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After the Gulf Spill, a Brighter Future for This Utility

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar. As BP and the market continued to contend with the Gulf oil spill, Morningstar's Paul Larson, editor of the Morningstar StockInvestor newsletter, has been looking for stocks that may have been unfairly punished as a result of the disaster in the Gulf. He found something interesting in the utility sector, and he is here to tell us a little bit about it today.

Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Stipp: So, this is an investment theme you have been thinking a lot about recently, and you came upon a pretty well-known utility. Tell us a little about the company and what it does.

Larson: Right. Well, when I was thinking about the oil spill, I thought to myself, "Okay. Let's try and find some of the silver linings here." And one of the stocks that I found is Exelon, a company that's actually in the Tortoise Portfolio in the StockInvestor newsletter.

And Exelon is a utility company, they own regulated utilities, ComEd here in Northern Illinois and PECO in Pennsylvania. But where the company gets the majority of its earnings and where the majority of their future value is, is their merchant power-generating business, and this is a business where they get the majority of their power from nuclear power plants. So, when you think about Exelon, it's clear that we should think about it as a nuclear power plant operator.

Stipp: Okay. And you mentioned to me that there are some different drivers that may be affecting its growth prospects in the future. What are some of the short-term drivers that you are looking at that may bode well for Exelon?

Larson: Well, the short-term drivers are, we have a normalization in the weather. In 2009, we had an extremely cool summer season, and in 2010, with the recent heat wave, we're having a much more normal weather pattern. And this is bullish for both electricity demand and power prices.

And then also, I would say that industrial production is another area that that's a bright spot. At the height of the recession, we saw industrial power demand actually decline from the peak by about 15%, which is just an unprecedented decline in power demand, and as the recovery continues to gain steam, we foresee a recovery in actual demand for electricity.

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Stipp: Well, I was on the East Coast last week, Paul, and I can tell you my demand for electricity certainly went up. You're also looking at some longer-term drivers that maybe affecting the company in a positive way. When you're looking out a little bit further, what things do you think are going to be a plus for Exelon?

Larson: Well, this is where the oil spill comes in. When you look at some of the effects of the oil spill, one we have the drilling moratorium, which is going to cut the future natural gas supply to this country, and though natural gas is not part of Exelon's business at all directly, Exelon is very much dependent on natural gas prices, and this is because the marginal watt of electricity is generated by natural gas fired power plants. So, electricity prices are determined by natural gas prices, and obviously electricity prices impact Exelon's business. So, a cut in natural gas supply is going to raise the price of natural gas, it's going to raise price of electricity.

Also, I think the oil spill is going to nudge things politically here in this country, where we may have an increased chance of some sort of carbon restriction. Whether this comes in a form of direct carbon tax, as these resources are extracted, or if we cut the subsidies, or if we do have some sort of cap-and-trade system in place that's put in place in this country, all these things are going to benefit Exelon.

Also, politically, if we move from hydrocarbon as the primary source of transportation fuel and move more towards electricity, whether this is electric cars, we just saw the IPO of Tesla and Chevy Volt that's about to come out, or if we move more towards plug-in hybrids, where you plug-in the cars overnight, all these things are going to greatly boost the demand for electricity, which is going to tremendously help Exelon.

Stipp: Okay. So, Paul, these sound like pretty positive drivers for the company, but you also said the company looks really attractively valued. What do you think is accounting for the market not seeing some of the positives that are in the cards for Exelon?

Larson: Right. Well, I think the market may be looking at the recent past and extrapolating far into the future. Like I said, 2009, we had very poor electricity demand. Also natural gas prices were exceptionally low. But when you look at the futures prices, natural gas has gone into fairly steep contango, especially after the oil spill, meaning the price in the far-out futures are much higher than the near-term futures. So, this is a very bullish thing for Exelon.

Stipp: So, Exelon, where are you pegging its fair value, then, compared to where the stock is trading right now?

Larson: The fair value estimate that we have is $73, and the stock is right around $40, so a fairly significant discount to our fair value estimate. And the stock is trading at only about 11 times earnings, and these are earnings that are generated in what I would call a trough cyclical conditions. And then also the dividend yield is highly attractive. It's got a dividend yield above 5%, which, again, I think is very attractive, especially relative to some of the other options out there.

Stipp: Nice way to get paid while you wait for the market to come around your way of thinking on the stock. Last question for you, when I'm thinking about the risks of investing in this utility what should be on my mind and what things should I begin to lookout for?

Larson: I think the primary risk is natural gas prices. If natural gas prices were to stay at these low levels or even fall further in the future, that is something that we definitely have to consider and commodity prices can be quite unpredictable at times.

Stipp: And also when you think about BP and the silver lining of this, as you described before, but also BP is faced with a big disaster, and I think of Exelon running these nuclear power plants, should I be worried about an accident?

Larson: Well, I think after the BP spill, I think people are keenly aware of the limits of human engineering. And we always have to be worried about accidents happening, and obviously that the magnitude of an accident, were it to happen to Exelon, would be large, but I would say that I'd view the probability as very, very low. Exelon has an excellent safety record, and if you look at the nuclear power plants, they are like surgical wards. And they really do focus on safety for obvious reasons.

Stipp: Well, Paul, thanks for your insights for that, a very interesting idea in the utility space.

Larson: Thanks for having me.

Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.