Why Bulls Fear Exelon: Utilities Could Lose 50% Of Value

| About: Exelon Corporation (EXC)

While I am largely bullish on energy and tend to be attracted to high dividend yields, I believe utilities are substantially more risky than what the market acknowledges. Regulatory headwinds, consolidation pressures, and the challenges in delivering actual value creation from those consolidation efforts are significant risk factors not reflected in betas (which is a function of past trends).

In this article, I will run you through my DCF analysis on Exelon (NYSE:EXC) and will then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Duke Energy (NYSE:DUK) and the Southern Company (NYSE:SO).

First, let's begin with an assumption about revenues. Exelon finished FY2011 with $18.9B in revenue, which represented a 1.5% gain off of the preceding year: deceleration. Analysts model 9.6% per annum growth over the next six years, and I view this as reasonable since it is about 100 bps below what is expected for the S&P 500.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model operating expenses as 75% of revenue versus 19% for capex. Taxes are estimated at 39% of adjusted EBIT (accounting for non-cash depreciation charges).

We then need to subtract out net increases in working capital. I expect that this will hover around 2% of revenue.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 7.5% yields a fair value figure of $42.09, implying 7.7% upside. However, value investors have frequently contested "weighted average cost of capital" as a way of calculating a discount rate to present value future streams of free cash flow. Particularly debt-loaded companies like Exelon frequently have a low WACC due to the tendency for equity to cost more than debt. And, as I stated in the beginning of this article, Exelon also has more risk than what the market acknowledges. I would require a 10% return to justify investing in Exelon. A WACC of 10% would imply that the company is worth nearly half of its current market value.

Overall, however, I am confident that the market will factor in a much lower WACC at least over the next half decade (around 8%). With all of the uncertainty surrounding capital markets, high income plays will be preferred. This preference will, however, be considerably weakened if the Obama administration gets its way and chooses to egregiously double-tax your dividend earnings above current levels.

All of this falls within the context of the merger with Constellation (NYSE:CEG) and strong operating performance:

2011 was another fine year for Exelon. We had very strong financial and operating performance; we grew the company through acquisitions, which are working on both on an earnings and cash flow basis; [and] we made progress on a range of regulatory, legislative and market issues…

Our fourth quarter operating earnings were $0.82 per share. While December was a little disappointing due mostly to weather, our full year 2011 operating earnings per share of $4.16 were within our final guidance range, better than our 2010 results and well above our original expectations for the year.

From a multiples perspective, Exelon is fairly attractive. It trades at a respective 10.4x and 12.7x past and forward earnings versus 16.5x and 14.2x for Duke and 17.6x and 15.8x for Southern. Assuming a multiple of 13x and a conservative 2013 EPS of $2.78, the rough intrinsic value of Exelon's stock is $36.14 - roughly in-line with my DCF result factoring in an 8% WACC.

Consensus estimates for Duke's EPS forecast that it will be roughly flat at around $1.45. Assuming a multiple of 15.5x and a conservative 2013 EPS of $1.41, the rough intrinsic value of the stock is $21.86. The company is planning a merger with Progress Energy (PGN), which will create the largest United States utility company. It would generate 57 gigawatts of US generating capacity to 7 million consumers. But the two are likely to meet complications at the state level even after making multiple concessions at the federal level. On Monday, the firms sought approval from the Federal Energy Regulatory Commission for its mitigation plan.

Southern Company is rated pessimistically on the Street based on data sourced from T1 Banker. Consensus estimates for the company's EPS forecast that it will grow by 3.9% to $2.67 in 2012 and then by 5.6% and 5.3% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.76, the rough intrinsic value of the stock is $38.64, implying 13.7% downside. The company has around 42K megawatts of generation and is seeking to add 2.2K more by building reactors that are estimated to cost $14B. The investment in nuclear power is a huge bet, but one that is overly risky. As the economy improves, investors may start looking for companies that are more speculative. To the extent that that occurs, however, don't expect to find unusually high returns. Accordingly, I recommend holding out on these utility producers for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The distributor of this research report is not a licensed investment adviser or broker-dealer. Investors are cautioned to perform their own due diligence. We seek business relationships with all of the firms in our coverage, but research covered in this note is independent.

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