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A Rider on Economic Recovery

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, one of the co-editors of Morningstar's OptionInvestor. And today it's my great pleasure to welcome Travis Miller, senior equity analyst in charge of utilities. Travis, thanks for coming.

Travis Miller: Thank you, Erik.

Kobayashi-Solomon: And thanks for coming back, after we did a Westar video as well.

Miller: Absolutely, yes. We still like Westar, and now we're going to talk about Exelon.

Kobayashi-Solomon: Great.

Miller: We think that's another good name in the utilities space.

Kobayashi-Solomon: Got a lot of interest in this Exelon investment. And just recently, I know there's been a lot of political developments that have kind of changed the landscape for Exelon. Can you talk a little bit about those, and where you see Exelon's fair value?

Miller: Sure. Everybody knows about what happened in Massachusetts in January. The Republican victory there with the Senate seat took away the Democrats' super-majority in the Senate. And that's a big blow to President Obama's energy legislation package, which included carbon caps. That was one of his key themes.

Kobayashi-Solomon: And carbon caps are, basically, increasing the price of inputs for energy, coal, or, let's say, natural gas, right?

Miller: Yeah, absolutely. They would increase the cost of generation for about 70% of the nation's power.

Kobayashi-Solomon: How does this affect our bullish position in Exelon?

Miller: Sure. Well, I think there's about $6 of value from carbon caps being instituted. So, if you think about that $6 coming off of our $73 fair value, it's a slight hit, but we still think there's a lot of value in the generation unit, even if you don't believe in carbon caps coming on in the 2013-2014 time period. We also see a little bit of incremental value at the regulated units.

Kobayashi-Solomon: Are carbon caps dead? I mean, do you think that this is really a done deal at this point?

Miller: Sure, it's a good question. It's one that everybody's asking. They're probably done for the near term in the Senate and the Congress and the House. They're probably not done in the near term at the EPA level. So there could be further regulation, around either emissions or other coal plant operations, that could force utilities to either shut down, retire, or just reduce production from the cheap coal plants that now exist.

Kobayashi-Solomon: I heard in the news the other day that the Obama administration have given some loan guarantees to a big Southeastern energy producer, Southern. And I wonder, first of all, how does this affect the political landscape? And also, is this something to worry about from Exelon's perspective? Can Southern start competing with Exelon, for instance?

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Miller: Sure. The loan guarantees were a policy out of the Energy Act in 2005. It was a President Bush-led initiative. And it's something that Republicans have put into their agenda: the nuclear build-out in America. So this is a bit of an olive branch to the Republicans, to approve these loan guarantees. Southern received an $8.3 billion loan guarantee out of an $18.5 billion pool. So we've got enough loan guarantees for about three more plants, we think.

It probably does not have much of an effect on Exelon. These are going to be plants located in the Southeast. It's very difficult to transport electricity to the markets where Exelon operates.

Kobayashi-Solomon: It's all about transmission, right? I mean, you just can't transmit the power that far.

Miller: Yeah. So we don't see much impact on Exelon, even if all of the loan guarantees that have been approved go through.

Kobayashi-Solomon: But this is a pretty rare thing, I think. I mean, nuclear power plant construction has been dormant for years, right?

Miller: Yeah. This would be a big shift in U.S. energy policy. We haven't built a plant in three decades.

Kobayashi-Solomon: Right.

Miller: And as it affects Exelon, the value still is in the brown-field nuclear plants. These new greenfield, so-called, nuclear plants are very expensive to build. They demand a high energy price to make them economic. And the value, we think, still lies in those owners of brownfield plants.

Kobayashi-Solomon: And when you say brownfield, you mean these are the existing nuclear plants.

Miller: Existing nuclear plants in the U.S. And the largest of those is Exelon, with 11 plants.

Kobayashi-Solomon: You've sold me on this idea. I mean, it really, to me, has a huge economic moat, looks like a very good economic bet. But the stock price has been trailing down since we published the original article back in October/November of last year. What is the market missing, do you think?

Miller: We think there are two concerns out there within the market. One is on the side of electricity demand. There's a big question right now: Is the economy coming back? Electricity demand tends to follow economic production, especially industrial production, and other economic factors. So, as the economy improves, we would expect electricity demand to rise, and with the rising electricity demand, you get higher power prices.

Kobayashi-Solomon: Sure.

Miller: Since Exelon's costs are relatively fixed, there's a lot of operating leverage, and every dollar increase in power prices is essentially a dollar increase in pre-tax profits for Exelon. So as the economy improves, we think Exelon is a good bet to increase profits.

The second part of that is commodity prices. Commodity prices have been mired in very multi-year lows for the last 18 months. And as the economy recovers, as there's more demand for energy, commodity prices rise, and commodity prices rising drives higher power prices. So, again, we get to higher operating profits for Exelon.

Kobayashi-Solomon: Sure. What's a downside scenario for Exelon? And on the other hand, what's an upside scenario for these guys?

Miller: Sure. Going back to our drivers, the economy and commodity prices, if the economy lags, if we get even a double-dip recession, if commodity prices stay where they are, especially natural gas prices, if demand for industrial uses in natural gas stays low, if supply stays at record-high levels, and gas prices remain in the $5-per-mcf range that we've seen, then the stock is just about fairly valued. We're really making a call on an economic recovery and a recovery in commodity prices.

Kobayashi-Solomon: I see. And if things were to bounce back big, do you do any scenario analysis about kind of an upside potential?

Miller: Sure. So, as there's about 50% downside to our fair-value estimate, there's just as easily a 50% upside. If you look at gas prices and power prices going back to levels that we saw in early 2008, even mid-2008, if you have hot weather that increases electricity use throughout the Midwest and Mid-Atlantic regions, that all drives much higher power prices.

Operating leverage works both ways for investors. It works on the downside and the upside. So we've seen it on the downside over the last couple of months, 18 months or so, for Exelon. Now we could expect to see it on the upside, if we get a rebound.

Kobayashi-Solomon: Seeing the double-edged sword cut the other way.

Miller: Yeah.

Kobayashi-Solomon: Well, Travis, thanks a lot for coming. Sure appreciate it.

Miller: OK. Thanks a lot, Erik.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website, where you can find many more great option ideas based on Morningstar's fundamental research.