By Ben Strubel of Strubel Investment Management
Opinion on Exelon is mixed. On one hand are the bulls who point to Exelon’s world-class nuclear plant fleet, best in class efficiency, and shareholder friendly management, and they believe EXC is currently undervalued. On the other hand are the bears who point to Exelon’s $5.8B underfunded pension and post retirement plan, depressed wholesale power prices, and lackluster regulated utility segment, and they believe EXC may not represent the deal some think it is. Our opinion is that Exelon’s excellent assets and long-term earnings power far outweigh its liabilities.
Exelon’s business is divided into three segments: power generation and its two regulated utility businesses ComEd and PECO. Power generation accounted for $1,972M or 75% of Exelon’s net income while the regulated utility segment accounted for 25% in 2010. ComEd contributed $337M in net earnings while PECO contributed $324M.
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Exelon owns eleven nuclear plants with a total of 17,047MW of power generation capabilities. Exelon also owns 6,189MW of fossil fuel and 2,383MW of renewable generation capacity. The company also has long-term contracts, with expiration dates from 2011 to 2030, for the purchase of 6,139MW, which it then resells.
The price at which power is sold is determined largely by coal and natural gas prices as well as power consumption demand. Exelon has hedged prices for 90-93% of its power generation in 2011, 67%-70% for 2012, and 32%-35% for 2013. Fuel costs should be relatively stable as the company has long-term contracts for the purchase of uranium. Combine the effects of the recession and depressed economic activity, natural gas prices at historical lows, and Exelon’s hedges wearing off and you can see why Exelon is trading at low valuations and why analysts are predicting a steep drop in earnings over the coming years.
Finally, with the tragedy unfolding in Japan there now may be an increased risk of regulation. The Obama administration has a history of enacting poorly planned and implemented regulatory measures, such as the job killing “temporary” drilling ban in the Gulf of Mexico. While a shutdown of nuclear plants is unlikely, it would be prudent to expect Exelon to experience increased costs in complying with whatever new regulations are dreamed up.
There is an upside to power generation. First, approximately 45% (as of 2009) of the power generated in the United States is from coal fired plants. Although low natural gas prices have spurred a build out of new natural gas plants, coal is still king. Many of these coal plants are old and outdated and will have to be retired because of noncompliance with new environmental regulations. It is also worth noting that far more people have died or suffered serious health effects as a result of the extraction and consumption of fossil fuels than from nuclear accidents.
Furthermore, historically low power consumption and natural gas prices are unlikely to continue indefinitely. The economy will eventually recover and power consumption will continue to rise. With nuclear plants having some of the lowest generation costs among all plant types, even small rises in power prices will be beneficial.
Regulated Utilities: ComEd and PECO
The remaining 25% of Exelon’s net income comes from its two regulated utility subsidiaries: ComEd and PECO.
ComEd is a utility that serves 3.8M customers in the Chicago area. Transmission and distribution of electricity is regulated, but generation is competitive. The regulatory environment for utilities in Illinois is challenging, and many cases have gone against ComEd. However, the population of the Chicago area is growing (although Chicago proper is shrinking) so this should allow for some revenue growth for ComEd. ComEd is also beginning to see growing load trends with residential, commercial, and industrial usage rising the past quarter. However, the Chicago area economy is still lagging the national economic recovery.
PECO serves 1.6M electric and 490k natural gas customers in Philadelphia and southeastern Pennsylvania. The regulatory environment in Pennsylvania is better than Illinois. Like ComEd’s service area, PECO’s service area is also seeing population growth including, surprisingly, the city of Philadelphia. As with ComEd, the transmission and distribution of electricity is regulated while generation is competitive. Load trends at PECO have remained positive to flat. The Philadelphia area economic recovery continues to be at or above national levels.
Besides low power prices and the expiration of Exelon’s hedges, the other big issue facing Exelon is a pension and post retirement plan that was under funded to the tune of $5.8B. However the company has enacted a plan to begin making up the funding shortfall as shown below.
Due to a change in tax laws, the company was able to make a $2.1B contribution to the pension fund in January of this year. Only $500M of the $2.1B contribution was made from cash that would have otherwise been available to shareholders. Some $750M of the contribution came from the tax benefits of the contribution itself, while the remaining $850M was funded from bonus depreciation. With this contribution the plan moves from being 71% funded to 89% funded status.
Over the next four years the company plans to contribute $110M to $195M per year to the plan. To put this in perspective over the last five years Exelon has generated average operating cash flow of approximately $5.5B and average free cash flow of approximately $2.5B. The remaining pension funding costs are not a significant hindrance to shareholders.
Management and Operational Efficiency
One of the most overlooked aspects of a company is the quality of its management, and that is perhaps because it is one of the most difficult things to judge.
We believe the management of Exelon is competent, disciplined, and focused on increasing shareholder value. The company has operating and net margins well above industry average. Indeed, Exelon recently completed its eighth straight year of operating its nuclear fleet at 93% utilization capacity. Exelon’s return on equity (ROE) is also above industry average.
The company is focused on controlling expenses as evidenced by O&M expenses still being below 2008 levels and only projected to rise by 2% during 2011-2013.
Finally, management has not engaged in “empire building” transactions that are destructive to shareholders. During the company’s 2010 fourth quarter conference call, CEO John Rowe said, “We are absolutely value-driven. We will not change. We will not abandon our value-added strategy out of the loss of an old man, out of the envy of other people’s shiny press releases, or for any other reason.”
More importantly Mr. Rowe has backed up that quote with his actions. Management has been more than willing to pass on potential acquisitions, such as Progress Energy, if the price or the company isn’t right for Exelon.
Exelon is currently trading at a historically low price to book multiple of slightly over 2 versus a historical average of 3.11.
(Data from Morningstar)
Taking Exelon’s historical average price to book multiple of 3.11 and book value of $20.49 a share gives us a price of $63.72. This matches well with other long-term price targets such as $54 by S&P 500, $60 from Tweedy Browne (mentioned in one of their quarterly letters), and Morningstar’s $73 estimate.
We believe that a share price of approximately $60 would represent a fair value. We disagree with Morningstar’s and other’s assessments that Exelon has a wide economic moat and Morningstar’s price target of approximately $70 per share. We caution against too optimistic an assessment of Exelon’s competitive advantages. While nuclear power generation does have immense barriers to entry, it is important to note that Exelon is in the power generation business and just so happens to generate a majority of its power from nuclear plants. While competitors may not be able to bring large numbers of new nuclear plants online, there are a variety of other cost-effective plant options available to them, including natural gas. A MW of power produced profitably is a MW of power produced profitably no matter the plant type.
At $42 Exelon currently has an earnings yield of 9% that is attractive versus a 6.2% earnings yield for the S&P 500 and 4.5% for 30-year T-bond. Analysts estimate that Exelon will earn $4.02 in 2011 and $3.03 in 2012, but those numbers should be taken with a large grain of salt. An SG Global Strategy study on American markets from 2001-2006 found that analysts’ earnings forecasts were off by an average of 47% after 12 months and 93% after 24 months. In short, no one knows the future. Even if earnings dip to $3.03 in 2012, a stock price of $42 equates to an earnings yield of approximately 7%, which is still attractive relative to the S&P500 and treasury bonds.
With Exelon, investors are able to buy some attractive assets run by competent shareholder-friendly management at historically low prices. While no one knows the future, should it turn out a bit more positively than the market expects, Exelon will be a great investment. If not, investors haven’t paid too much and can take some comfort in an attractive albeit likely static 5% dividend.
Disclosure: Long EXC