Because of my value bent I often come across companies that are troubled, during my research. Just like Royal Dutch Shell (RDS) - 4.7% yield - which I wrote about earlier this year, Exelon Corp (NYSE:EXC) suffers through a dry earnings spell because of low energy [GAS] prices.
A combination of slow growth in electricity demand, competitively priced natural gas and programs encouraging renewable fuel use are causing this. Lower prices for energy are reflected in the company's margins that haven't been this low in the last 10 years that I looked at.
EXC data by YCharts
Exelon Business Summary
Exelon, incorporated in Pennsylvania, in February 1999. It is a utility services holding company engaged, through its principal subsidiary, Generation, in the energy generation business, and through its principal subsidiaries ComEd, PECO and BGE, in the energy delivery businesses.
Outlook Energy Prices
The outlook on energy prices is not extremely favorable on the short term. I compiled a 2013-2014 chart on estimated total retail energy prices (including industrial and commercial) from data by the U.S Energy Administration. The forecast is a 1.2% increase in prices.
If the short-term outlook for prices were decisively positive the stock and the current opportunity would not exist. There is no great encouragement on the short-term data but given history I like the chances of unexpected price increases over the mid- to long-term.
Why Invest in Exelon?
Exelon has a few very attractive qualities that make it stand out from its competitors. The firm has these advantages because it is the largest nuclear power generator in the United States. The company owns 11 nuclear plants and 34 gigawatts of generation capacity. It produces 22% of U.S. nuclear power and 4% of all U.S. electricity. Almost half of its total power output is generated by Nuclear power. Generating nuclear power has disadvantages and advantages. To start with the advantages:
The company has very low operating costs because that is the nature of Nuclear Power generation. It produces nuclear waste but in terms of fuel costs are very low. Usually this would not result in a true competitive advantage as competitors would just match your investment in plants - read Greenwald on competive advantages.
But Nuclear plants require massive upfront investments - multiple billion dollars - that will only pay off many years into the future. They take many years to construct and it is impossible to know what will have happened to energy prices by that time.
In addition before construction can start there is usually also a ton of resistance from local communities. There are very few people who are delighted with the prospect of a nuclear plant in their backyard. All these factors add up to a significant barrier to entry. That's why Exelon will be able to sustain its competitive advantage of producing at below industry average cost.
Well positioned from environmental perspective
Nuclear plants have very low greenhouse gas emissions. In an environment of tightening regulations - The Environmental Protection Agency just more or less stopped coal plants from being feasible - this is a valuable advantage. Competition may be hit by regulation while Exelon is relatively safe.
Exelon pays a nice dividend
Exelon recently decreased its dividend because of the challenging conditions but it still pays out a healthy 4.2% a year. As do many investors - I favor dividend payers by some degree over companies that don't pay a dividend.
Return on Equity
A return on equity graph shows why Exelon's share price is currently depressed and also illustrates why I think the company might be undervalued.
Returns are currently at the low range of what has historically been the case. The fundamentals of the business are ever shifting but I would be hard pressed to believe they have changed sufficiently for the new profit margins of Exelon to remain in current depressed territory.
EXC Return on Equity data by YCharts
Long Tail Risk Aka Black Swans
Nuclear Power is what sets this company apart as a power company with a competitive advantage and also as an investment with an additional risk. Nuclear accidents don't have to happen at the company owned plants to have a negative effect on the stock price.
A major nuclear accident anywhere in the world could move regulators towards an unfavorable stance - Example Germany after Fukushima 2011. Regulators are a risk to all energy companies but particularly in respect to Nuclear Energy.
Investing in a Nuclear Power Utility opens you up to obvious long tail risks - or Black Swans as Nassim Taleb calls them. Is it worth it to run this risk and heed the warnings of Taleb?
Black Swan Theory Definition - Wikipedia
The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.
The theory was developed by Nassim Nicholas Taleb to explain:
- The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology
- The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
- The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs
Does my greed to pick up shares of Exelon make me blind to the devastating effect of a Black Swan Event in the industry? What are your thoughts on the matter?
A company with earnings that are depressed from "normal" values is hard to value but that also makes it worth the effort. I used a discounted cash flow model to estimate the true value of Exelon.
First I tried to determine what more normalized earnings would look like - based on 10 years of historic earnings but adjusted for an increased revenue base - and then factored in a small growth rate from there for a short period of five years. What I ended up with were normalized earnings of $3.5 per share. I discounted against the S&P 500.
This exercise leads me to believe that $39 / share is not an unreal valuation for Exelon while it's currently trading at $29.62 /share. That would mean the company is over 30% undervalued. I think an undervaluation like this is sufficient to run a long tail risk for a limited period like three to five years.
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.