Has Exelon's Rally Run Its Course?
We're still bullish for the long term, but the stock may have gotten ahead of itself in the short term.
Exelon (EXC) has been on a tear, up 21% since hitting a nine-year low in November amid concerns about a dividend cut and credit risk and up 16% year to date, handily beating the S&P 500 and the Morningstar Utilities Index. But Exelon's fundamental earnings power has not changed, and we're concerned that this has been a ghost rally built on yield-seeking multiple expansion and spot power price rallies. Exelon has virtually no exposure to spot power prices, given its hedge profile, and forward power prices have hardly changed since November. Little has changed in its other businesses. Given the static earnings outlook, we think Exelon could find itself back where it started if the yield rally stalls.
Despite all of the focus on the near-doubling of spot natural gas prices since mid-2012, forward 2015 gas and power prices haven't budged since November. Exelon has virtually no exposure to near-term power or gas prices, with 94%-97% of its 2013 expected generation hedged as of February. Its core value lies in 2015-16, when its expected generation is mostly unhedged. The difference between our $42 fair value estimate and our $30 mark-to-market estimate is our bullish midcycle power price assumptions. We estimate that a 10% change in Exelon's average realized power price on an open basis would result in a 15% change in its midcycle earnings and $7 per share of value.
With little change in the firm's fundamental earnings power, we attribute Exelon's recent rally to multiple expansion. At its low in late November, Exelon traded at 12 times our 2014 trough mark-to-market earnings estimate. Now near $35 per share, it trades at more than 15 times our unchanged 2014 trough earnings estimate. We think a fair 2014 price/earnings multiple is closer to 14 times.
We've seen this multiple expansion across the utilities sector during the past year as the market turns to traditional low-uncertainty, high-yield investments. But we believe investors who are looking for stable cash flow and long-term dividends should avoid Exelon, given its heavy exposure to volatile power prices. Although we don't think the current lower dividend faces near-term risk, its growth prospects depend significantly on the direction of power markets and electricity supply/demand fundamentals.
Exelon also now appears rich relative to its closest diversified utilities peers. We believe Exelon's size, high-quality assets, and earnings upside deserve a premium multiple to its group, but we think a 16 P/E is a bit excessive. In addition, Exelon offers one of the lowest dividend yields of any U.S. utility, at 3.6% based on its new $1.24 per share annual implied dividend. Our $42 fair value estimate implies a 10 P/E on our midcycle 2016 earnings estimate, in line with current implied midcycle P/E multiples for the other U.S. diversified utilities.
Still Bullish on Exelon's Long-Term Competitive Position
We think Exelon's earnings upside and long-term competitive position are intact. We expect consolidated earnings per share can top $3.50 by 2015 with only modest upticks in power prices from here. On a midcycle basis, we continue to estimate Exelon's long-term earnings power at $4.25 per share.
Exelon's wide-moat nuclear power plants continue to produce outstanding returns. Adjusting for the Constellation acquisition that closed in March 2012, we estimate Exelon's generation fleet produced a 12% return on invested capital for the full year, primarily due to its continued world-class nuclear operations. Constellation's less profitable generation fleet and retail business hurt ROICs along with continued falling nuclear fleet hedged margins due to weak power prices. Even as earnings bottom next year based on current power and retail market conditions, we still expect Exelon's generation unit to produce ROICs well above our 8% cost of capital estimate for the generation business.
Exelon continues to optimize the value and competitive advantage of its nuclear fleet, which achieved a 93% capacity factor in 2012, continuing an eight-year string of achieving at least 93%. An increase in refueling and outage days in 2011 and 2012 resulted in slightly lower capacity factors, but its operating performance remains well ahead of peers'. The U.S. nuclear fleet in 2012 achieved just an 86% capacity factor, the lowest since 1999.
We think concerns about Exelon's nuclear fleet economics and lifespan are overblown. Based on the $1.2 billion of average annual investment Exelon has made in its nuclear plants in the past decade and our estimate of a nuclear plant's economic depreciation, we estimate Exelon's fleet is only two years old on an economic basis. We think management will keep maintenance spending near $1 billion even after including an estimated $350 million of Fukushima upgrades in 2013-17. The fleet has no near-term relicensing requirements that would require significant outlays.
Exelon's other businesses continue to operate in line with our expectations. We expect the utilities to contribute $1 in EPS by 2014 and grow 5%-7% on a weather-normal basis. On the retail side, margins remain depressed but appear to have stabilized. Lower volatility is reducing the competitive advantage that we think Exelon's retail business could achieve with its scale and access to its own wholesale generation, but that's not having a material impact on profitability.
Management Strategy: Where From Here?
CEO Chris Crane passed his one-year anniversary in March. He appears to be leading a successful integration with Constellation. In November, management raised its synergy estimate to $550 million from $500 million and says it can achieve most of those by the end of this year, representing $0.40 in EPS. Since late last year, Crane has addressed the market's fears of a cash flow shortage by deferring $2.3 billion of investment and cutting the dividend 41% to $1.24 per share annualized, saving $740 million annually.
But we're still waiting for the management team and the reshaped board to present a definitive long-term strategy. Since the Constellation deal closed, five legacy Exelon directors are gone and six new directors--including four from Constellation--have joined. Only two of the 16 directors have been with the company since the 2000 merger that created Exelon.
Overall, we think management is making good near-term decisions. Given our bullish outlook on power prices, we think investors are best served if management continues to take a cautious approach to hedging its expected generation, keeping alive some of the upside we think could be available in 2015 and beyond.
Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.