Tag Archives: nyseexc

Exelon Corporation: A Promising Investment Opportunity

Summary The acquisition of Pepco will grant Exelon enhanced operational capacity as well as increase its ability to serve a greater number of customers in the different counties of the United. This acquisition will also result in expanded regulated business that will improve Exelon’s risk profile and ensure more stable revenue and earning steams compared to unregulated operations. Moreover, the hedging of commodity risk has not only ensured Exelon’s future earnings stability but has also given it a competitive edge in the industry. The company has a significant amount of debt to supports its project financing which will result in a focused business model. Based in Chicago, Illinois in the United States of America, Exelon Corporation (NYSE: EXC ), a well-known energy producer, has been pleasing its investors for a long time and has witnessed a sharp rise of more than 35% in its stock price over the past year. Source: Finviz The impressive performance was mainly due to some smart moves recently taken by the company. These initiatives have not only made the future profits more predictable but they have also given Exelon a competitive edge in the market. I believe Exelon is a promising investment opportunity for the long term. Let us analyze a few factors that support my opinion on the stock. Strategic Acquisitions and Divestitures Have Resulted in a More Focused Business Model Exelon Corporation has been making several acquisitions over the past few years that have not only enhanced its operational capacity but have also enabled it to enter and cater to new and growing markets. In April 2014, Exelon announced it would acquire Pepco Holding, Inc. which is one of the largest energy delivery companies in the Mid-Atlantic region that currently serves approximately 2 million customers in Delaware, the District of Columbia, Maryland and New Jersey. This merger will bring together Exelon’s gas and electric utilities – BGE, ComEd and PECO – and Pepco Holdings’s (PHI’s) electric and gas utilities – Atlantic City Electric, Delmarva Power and Pepco thus improving the combined operational capacity. This acquisition will enhance the company’s operational capacity as well as increase its ability to serve a greater number of customers in the different counties of the United States. As Exelon’s CEO said, “The combination of our companies will provide us an opportunity to take the customer service and reliability improvements we’ve already made in Maryland to an even greater level.” Moreover, the acquisition of Pepco will result in expanded and strong regulated business operations. This merger is expected to increase Exelon’s regulated business exposure to 60% to 65% during 2015-2016 which was previously approximately 55% to 60% on a standalone basis. The expanded regulated business will result in an improved risk profile with more stable revenue and earning steams compared to non-regulated operations. However, the Public Service Commission (PSC) has recently asked for some changes in the merger requirements that Exelon’s president has not agreed with. Since the PSC staff has demanded all the utilities to be managed at micro level with an independent board of directors for Pepco, this would impair Exelon’s ability to exercise control over its subsidiaries. Among the requests, the PSC staff has also demanded a $50 payment to each Delmarva residential customer, a $40 million 10-year set aside for Delaware workers’ job protection and some charitable commitments. These requests, if agreed upon, can result in heavy costs for Exelon thus hurting its future profitability. On the other side, the non-inclusion of these points would force the staff to push the commission to deny the company’s merger application. Presently, Exelon is facing a dilemma regarding the commission’s demands. This posed a possible risk to its future profitability. Perhaps, fair negotiations with the PSC staff could result in a win-win situation. Similarly, Exelon has been selling some of its non-core business assets in order to create a more optimized asset portfolio. To date, the company has divested five non-core assets which has resulted in nearly $1.4 billion of after-tax sales proceeds. This included the sale of its Fore River, Quail Run and West Valley plants for total after tax proceeds of $975 million during the third quarter of 2014. The company can use the sales proceeds to finance the acquisition of Pepco and build two combined-cycle gas turbine (CCGT) units in Texas that will enhance the company’s generation capacity as each unit is expected to add nearly 1,000 MW of capacity to their respective sites. Strategic acquisitions and dispositions have resulted in a more focused business model with improved generation capacity. This will support Exelon’s ability to successfully cater to the growing markets and give it an edge over those in its peer group. Effective Hedging Ensues Stable Earnings in Future Exelon’s energy generation business is exposed to commodity price volatility that can reasonably affect its future top and bottom lines. I believe the company can ensure stable revenue and earning streams in the future because it effectively reduces the commodity risk by hedging a portion of its portfolio on a three-year rolling basis. The hedge targets are approximately 90% – 98% in the first year, 70% – 90% in year two and 50% – 70% in year three. Source: Investor