What to Do With Exelon?

After missing out on nearly all of the stock market’s rally since March 2009,  Exelon (EXC) has been on a tear this year. The stock is up 29% year to date while the S&P 500 is up just 8%, both including dividends. The rally leaves Exelon trading at the smallest discount to our fair value estimate since July 2008. But we still think the upside outweighs the downside, making Exelon one of the most attractive utilities we cover. For bulls, we still see 18% upside if power markets continue climbing toward our midcycle assumptions. For bears, we question management’s capital allocation and suggest that the market could be overvaluing Exelon’s regulated utilities. Here we present both sides of the story for investors wondering what to do with this embattled but high-quality company.

Even After Its Rally, Exelon Is Among the Cheapest Utilities
Exelon has far outpaced the Morningstar Utilities Index and the S&P 500 with a 29% total return through July 2. Exelon now trades at just an 18% discount to our $40 fair value estimate, the smallest discount since 2008. Despite the stock’s shrinking discount to our fair value estimate, it retains the most leverage of any utility to our bullish long-term view on power markets. It is one of just eight U.S. utilities we cover trading below our fair value estimates, and it trades at a 23% discount to the median price/fair value estimate of our utilities sector coverage.

We continue to expect trough earnings at $2.37 per share in 2015 and midcycle earnings near $4.30 per share based on our bullish outlook for power and gas prices. On a midcycle basis, we project that Exelon Generation can earn $5 billion of EBITDA. This is nearly double our 2016 trough mark-to-market EBITDA estimate for Exelon Generation. Our midcycle power prices are about 30% above current forwards as of early July based on a $5.40 per thousand cubic feet midcycle gas price and market heat rates about 20% higher than current 2016 forwards. At the retail business, we assume 8% long-term normalized gross margins and 1% annual volume growth beyond 2015.

At the regulated utilities, we assume that all three utilities (excluding  Pepco ) earn an average 10% return on equity starting in 2015, and we increase the rate base 7% annually through 2017 based on $3 billion of average annual investment. We use a 10% cost of equity and 7.5% cost of capital in our discounted cash-flow valuation.

Pepco Acquisition: In the Eye of the Beholder
On April 30, Exelon announced that it offered to acquire Pepco Holdings for $6.8 billion plus $5.3 billion of assumed debt. The proposal offers Pepco shareholders $27.25 per share in cash, a 25% premium to Pepco’s stock price before rumors of the deal leaked. The offer represents a 43% premium to our $19 stand-alone fair value estimate for Pepco and results in $2 billion ($2.28 per share) of value dilution, which we include in our $40 fair value estimate for Exelon.

Offsetting some of that equity dilution is Exelon’s plan to finance the transaction as a backdoor leveraged buyout. Management said it plans to fund half of the equity investment with debt, another $1 billion with cash from noncore asset sales at Exelon Generation, and an undisclosed amount with convertible debt. All told, we estimate that Exelon will require only about $2 billion of new equity, assuming it can raise the full $1 billion from asset sales. On June 12, Exelon priced $1.75 billion of common shares at $35 per share and another $1 billion of hybrid equity units. This limited equity investment and Exelon’s capacity to issue low-cost parent debt partially offset the premium price it is paying for Pepco.

Earnings Accretion Not Difficult
Management estimates that the deal will be $0.15-$0.20 per share accretive in 2016, the first full year of earnings contributions, if the deal closes in mid-2015 as forecast. This is in line with our projections based on our estimate that Pepco will earn $363 million on a pre-merger basis in 2016. If Exelon can raise $3.4 billion of new debt at 6%, it should be able to hit its accretion target. We expect merger costs--including customer rebates--will mostly offset any synergies.

Based on these calculations, we estimate that Exelon will earn near 8% returns on its incremental equity investment. We consider this fair if unimpressive for a regulated utility. Exelon also has reasonable upside if it can reverse Pepco’s persistent regulatory struggles. We estimate that Exelon could add $0.10 per share to its 2017 earnings if it can bring Pepco’s earned returns up to its allowed returns. That would boost returns on its equity investment into the double digits and make the deal value-accretive for shareholders.

Better Uses of Capital Elsewhere
However, the earnings accretion can’t disguise the fact that we think Exelon overpaid for Pepco’s assets by about $2 billion. Even if Exelon had offered a 20%-30% premium to our fair value estimate for Pepco, Exelon's implied returns on equity would have been substantially higher than the 8%-10% return we expect it will earn.

