for long-term earnings, and thus dividend growth, of 4% to 6% per year.
Overvalued UNLESS you've have a VERY LONG time horizon
|Utility||Yield||5 Year Avg Yield||P/OE||Historic P/OE||P/CFO||Historic P/CFO||Average Historical Premium|
There are two things to notice about Exelon's yield, price to operating earnings, and price to operating cash flows, both relative to its rivals, and its own historic norms. First, Exelon, like most big utilities, are trading at a slight historical premium right now, thanks to the strong rally over the past year.
Second, note that, on an absolute basis, Exelon trades at a huge discount to Duke, Dominion, and Southern Company. That is mostly explained by its poorer margins, and recent difficulties, both on an operating level, as well as punishment from investors for its relatively poor dividend growth track record.
Of course, if management can execute on the promised turnaround, diversifying away from wholesale power generation, and boosting both its margins, and forward dividend growth prospects, than those multiples could expand. Which brings me to the most important question regarding whether or not Exelon is a good investment today.
|Utility||Morningstar Fair Value Estimate||Current Share Price||Premium To Fair Value|
When it comes to five year intrinsic value approximations, I consider Morningstar's fair value estimates, which are created using conservative growth assumptions and a two stage discounted cash flow, or DCF analysis, the gold standard.
However, while Morningstar's Travis Miller considers Exelon the most overvalued utility among its relative to its medium-term prospects, keep in mind that Morningstar's assumptions about Exelon may end up proving overly conservative.
For example, the firm recently cut its fair value estimate from $35 to $30. However it's five year valuation model not only takes into account the retirement of the Clinton, Quad Cities, and Oyster Creek plants, but also it's Three Mile Island, and high risk of a shutdown of the Byron plants as well.
Now, I'm not saying that most of those retirements won't go through, as management has already announced that three of those five early retirements are done deals. However, I also think that assuming that Exelon will shut down what is essentially 25% of its nuclear capacity, when the widest moat business it operates is emission free nuclear power, is perhaps overly cynical.
Similarly, Morningstar's model estimates that Exelon's returns on its massive capex spending will come in at a 10% return on equity, while the company's most recent earnings saw rate increase agreements announced in Maryland, Delaware, and DC which granted 10.6% ROE.
|Utility||TTM EPS||10 Year Projected Growth Rate||Intrinsic Value Estimate||Growth Baked Into Current Price||Margin Of Safety|
In fact, my own intrinsic value estimate, which is based on: a 30 year, two stage DCF analysis that assumes 3.6% EPS CAGR over the next decade, 3% CAGR over years 11 through 30, and a 9.1% discount rate, (equal to the S&P 500's historical total return) shows that Exelon might make a decent long-term value investment, even at today's share price.
In fact, Exelon appears to be most undervalued based on its long-term growth prospects, creating the largest margin of safety. How is that possible given the recent difficulties the utility has faced? Two main reasons.
First, my model takes into account future growth opportunities such as investments into smart grid technology, to keep Exelon's long-term earnings growth slightly above that of GDP growth.
And most importantly, given the long time frame I'm operating under, rival utilities will most likely see their growth rates moderate over time. And given Exelon's very low multiples right now, indicating Wall Street is actually pricing in negative growth in the coming years, all Exelon needs to do over the next few years is to beat very low expectations to potentially generate impressive capital gains.
In other words, given a long enough time horizon, my model predicts that a convergence of valuation multiples means that Exelon, with the lowest valuations on an absolute basis, could prove the safest utility to own at the current price.
Of course that doesn't mean that I actually consider the utility the best dividend growth investment at this time. After all, any long-term model has large margins of error, and most utility investors are concerned more with the dividend profile than with long-term total return projections decades down the road. And then there are the risks Exelon must navigate in the coming years, and decades, that could derail its bullish turnaround fueled, multiple expansion thesis.
Risks to consider
Exelon's turnaround hinges on two things in particular: the rising of wholesale power markets which will make its existing fleet of nuclear plants cost competitive with competing power generation, and a friendly regulatory environment in the Midwest, and East Coast markets in which it operates.
However, should energy prices in those markets rise too high, then there is the political risk of re-regulation in the form of price caps that could cut off management's earnings growth efforts. This is especially a concern in Illinois and Maryland, whose regulatory environments have been notoriously challenging with regards to utilities.
Similarly, numerous environmental groups are pushing for low carbon energy alternatives, but remain opposed to nuclear energy, and in favor of wind and solar. For now the lack of energy storage technology makes nuclear an important component of providing America's energy with low carbon alternatives. However, in the coming decades new battery and super capacitor technology could create disruptive breakthroughs that cost Exelon its remaining moat, and derail its efforts at delivering consistent earnings, and dividend growth.
Bottom line: Exelon remains a deep value, LONG-TERM turnaround play, but for high-yield dividend growth investors, superior alternatives are available at better relative valuations
Investing is never done in a vacuum. With limited capital you need to be selective into what high-yield utilities you buy. With Exelon's: lower yield, poor long-term dividend growth prospects, and higher political risk pertaining towards its more controversial fleet of nuclear plants, I simply can't recommend investors apply new capital into Exelon shares when Dominion Resources, Southern Company, and Duke Energy offer better, risk-adjusted, long-term income growth opportunities.
That being said, If you already own Exelon, and have sufficient patience, and faith that management can get its act together to actually achieve its targeted EPS growth guidance, then the company may make a decent deep value play. However, even then I'd recommend waiting for a more attractive price; one more in line with its historical norms.
Disclosure: I/we 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.