Exelon's Moat Narrows

We have cut our economic moat rating for

Exelon still earns industry-leading returns on capital from its nuclear fleet, which previously supported our wide moat rating. However, those returns have come down markedly in the past three years as power prices have fallen and competing generation sources such as gas and renewables have grown. In March, we cut our long-term midcycle power price assumptions, lowering our long-term normalized forecast returns on capital for Exelon.

At these lower returns, a material impairment of a portion of its nuclear fleet could drop Exelon's consolidated return on capital below our 7.1% assumed cost of capital. Exelon has one of the best-run nuclear fleets in the world, and we don't forecast any imminent impairment. However, political support for nuclear has waned, giving us less confidence that maintenance investments will be economic with near certainty 10 years from now. Exelon's management recently suggested that at least three of its plants are struggling to earn fair returns at current power prices.

The second component of our moat downgrade is Exelon's expansion into no-moat non-nuclear generation and retail energy supply. We have no confidence that returns on capital for these businesses will exceed Exelon's cost of capital in the long run.

The third component of our moat downgrade is Exelon's growing share of earnings from narrow-moat regulated distribution utilities. We expect more than half of Exelon's earnings to come from these businesses after incorporating Pepco Holdings.

Still Leveraged to Power Prices Despite Diversification As the largest nuclear power plant owner in the U.S., Exelon long has been a profit machine and an industry-leading source of shareholder value creation. But power prices have crashed hard since their 2008 highs and appear stuck at current levels for at least the next two years. That has resulted in a sharp drop in Exelon's returns, a 41% cut in the dividend in 2013, and a shift in strategy to increase contributions from the countercyclical retail supply and regulated distribution businesses. This includes the $12 billion (including assumed debt) proposed acquisition of Pepco in April 2014.

Even with increased earnings diversification following the 2012 acquisition of Constellation, Exelon can't escape its overwhelming leverage to Eastern and Midwestern U.S. power prices, which drive almost half of earnings. The low operating costs and clean emission profile of its nuclear fleet make Exelon the utilities sector's biggest winner if our outlook for higher power prices and tighter fossil fuel environmental regulations materializes. Exelon's world-class operating efficiency ensures it will be able to capture that upside.

As the nation's largest wholesale generator and retail supplier, Exelon's competitive edge requires Eastern U.S. power markets to remain deregulated. In the decade following deregulation, rate caps and other regulations limited Exelon's profits. Those are gone, and lower power prices have eased concerns about re-regulation. But we expect politicians and regulators will continue to monitor customers' utility bills and could intervene if power prices skyrocket. Exelon's most pressing current issue is ensuring it receives full economic credit for its nuclear fleet's reliability, especially in areas with subsidized intermittent renewable energy.

We estimate Exelon's regulated distribution utilities will contribute about half of consolidated earnings by 2016, up from just 20% during the commodity peak in 2008. Regulation improved in Illinois after 2011 state legislation implemented formula rates with annual true-ups. PECO and BGE also will help drive what we think can be 10% earnings growth from Exelon's utilities the next three years.

Wide Moat No Longer Considering its full suite of businesses, we think Exelon earns a narrow economic moat.

Nuclear generation in general still has wide-moat characteristics, with returns on capital well above costs of capital for the foreseeable future. However, that spread between long-term returns on capital and Exelon's cost of capital has shrunk based on our midcycle outlook for power prices in the Eastern U.S. Exelon's increasing diversification into narrow- and no-moat businesses together with the shrinking returns at its nuclear generation business supports our narrow moat rating.

Nuclear generation's wide-moat economics are based on two primary competitive advantages. First, nuclear plants take more than seven years to site and build, cost several billion dollars, and typically face community opposition. These are significant barriers to entry, giving operators an effective low-cost monopoly in a given region. Exelon's large fleet gives it scale advantages that allow it to add capacity at its plants at a fraction of the cost and risk of a greenfield project. It is unlikely a competitor would be able to earn sufficient returns on capital by building a nuclear plant in close proximity to any of Exelon's plants.

Second, no other reliable power generation source can match the cost or scale of a nuclear plant. Nuclear plants' low variable costs and low greenhouse gas emissions relative to competing fossil fuel power generation sources like coal and natural gas reduce substitution threats. Renewable energy, with effectively no marginal costs, has depressed wholesale power prices and hurt Exelon's returns on capital in some of its regions. We believe this is a market distortion that fails to recognize the value of Exelon's nuclear fleet reliability relative to intermittent renewable energy.

As long as electricity remains a critical energy source in the U.S., we expect nuclear plants will maintain a substantial low-cost advantage and generate high returns on capital. To monetize this competitive advantage, Exelon must continue to have access to wholesale power markets. Any reregulation of its generation fleet would shrink its moat. In addition, nuclear generation must maintain regulatory and political support in the U.S. and states where Exelon operates. If that support erodes, it could affect the economics of routine maintenance investments and lead to plant shutdowns, as we've seen elsewhere in the U.S. and overseas.

We believe Exelon's regulated distribution utilities and Pepco have narrow economic moats. Regulatory caps on profits offset the service territory monopolies and network efficient scale advantages. Utility regulation in the U.S. aims to fix customer rates at levels that ensure capital providers earn fair returns on their investments while keeping customer costs as low as possible. We believe this regulatory compact ensures Exelon's utilities will earn at least their costs of capital in the long run.

We believe Exelon's retail supply business has no economic moat. Retail power and gas markets are highly competitive with virtually no barriers to entry, switching costs or product differentiation. Although customer relationships can be sticky, retailers mostly end up competing on price.

Regulation a Risk, but Dividend Should Be Stable Investors should pay the most attention to political developments that would reregulate competitive electricity markets in the Midwest and Mid-Atlantic. Even though sharp increases in power prices would result in an earnings windfall for Exelon, it could lead politicians and regulators to pursue price caps as they did when markets first deregulated. Although we think this is unlikely in the current environment, it could have a substantial negative impact on our fair value estimate. If market power prices are capped or regulated, Exelon will lose its primary profit source.

Reregulation also would destroy Exelon's retail business. Although that business is still a relatively small source of consolidated earnings, it would eliminate Exelon's effective hedge against its generation fleet, potentially leading to more volatile earnings.

As Exelon's regulated utilities generate a greater share of earnings, investors will be subjected more acutely to the state and federal regulatory risk that all distribution and transmission utilities face. Illinois and Maryland are two historically tough regulatory environments, and punitive rate decisions could have a material impact on earnings and growth.

Exelon's biggest challenge is warding off cash constraints in unfavorable power markets. The 2007-08 commodity boom led management to raise the dividend and buy back stock. But as power markets have fallen from their 2008 peaks, the company has focused on preserving its investment-grade credit rating. In 2011, the board spent $2.1 billion to reduce its pension liabilities instead of reinstating a $1.5 billion share-repurchase plan approved in September 2008 but never executed. In February 2013, the board cut the dividend 41% to $1.24 per share annualized, freeing up $740 million in annual cash flow. We expect the dividend to stay at this level for at least the next two years.