Exelon Is Worthy, But Gas Natural? Not So Much

| About: Exelon Corporation (EXC)
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There is hardly a utility company that I don't like. However, don't take this statement as a "buy any and all utility stocks regardless of the price," but rather as an endorsement of the utility sector as an important part of an income and growth investment strategy. As with any sector, there are times to buy utility stocks and times when an investor should consider reducing sector exposure.

As a fundamental value investor, I find many utility stocks are not very attractive at current valuations due to higher P/E valuations and/or lower dividend yield. Add in a bit of future interest rate risk, and most utilities could be considered fully valued.

There are opportunities, however, in selected companies and situations. Exelon (NYSE:EXC) is one worthy of consideration due to its higher current yield and potential for capital gains for patient investors with a three-year time horizon. EXC is a combination of regulated electric utilities servicing Chicago, Philadelphia, Baltimore, and Washington areas. In addition, it operates one of the largest merchant power portfolios in the industry, mainly focused on low-cost nuclear power in the Northeast, Midwest, Texas, and California.

Gas Natural (NYSEMKT:EGAS) falls on the other end of the spectrum, and recent management moves may be more advantageous to its CEO than current shareholders. This small-cap natural gas firm has been buying utility assets owned by its CEO, and recently agreed to purchase a natural gas E&P, which is both in bankruptcy and majority owned by EGAS CEO.


While there are risks to Exelon's nuke exposure, the dividend has not been increased for a while, and earnings peaked a few years ago and have been sliding lower, a case can be made that the bottom is close at hand -- or is already here -- for both commodity electricity pricing as set by the PJM Auction and EXC's fortunes. Consolidation of the utility sector continues and EXC is digesting its latest acquisition, expanding its footprint in the regulated business. Other merchant power producers have been making similar moves to reduce exposure to, and the earnings variables of, commodity electricity. This acquisition will add to the stability and visibility of earnings over time. However, the turnaround story lies in its merchant power business.

EXC operates the largest fleet of nuclear power plants in the country and is a "powerhouse" in the merchant electricity business -- pun intended. According to wikinvest.com, in 2010:

  • EXC generated 20% of all nuclear power supplied in the U.S.
  • EXC generated 10% of total power in the 14 state Mid-Atlantic region.
  • EXC generated 3% of total U.S. electric generating capacity, inclusive of all fuel types.

The majority of its geographical exposure is involved in the auction market where large amounts of electrical needs are put out to bid on a rolling three-year basis. For example, the most recent PJM electricity auction in May set pricing for actual electricity purchases in 2015.

Merchant power producers use coal, natural gas, nuclear and alternatives of wind, solar and hydro to create electricity. The political pressures on coal-generated production will create higher costs and lower capacity which will not be totally offset by currently-low priced natural gas. The conversion of coal plants to natural gas, or their closing altogether, is moving natural gas into the spotlight as a challenger to low-cost nuclear power. However, as an energy commodity, investors should expect natural gas to eventually revert to a historic price range in the $4.00 to $6.00, off its current low of about $2.50. As rising natural gas prices will have a higher impact on electric generation pricing due to its increase use as a fuel source, along with overall increased production from higher cost alternative energy, look for PJM auction pricing to increase as well.

This upward pressure is already being felt in the futures market for PJM electricity as demonstrated by the 2015/2016 Reliability Pricing Model (RPM) Base Residual Auction that took place in early May 2012. The most recent auction contracts for actual delivery pegged pricing in 2015/2016 at $136 per megawatt-day. The auction price in Northern Ohio was a whopping $346 per megawatt-day. From PJM's website describing the auction: "This RPM auction was impacted by an unprecedented amount of planned generation retirements (more than 14,000 MW) driven largely by environmental regulations, which drove prices higher than last year's auction." Keep in mind the 2015/2016 RPM auction prices of $136 is almost five times higher than the same auction rate pricing covering 2013/2014 of $28. More information on PJM can be found here.

Many merchant power producers have long-term power supply contracts lasting upwards of 20 years. EXC, on the other hand, has a higher exposure to PJM pricing, and its recent strength will show up in EXC's profitability in a few years. The same influences that have contributed to a decline in earnings between 2009 and 2012 will be contributors to higher earnings 2014 and beyond -- market pricing and consumption. Since 2009, pricing and consumption have been on the decline due to the recession and lower commodity pricing. As the economy continues on its slow recovery, EXC will benefit from both higher pricing and higher demand. But it will take time.

There are concerns cash flow may not cover expected capital expenditures and higher debt and/or equity dilution is in the cards. While this may be the case in the short term, patient investors with a 2015 time frame should benefit from the potential of higher electric prices and demand.

Earnings estimates going out to 2014 call for a declining and stagnant $2.30 to $2.60 range, based on a weak pricing model and very slow pickup in demand. According to Yahoo Finance, this is the low end of estimates, and EXC was very recently downgraded by Citi to a Sell based on current valuation. However, PJM auction pricing and supply availability could be an indication of a potentially different future for merchant power producers.