Alternatively, we think there are better uses of its capital, especially if power markets rebound. In the past few years, management has considered these alternative uses of capital that we think would yield better long-term returns for shareholders:

A plan to spend $3.5 billion to add 1,300-1,500 MW of uprates at its nuclear fleet over 2010-19, an 8% increase to its legacy capacity. That additional generation could have yielded $0.40 per share of earnings and added $4 per share to our fair value estimate based on our midcycle power market assumptions. A $1.5 billion share-repurchase plan approved in September 2008 but never executed.

Fossil fuel generation acquisitions would give it more leverage to power and gas prices. Duke Energy, American Electric Power, and AES’ DPL are said to be shopping coal and gas plants in Exelon’s core territory. We think adding generation in Texas and the Northeast to support its retail business makes good business sense at the right price. Instead, Exelon is shrinking its non-nuclear fleet if it goes through with its projected $1 billion asset sale to fund the Pepco deal.

Investments in contracted renewable energy also are yielding 10%-plus returns on equity for other utilities with less risk than Exelon is taking on with the Pepco deal.

Bulls: Power Market Revival
Power and natural gas markets have awakened in 2014. Extreme cold and natural gas pipeline constraints this winter in the eastern United States sent power prices soaring in Exelon’s core regions.

The higher prices and volatility spread through the forward curve as well. In northern Illinois, where Exelon sells almost half of its power generation, forward 2015-16 power prices are up 16%, to $35/MWh from $30/MWh at the start of the year, based on EOX Live data. As of March 31, Exelon reported that it had hedged 66%-69% of its expected 2015 generation in the region at $32.50/MWh and 36%-39% of its expected 2016 generation at $33/MWh. Our $47/MWh midcycle assumption is 28% higher than current 2017 average forward prices.

In the Mid-Atlantic, where Exelon sells about 40% of its power generation, forward 2015-16 power prices are up 16%, to $43/MWh from $37/MWh at the start of the year, based on EOX Live data. As of March 31, Exelon reported it had hedged 63%-66% of its expected 2015 generation in the region at $42/MWh and 37%-40% of its expected 2016 generation at $43/MWh. Our $57/MWh midcycle assumption is 32% higher than current 2017 average forward prices.

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In the first quarter, Exelon wasn’t able to take advantage of the price spikes, since it came into the quarter with most of its expected generation hedged. However, Exelon did take advantage of the higher prices to hedge an additional 2% of its expected 2015 generation and 7% of its expected 2016 generation in the first quarter. Exelon now has hedged two thirds of its fleetwide 2015 expected generation and one third of its fleetwide 2016 expected generation. In early June, Exelon management said its hedging in April added $350 million to its 2015 hedged gross margin, now $7.8 billion, and added $600 million to its 2016 hedged gross margin, now $8.0 billion. On an open basis, we estimate that a 30% increase in power prices represents about $1 per share of earnings and $10 per share of value for Exelon.

Regulated Utilities Are Richly Valued but Support the Dividend
The median U.S. regulated utility in our coverage universe is trading at a 16 times price/earnings ratio. Using this metric, we believe the market could be valuing Exelon’s utilities at $18 per share based on our 2014 earnings estimate for ComEd, PECO, and BG&E. Since we think the regulated utilities group is 8% overvalued, we believe Exelon’s regulated utilities are worth more like $16 per share. At 1.2 times year-end projected rate base, we estimate that Exelon’s regulated utilities would be worth just $14 per share.

The regulated utilities are a key source of support for Exelon’s $1.24 per share dividend. We think the utilities could cover the full dividend on an earnings basis by 2016 assuming current regulation. But the utilities continue to be net investors, with capital expenditures averaging $3 billion the next three years. With this level of investment, we estimate that the utilities can contribute about $800 million of cash to pay the $1.14 billion dividend and parent debt interest.

We estimate that Exelon Generation can produce about $700 million of cash for the parent in 2014, but that could fall to just $300 million based on management’s downside gross margin estimate and if it maintains its current projected growth investments. We would expect management to cut or defer some of its growth investments if results began trending toward that downside scenario.

PJM Capacity Market Changes Moving in Exelon’s Favor
On May 23, PJM officials announced that capacity prices across most of the 13-state PJM Interconnection region cleared at $120 per megawatt-day for 2017-18, in line with our expectations. For power producers in the western area of PJM, this year’s clearing price is double the clearing price in last year’s auction for 2016-17. This is a key win for Exelon, which has the largest fleet in the western area. The difference between last year’s $59.37/MW-day for 2016-17 and this year’s $120/MW-day clearing price for 2017-18 represents about $100 million of incremental EBITDA for Exelon.

