In our August 13th report evaluating Exelon's Q2 2012 performance, we were amused at the alliterative alphabet soup of adjustments (EXC's Q2 2012 adjustment letter footnotes" went up to "J") in Exelon's Q2 2012 results. Despite the fact that Natural Gas Prices have skyrocketed from $1.89/MCF in April to $3.70 as of November 1st, Exelon served up another steaming hot bowl of alphabet soup adjustment excuses to investors with regards to its financial performance. We find it interesting that not only has Exelon's Q3 2012 adjusted EPS declined by 31.25% year-over-year, but that 54.5% of Exelon's adjusted EPS is lost to its recurring bout of "non-recurring charges".
Source: Morningstar Direct
As far back as May, the company's consensus estimates for Exelon's FY 2012 and FY 2013 EPS were $3.01 and $3.03 respectively. This represented a 20% decline versus 2011 EPS, which have stagnated since 2007. At the June 7th Investor Day meeting, Exelon announced that the company couldn't even meet those low bar targets. Exelon announced that 2012 adjusted operating EPS was $2.55-$2.85. Because natural gas prices have skyrocketed by nearly 100% over the last six months, Exelon was able to recently increase its full year adjusted EPS guidance to $2.75-$2.95 as well as generate adjusted EPS of $.77 for Q3 2012 that beat analyst expectations by $.05. We are shocked that natural gas prices have skyrocketed by nearly 100% since bottoming out in April even though the US is facing another potential recession, fracking has served as a game-changer for gas production and natural gas production had increased by 6.8% year-to-date versus prior year levels. The reason why we believe that fracking is an important game-changer in the energy industry in general and the natural gas segment in particular is because natural gas production has increased by 6.8% even though the number of natural gas drilling rigs has dropped by 55% year-over-year.
We are glad that Exelon's Cover Slide did not include the words "Performance that Drives Progress" in its financial presentation supplement documents since we see a company with a long and proud track record of underperformance and its 2012 adjusted EPS is regressing back to 2004 levels. Exelon did this in Q1 2012 and followed it up in Q2 2012 by declaring "Another quarter of solid financial and operating performance". We're surprised that EXC was proud of its performance because although it beat expectations, its adjusted EPS still declined by over 31% even though natural gas prices have almost doubled in the last six months and that provides positive incremental revenue to EXC's wholesale power generation subsidiary Exelon Generation. EXC's management is entitled to its own opinion, not its own facts. Exelon's Q3 2012 adjusted net income declined by 11.45% versus Q3 2011 levels even with the inclusion of Constellation Energy's (CEG) results.
Source: Morningstar Direct
Evaluation of Exelon Generation LLC (Power Generation Subsidiary)
We were disappointed but not surprised that Exelon did not report pro forma results for Exelon Generation. That didn't really matter because its performance was simply awful anyway. Despite bulking up the division with the acquisition of Constellation NewEnergy, ExGen's adjusted net income declined by 12.3%. Exelon's bulls have continually brayed "Wait until natural gas prices rise". Despite the fact that Henry Hub Natural Gas prices have risen by nearly 100% from the end of April to the end of October and despite the inclusion of NewEnergy's operations in the income statement, ExGen's linked quarter adjusted net income increased by less than 15% ($399M in Q2 2012 to $458M in Q3 2012). Unfortunately ExGen has $134M more charges in Q3 2012 than in Q2 2012.
ExGen's adjusted net income declined due to higher nuclear fuel costs, lower realized market prices for the sale of energy and a lower capacity utilization factor on a year-over-year basis. ExGen achieved a 90.7% capacity factor in Q3 2012 versus 93.4% in Q2 2012 and 95.8% in Q3 2011. We were surprised that the Net Averaged Realized Margin/MWH sold declined on a linked quarter basis even though natural gas prices have been rapidly rising since April. We were surprised that natural gas prices have continued to rise so rapidly because we don't see any rational and fundamental reason for gas prices to keep up the rapid increase since April. The reason why we think natural gas prices have no fundamental reason to rise is because the US is facing an economic slowdown combined with "the fiscal cliff", the European debt crisis and hydraulic fracturing serving as a supply and demand changer.