The current dividend could be considered stable with little potential for a cut, unless the entire industry comes under duress. With a 5.5% current yield, EXC offers a higher than "average" utility dividend. While dividend growth has been virtually non-existent over the last few years, Exelon's current yield should be high enough to provide interest in the stock, along with providing yield support to its price.

Gas Natural

Gas Natural provides regulated natural gas service in Montana, Wyoming, Northern Ohio, Western Pennsylvania, Maine, and North Carolina. Gas Natural has increased customer count to 70,000 through acquiring small, local gas utilities, such as its Ohio purchases that added 25,000 customers. Management prefers to add geographic areas where natural gas market penetration is below the national average of over 50%. Natural gas operations generated 95% of 2011 operating net income, with 3% from a gathering and interstate gas pipeline and 2% from natural gas marketing and production. Gas Natural has interest in over 100 gas wells in the West.

EGAS has an interesting history. The current CEO, Richard Osborne, was hired in 2006 to turn around a failing natural gas utility in Montana. Since his hiring, Osborne has grown the customer base and geographical reach by acquiring other small gas utilities using a roll-up business model. However, recently, acquisitions have been focused on businesses controlled by Osborne.

In 2010, EGAS purchased three utilities serving Northern Ohio where Osborne was also the CEO and major stakeholder. While this type of insider dealing is not necessarily to the detriment to shareholders, it is bothersome that these assets have been underperforming, even in a weak natural gas utility market. Initially proposed in 2009, this acquisition was rejected by EGAS shareholders because it was funded entirely by additional debt. On its second attempt, shareholders approved the merger when Osborne agreed to accept an all-stock transaction along with assumption of outstanding debt. Right after the merger, Osborne owned almost 50% of the outstanding EGAS shares and has been selling his stake ever since, and now owns about 15%.

In April of this year, EGAS announced it was acquiring John D. Oil and Gas (OTC:JDOG), an Ohio-based natural gas exploration and production company. This is another company that is controlled by Osborne, but should be subject to more investor scrutiny than the Ohio utility purchases. JD Oil is currently in bankruptcy and Osborne has personally guaranteed a large portion of JD Oil's debt using his shares of EGAS as collateral.

The price being paid for J.D. Oil by EGAS shareholders seems exorbitant. The acquisition will be $2.875 million in EGAS shares plus estimated performance payouts of between $2.875 million and $5.29 million as per the example outlined in the SEC filing. Total purchase price could be as high as $8.1 million, or higher, as there is no cap on the performance payouts and could represent upwards of 10 times JDOGQ EBITDA multiple per the filing. The number of shares to be issued should be at least 500,000 at a purchase price of $5.6 million ($2.8 million initial and $2.8 million performance), and could be over 750,000 and upwards of 1 million shares. This represents a dilution of over 6.1% and could reach 12%.

For a company that is in bankruptcy with negative stockholder equity of -$4 million (assets of $8 million and liabilities of $12 million), paying upwards of an $8 million purchase price seems a bit self-serving for Osborne at the expense of EGAS shareholders. J.D. Oil's 2011 total revenues were $1.46 million, making the purchase price upwards of 5 times revenues. The current market cap of JDOGQ is $180,000, but it doesn't trade often with Yahoo reporting the last trade on Sept. 7, 2012, at $0.02 with volume of 20,000 shares and there are 9 million shares outstanding. Last April, before the acquisition was announced, JDOGQ traded at $0.0026 with a market cap of $24,000. EGAS will be paying upwards of $8 million for JD Oil and this is being presented as "good" for long-term shareholders?

From Gas Natural's SEC filing of its 10-Q in August 2012 Legal Proceedings (page 18):

On June 20, 2012, the Company was named as a defendant in a lawsuit captioned RBS Citizens N.A., dba Charter One v. Richard M. Osborne, Gas Natural Inc. (f/k/a Energy, Inc.) and the Richard M. Osborne Trust, Case No. CV-12-784656, which was filed in the Cuyahoga County Court of Common Pleas in Ohio. In an effort to collect on judgments obtained against Richard M. Osborne, Chairman and Chief Executive Officer, the complaint seeks (1) an order requiring the Company to pay over to RBS Citizens any distributions due to Osborne by virtue of his ownership in Gas Natural as well as any proceeds payable to him as part of the previously announced proposed acquisition of John D. Oil and Gas Marketing Company, LLC ("JDOGM"), (2) the imposition of a constructive trust on dividends or assets that Osborne might receive as part of the acquisition of JDOGM and (3) an injunction preventing the acquisition of JDOGM.

EGAS pays a dividend monthly at a $0.54 annual rate, for a 5.4% current yield, but it has not been raised for several years. While I like the roll-up business model and the prospects in several of their service areas, such as Maine, I sold my position when the J.D. Oil acquisition was announced. This acquisition may become a prime example of company insiders dealing themselves a better hand than shareholders and, in my opinion, breaches management's fiduciary responsibility to the owners of the company -- its shareholders. Buying underperforming Ohio utility assets is almost forgivable if profitability can be turned around, but bailing out Osborne by engineering Gas Natural to purchase his failed and bankrupt JD Oil should be unforgivable.

Exelon should be worthy of utility investors time and effort for further research, while Gas Natural is not.

Disclosure: I am long EXC. 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.

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