Presentation The hedging activity will help the company to meet its future cash requirements and other financial objectives that include dividends and investment-grade credit rating under a stress scenario. This again gives Exelon a competitive edge in the market and makes it an attractive investment option especially for dividend investors who seek a stable cash flows stream. Significant Debt Financing Supports the Core Business In the past, Exelon raised a significant amount of debt for project financing. Over the past three years it has successfully raised nearly $3 billion to finance several projects including Antelope Valley Solar Ranch, ExGen Renewables, Continental Wind and ExGen Texas Power. These projects have significantly increased the company’s generation capacity with no debt maturing earlier than 2021. Moreover, the company recently announced it would issue $750 million of senior notes maturing in 2020 with a coupon rate of 2.95%. The net proceeds will partially be used to pay-off Exelon’s exiting senior loan notes of $550 million with a coupon rate of 4.55% maturing in June 2015. This would result in interest costs savings of nearly $9 million annually and $4.5 million semi-annually that will boost the company’s future bottom line. Additionally, the remaining proceeds can be used to finance the Pepco acquisition that is expected to benefit Exelon in the long term. Significant debt financing will help Exelon to expand its core business and increase its generation capacity which will in turn support its ability to appropriately cater to the market. Rising Competition can limit its Future Growth Although Exelon is the largest nuclear energy producer in the United States, many alternative energy producing methods can give the company a tough time in the coming years. Presently, natural gas energy producers seem to maintain the lead. Due to the heavy capital outlay required for nuclear power plants and the way their reactors work, it is not easy to stop power generation whenever desired. On the other hand, natural gas fired plants are less capital intensive and the power generation can be easily tailored to meet the desired demand schedule. This gives natural gas energy producers a cost advantage over nuclear energy producers, thus enabling them to easily attract a greater number of customers by offering lower prices. Moreover, rapidly declining natural gas prices are further reducing the electricity production cost for these energy producers. During December 2014, the U.S. natural gas prices fell below $3 per million British thermal units for the first time since 2012. Source: Yahoo Finance Natural gas is the second largest source of power generation in the U.S. and produced nearly 27% of the country’s total electricity in 2013. The continuous decline in the natural gas prices and flexibility offered by less capital intensive natural gas fired plants supports the energy producers’ ability to price electricity at comparatively lower rates than nuclear energy producers thus capturing a major market share. In addition, the conventional energy producing methods including the coal fired and nuclear plants are severely affecting our climates, economies and most importantly, health. The electricity production in the United States accounts for more than one third of the total global warming emissions by the country. The coal fired power plants accounts for nearly 25% of these emissions whereas, natural gas fired plants represent only 6%. The rising concerns about global warming have forced many countries to invest in clean energy. The graph below shows the rising trend of clean energy consumption in the last 5 decades in different countries of the world. Source: Vox As the government is continuously encouraging the use of renewable source of energy, many renewable energy producers will witness a rising demand curve for their services in the near future. PPL Renewable Energy, one of Exelon’s competitors, is concentrating on natural gas and wind energy for power generation and has benefited from the falling natural gas prices in the past. Moreover, the company is continuously increasing its investment in renewable and clean energy production. Its hydroelectric expansion project in Montana has increased its clean energy generation capacity by 70% . The company’s hydro plants in Pennsylvania and Montana have a combined capacity of 757 megawatts of clean energy. Since Exelon is facing intense competition from both natural gas and renewable energy producers, it needs to focus on and invest in alternative energy producing methods for maintaining its market share. Conclusion The sum and substance of my analysis is that Exelon’s recently enacted initiatives have made it is well-positioned to serve the growing market. The strategic acquisitions and dispositions have resulted in a more focused business model along with improved generation capacity. A significant amount of debt financing also supports its future projects. Moreover, the hedging of commodity risk has not only ensured Exelon’s future earnings stability but has also given it a competitive edge in the industry. All of these factors make Exelon a safe and promising investment opportunity for long-term investors. However, Exelon also needs to focus on and invest in natural gas and clean energy producing methods for maintaining a decent market share in this highly competitive environment. Based on my analysis, I give the stock a buy recommendation.