Environmental Rules Turning in Exelon’s Favor
Federal court rulings in April handed momentum back to the U.S. Environmental Protection Agency this spring, supporting two of its key noncarbon emission regulations. Power prices in the coal-heavy Midwest and Mid-Atlantic regions rallied on the news.

On April 15, the D.C. Circuit Court of Appeals ruled in favor of the Mercury and Air Toxics Standards, likely ending the legal battles and clearing the way for April 2015 implementation. Although most utilities have been preparing for MATS, we think the court ruling ensures that utilities will go forward with their plans to close smaller, older coal plants and invest substantial capital in emission-control equipment. The Energy Information Administration reports that 18.7 gigawatts of coal plant capacity have closed since 2011, representing 5% of total U.S. coal plant capacity. We count another 38 GW of capacity that before the April 15 ruling utilities had already announced they would close within the next five years.

On April 29, the U.S. Supreme Court upheld the EPA’s authority to enforce the Cross State Air Pollution Rule, or Transport Rule 6-2, overruling a previous ruling by the D.C. Circuit Court. We think this is bullish for energy prices in 2015 and 2016. We also think this is bullish for capacity prices for the upcoming delivery year 2017-18. Ultimately, PJM and other markets including MISO and ERCOT will need to procure the energy to fill the resource gap left by coal. The new build will most likely be gas-fired combined cycle plants and peaking gas CTs that will set the marginal cost of electricity, forcing the market to become even more reliant on the volatile Henry Hub and gas basis markets.

On June 1, the EPA issued a draft rule to reduce carbon emissions from existing power plants 30% from 2005 levels by 2030. The proposed rule is one of the most far-reaching environmental regulations of the power industry in history, but the amount of the reduction was in line with our expectations. Although the full impact will take many years, the proposed rule is a positive for companies with low-carbon or zero-carbon-emitting fleets like Exelon.

We think this plan, if implemented, will have little effect on power prices in the intermediate term. The 30% carbon reduction target was on the high end of market expectations, but the 2005 baseline and 2030 implementation date dramatically weaken the proposal. Eastern markets like PJM and MISO have already dramatically reduced their dependence on coal during the past several years, with many more retirements planned in 2015 and 2016. We think the MATS and CSAPR provide more support to power prices one to five years out and also will help states achieve compliance before 2030.

The EPA’s carbon regulation does increase the long-term risk that the grid will become increasingly reliant on highly volatile gas and gas basis markets. Increasing long-term natural gas demand, combined with increasing natural gas exports, could put a bid on forward gas prices eventually. However, right now the Marcellus Shale is so flush with gas the forward market doesn’t register any worry about the demand picture.

Nuclear Generation Still Has a Wide Moat
We’ve long considered nuclear generation a wide-moat business characterized by low variable costs, significant barriers to entry, and efficient scale in regional power markets. But new environmental regulations, volatile power markets, and the fallout from the environmental nightmare at Fukushima in Japan are raising questions about nuclear generation economics. Exelon management has acknowledged that several of its plants face marginal economics, and it recently announced that three of its plants--Byron and Quad Cities in Illinois, and Oyster Creek in New Jersey--did not clear the 2017-18 PJM capacity auction. Dominion and Entergy have announced plant closures for economic reasons.

We think rising power prices ultimately will allow Exelon to sell those plants’ capacity into incremental markets and run the plants as usual in 2017-18. Exelon management recently said it won’t make any retirement decisions until at least June 2015. However, it is using the opportunity to push for pro-nuclear legislative and regulatory changes. In late May, the Illinois House of Representatives introduced HR 1146, which would require a dozen federal, state, and regional regulators and other entities to produce a report as soon as November on how to save nuclear plants. We think the bill has a chance of passing, given that Illinois gets about half of its electricity from nuclear plants, most of them Exelon’s, and plant closures would have significant economic and political implications.

Despite near-term struggles for some plants, we continue to believe most existing nuclear plants are essential to the stability of energy supply in the developed world and still warrant wide economic moats in nonregulated markets and narrow moats in regulated markets. In the United States, we believe that recently announced plant closures are exceptions that do not apply across all existing nuclear plants. Nuclear plants still enjoy much lower variable generation costs than competing coal and natural gas plants. We estimate that average variable production costs are near $12/MWh in the U.S., producing positive returns in most markets. For the most efficient combined-cycle gas turbine, we estimate that variable production costs are as low as $24/MWh at today’s gas prices, still well above nuclear generation dispatch costs.