Source: Exelon Q3 Earnings Release
Evaluation of Utility Subsidiaries
Commonwealth Edison's Revenue declined by 16.8% during Q3 2012 versus prior year levels; however the majority of the revenue decline was offset by sharply reduced purchased power expenses. Unfortunately for ComEd, its adjusted net income declined by 19.6% due to a 5.4% decline in its gross margin, which was partially offset by a 3.44% decline in its operating expenses. ComEd saw an 11.6% decline in operating and maintenance expenses. ComEd's depreciation and amortization expense saw an increase of nearly 16.3% during Q3 2012 versus Q3 2011. YTD 2012 income has declined by 25.8% versus YTD 2011. Although the Illinois Commerce Commission had agreed to reopen ComEd's formula rate case; the results were unfavorable to ComEd. As a result of the unfavorable ruling, ComEd has deferred $450 million of capital expenditures from 2012-2014 to 2015 and beyond. ComEd filed a noticed of appeal to challenge the interest rate used on reconciliation balances.
PECO's Net income increased by 20.4% quarter and declined by 1.64% year to date. This was due to a decline in operating revenues of 15% for Q3 2012 versus Q3 2011 levels and 18.6% for YTD 2012 levels versus YTD 2011 levels. PECO's operating revenues were nearly offset by reduced excise taxes and purchased power and fueling costs. PECO's gross margin was flat on a year-over-year basis during the quarter versus the prior year period. PECO's performance was also influenced by unfavorable weather trends in its Southeastern Pennsylvania service area.
Baltimore Gas and Electric actually saw its revenues stabilize in Q3 2012 versus Q3 2011 even with the lower cost for purchased power and other fuel expenses. Operating and maintenance expenses slightly decreased versus the prior year's period and depreciation and local taxes slightly increased versus the prior year's period. Interest expense slightly increased during the period in comparison to last year's comparable period and BGE saw a $4M loss for the quarter due to preferred stock dividends. Excluding the preferred stock dividends, BGE broke even for the quarter.
We'd also like to point out that Wisconsin Energy (WEC) is 90 miles north of Exelon and its oldest operating subsidiary ComEd. Wisconsin Energy generated a higher level of net income during the quarter than ComEd and BGE combined as well as PECO and BGE combined. Wisconsin Energy's Net Income was within 74% of the combined net income of Exelon's three utility subsidiaries, despite having one-third the total revenue of Exelon's collective utility subsidiaries and a metropolitan service area (Milwaukee) that has maybe 8% of the total population of the metro areas of Exelon's three utility subsidiaries.
Exelon's management increased its forecasted FY 2012 adjusted EPS range from $2.55-$2.85 in August to $2.75-$2.95 and said it was comfortable reaching in that range. Considering that it is a wide range, we think that's a pretty easy goal to meet. Wisconsin Energy only has a $.02 cent range ($2.31-$2.33). Another thing we don't like about Exelon is all the "non-recurring charges that it takes". Of the $658M in "adjusted net income", $364M represents "non-recurring charges" that reduce reported EPS. Wisconsin Energy didn't report any "non-recurring charges" this period. Then again, Wisconsin Energy is the Midwest's leading utility company and as such, it doesn't have to Alibi Ike its earnings with "non-recurring charges".
ExGen accounted for nearly all of the "non-recurring charges" and with $367M of "non-recurring net charges" this accounted for 80% of its "adjusted segment net income". Plant divestitures required in order to satisfy regulatory approvals of the Constellation acquisition accounted for $193M in realized losses on the sale of the plants in Q3 2012. Constellation merger and integration costs accounted for $31M in non-recurring costs, amortization of commodity contract intangibles accounted for $187M in non-recurring costs and other non-recurring gains and losses accounted for a net benefit of$44M. The good news is that Exelon's management thoughtfully put a letter explaining each adjustment to net income. The bad news is that the "adjustment letter footnotes" went up to "P" in this quarter, versus "J" in the prior quarter. Even with the lack of adjustments, Wisconsin Energy's actual profit margin was comparable to PECO's adjusted profit margin. WEC's actual profit margin exceeded the adjusted profit margin of the rest of Exelon's subsidiaries, including the highly-vaunted Exelon Generation wholesale merchant power generation subsidiary.
In conclusion, we believe that if one is looking for a high-quality utility to invest in, we don't recommend investing in Exelon (EXC). While the bounce back in natural gas prices will help keep profits at Exelon and its flagship subsidiary ExGen from collapsing further, we are still not impressed with Exelon's operations, assets or its management. Even with natural gas prices returning to the levels seen in Q3 2011, EXC's adjusted EPS declined by 31.25%. While Exelon's bulls can bray about EXC's 6% dividend yield, we think Exelon's ticker EXC is short for "EXCuses", since the company seems to have those in spades. Considering that natural gas prices are nearly 14% higher on October 31st 2012 versus October 31st 2011 levels, we think it would be inexcusable for Exelon to report Q4 2012 EPS that misses expectations and is anything less than the $.82 generated in Q4 2011.
Source: EIA Natural Gas Pricing Data
Disclosure: I am long WEC.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.