Utilities And Other Industries: Capital Expenditures Vs. Depreciation

It is very common among new investors to assume that depreciation equals the capital expenditures required to keep the company in place. Free cash flow is usually calculated by subtracting the full value of the capital expenditures. This can be wildly inaccurate. The utilities industry has capital expenditures and depreciation that are very different. If all capital expenditures by utilities were maintenance, the industry would be bankrupt very quickly. It is important to understand what, where, how, and why the company you are researching is spending money on capital expenditures in order to value it. Capital expenditures (capex) include a wide variety of things companies spend money on. Capex can include buying land, fixing machinery, building a new plant, upgrading the power system, or many other items. Some of these items are to reduce expenses, increase production, or improve the production process. These are called growth capital expenditures because they improve the company above its performance prior to spending them. Other capital expenditures that keep the company at its current steady state are called maintenance capital expenditures. Most companies spend some capex in both the growth and maintenance bucket so it is important to determine how much of each in order to value the company. One of the industries where this is glaringly obvious is the utility industry. Utilities routinely spend lots of money to support new infrastructure as growth capex. They also spend money on maintenance capital expenditures to ensure their existing operations are in good shape and highly reliable. A high level summary of net income, depreciation, and capital expenditures for some of the major utility companies is shown in the following table. Utility Company 2013 Net Income (millions) 2013 Depreciation (millions) 2013 Capex (millions) Capex minus Depreciation (millions) Capex divided by Depreciation Dominion Resources (NYSE: D ) 1,697 1,390 4,104 2,714 2.95x NextEra Energy (NYSE: NEE ) 1,908 2,163 3,228 1,065 1.49x Duke Energy (NYSE: DUK ) 2,665 3,229 5,526 2,297 1.71x Exelon Corp (NYSE: EXC ) 1,719 3,779 5,395 1,616 1.43x Southern Company (NYSE: SO ) 1,644 2,298 5,463 3,165 2.38x As you can see from the table, the capital expenditures of the utility companies exceeds the depreciation charge, typically by several billion dollars for companies this size. If all of these capital expenditures were maintenance capital expenditures, the market would have to be completely insane to assign the earnings multiples shown in the following table. Utility Company Current Price/2013 Earnings Dominion Resources 25x NextEra Energy 27x Duke Energy 23x Exelon Corp 19x Southern Company 28x Average 24x Earnings multiples this high are usually reserved for high growth companies. Many of the new projects these utility companies are investing in will earn a regulated rate of return between 8% and 12% which doesn’t sound like a high growth company. If anything, this is close to an average company’s rate of return and generally average companies trade closer to 15x earnings. Depreciation is a noncash expense that reduces the net income reported. When valuing companies, it is generally advisable to add back depreciation to net income and then subtract maintenance capital expenditures to get a truer view of profit. In the case of utility companies, they generally spend less money on maintenance capital expenditures than they expense on their income statement as depreciation. This deflates their net income number which makes their price/earnings ratios look higher. The following table shows the capex numbers in relation to the net income numbers for the utility companies. Utility Company 2013 Net Income (millions) 2013 Capex (millions) Capex divided by Net Income Dominion Resources 1,697 4,104 2.42x NextEra Energy 1,908 3,228 1.69x Duke Energy 2,665 5,526 2.07x Exelon Corp 1,719 5,395 3.14x Southern Company 1,710 5,463 3.19x By looking at the capex divided by net income column it is very obvious that most of the capex must be growth capex. If most of the capex was maintenance capex and the cost of maintenance was 1.69x to 3.19x the amount of profit each company was making, they would be out of business very quickly. In addition, one of the quirks about the utility industry is that lots of its “maintenance capex” still plays into the regulatory assets that allow future rates to be raised to earn the cost of investment plus a predetermined return on equity. An easier way to track maintenance capex for utility companies is to read their filings and see how much and when the regulatory bodies approve expenditures to be counted towards the regulated rate of return. However, for companies that aren’t in the regulated utility industry, it can be more difficult to determine much of capex was maintenance capex. In general, it is a good idea to use the laws of large numbers when determining maintenance capex for companies that don’t specifically break it out. For example there could be two oil companies. Company A spent an average of $30 million on capex for each of the last few years and kept production flat. Company B spent an average of $30 million on capex for each of the last few years and production grew by 40%. Therefore it stands to reason that Company B was likely spending a much higher percentage of their capex on growth. Some companies half break it out by giving you a list of the major items they spent capex on and you can place each in the growth or maintenance bucket depending on the type. Maintenance capex should generally be determined over several years because things don’t break at the same frequency every year. This is more important for valuing small companies because larger companies generally spend similar amounts of maintenance capex every year. Another common capex that seems to be often included as an expense to reduce a company’s profit is when they buy or construct a new building for their corporate headquarters. This is actually growth capex because it will reduce future rent expense by the company (i.e. increase their profit) and it will appreciate over time. These are the reasons and some advice about making sure to understand the company’s capital expenditures when trying to value a company. It is especially important in the utility industry but even in other industries your valuations could be dramatically off without understanding where and why the company is spending money.

Is It Too Late To Buy Exelon?

While returning 41.9% total return over the previous 12 months, EXC has a bit more juice in its gas tank. Fundamental business changes have reduced earnings volatility. Gains in profitability are dependent on improving power markets. PJM is so afraid of a lack of generating capacity it has proposed a premium for reliability. While Exelon (NYSE: EXC ) had generated total returns of 41.9% over the previous 12 months, vs 21.2% for the Morningstar Diversified Utilities Index and 11.6% for the S&P 500, there may still be a bit of juice left in its gas tank. However, just do not look at 1-year and 3-year returns as it may make you sick at a puny 1.6% and an even worse -1.2%, vs. 12.6% and 10.5%, respectively, for Diversified Utilities and 18.4% and 14.2%, respectively, for the S&P. Driving EXC higher will be fundamental business strategy changes that is expected to increase earnings from $2.40 in 2014 to $2.51 in 2015 and $2.66 in 2016. The changes include the transformation from 20% regulated revenue (Exelon Utilities segment) and 80% unregulated revenue from merchant power (Exelon Generation segment) in 2008 to around 61% regulated and 39% merchant power by the end of 2017. Profitability in its regulated utility segment should improve over the next few years. Illinois enacted an annual rate evaluation in 2011 that is being phased in and should improve the profit uncertainty of Exelon subsidiary ComEd. 2014 ROE for ComEd is estimated at 8% to 9% vs a target of 9.0% (30-yr Treasury + 5.8%). PECO’s 2014 ROE is expected to be 11% to 12% vs a target of 10% and BGE’s 2014 ROE is expected to be 7% to 8% vs a target also of 10%. ComEd has annual rate reviews using the above formula. PECO is looking for a rate increase to be filed either this year or next and BGE anticipates requesting a rate increase this year and will be its first since 1999. In addition to the above ROE, EXC’s regulated rate base is expected to expand over the next few years. For example, ComEd is expected to grow its rate base from $9.6 billion in 2014 to $12.6 billion in 2017. PECO will increase its rate base from $5.6 billion to $6.3 billion and BGE is expected to expand its rate base from $4.9 billion to $5.8 billion over the same time frame. Combined, EXC is expecting to increase its regulated asset base from $20.1 billion to $24.7 billion over the next three years and would represent 7.8% annual growth. Management believes these regulated utilities can generate 8% to 10% annual EPS growth over the next three years. EXC is in the process of acquiring the regulatory approval to complete its merger with PEPCO (NYSE: POM ). This expansion will not only fill in the geography of its service territory but offers future profit potential as well. Below is a map from EXC’s latest investor presentation outlining the combined service territory after the merger. PEPCO includes Potomac Electric with 800,000 customers, Atlantic City Electric with 545,000 customers and Delmarva Power and Light with 632,000 customers. Source: Exelon investor presentation. An interesting aspect of the acquisition will be EXC management’s ability to improve profitability at PEPCO. Each operating unit has underperformed its allowed ROE, and some by a substantial amount. Below are the 2013 results for earned ROE and allowed ROE, by business: PEPCO MD earned ROE of 7.5% out of an allowed 9.4% PEPCO DC earned ROE of 6.7% out of an allowed 9.5% Delmarva DE Electric earned ROE of 8.8% out of an allowed 9.8% Delmarva DE Gas earned ROE of 8.6% out of an allowed 9.8% Delmarva MD earned ROE of 8.0% out of an allowed 9.8% Atlantic City Electric earned ROE of 4.9% out an allowed 9.8% Management believes regulated utilities can earn $1.25 to $1.55 per share in 2017, sufficient to cover its annual dividend. The balance of EXC’s business is providing merchant power. Of its 32 GW capacity, 60% is power by nuclear, 25% by natural gas, 7% each from hydro and oil, and the remaining 3% from wind and solar. The majority of their generating capacity is located in the PJM controlled Mid-Atlantic and eastern Midwest, but has a growing generating base in Texas. As a merchant power producer, EXC has historically offered substantially higher exposure and risk to the volatility of commodity power markets. As the nation’s largest nuclear power generator, EXC is one of the lowest-cost providers of reliable, base load electricity. Industry peer Southern Company (NYSE: SO ), a major electricity provider in the Southeast, provides its merchant power customers based on a long-term Purchase Power Agreement PPA that could extend over 20 years. EXC, on the other hand, relies on the regional PJM-managed three-year rolling contracts, making pricing more susceptible to the whims of the commodity power market. It is important for investors to appreciate this fundamental difference as it influences both revenue and profitability. Below is the Front Year Price graph on electricity pricing for the PJM Western Hub dating back to 2001, as offered by sriverconsulting.com (pdf), a segment of EnerNOC (NASDAQ: ENOC ). The graph is the average of the front 12 months NYMEX future contracts for PJM West-Hub Electric trading on that date. Example: The front-year on July 15, 2008, was the average of the July 2008 to June 2009 contracts, which was $104.35/MW. (click to enlarge) Source: South River Consulting. Notice the collapse from $120 in June 2008 to a bottom of $40 in February 2012. Since 2009, pricing has been stuck in the $40 to $60 range. The spike in January 2014 was the result of very low generating reserve capacity during the polar vortex cold spell in the Northeast. Below is a graph of EXC’s 15-year return on invested capital ROIC: (click to enlarge) Source: F.A.S.T.graphs.com. The correlation between PJM pricing and ROIC is obvious in these two graphs. It is not a coincidence profits and stock prices also peaked at the same time — in 2008. The growth of EXC will be reliant on a recovery of electricity pricing in the Mid-Atlantic and Northeast. The sharp price spike in 2014 is indicative of the severe supply dislocation experienced during the cold snap. Not only was natural gas generating plants curtailed due to a lack of pipeline capacity but equipment seized up in the cold. Coal piles were frozen, making it difficult to feed the plant. Combined, an unsustainable 22% of available generating capacity was offline. Considering the possibility of another vortex-like event, PJM stated , a comparable rate of generator outages in the winter of 2015/2016, coupled with extremely cold temperatures and expected coal retirements, would likely prevent PJM from meeting its peak load requirements. In a letter (pdf) to the House Energy Subcommittee concerning the power situation in the Northeast, PJM’s Craig Glazer, VP-Federal Government Policy, wrote: Because less-expensive coal generation is retiring and in part is being replaced by demand-response or other potential high energy cost resources, excess generation will narrow and energy prices could become more volatile due to the increasing reliance on natural gas for electricity generation. “Would likely prevent PJM from meeting its peak load requirements” is a nice way of saying brownouts or blackouts. “Energy prices could become more volatile” is also code for higher prices. The lack of power reserves and the spike in prices spooked the PJM to alter its auction process and to offer a price premium to power generators who would guarantee reliability regardless of the weather. Nuclear power generation is considered the most reliably by the PJM, and EXC’s plants qualify for the premium. The premium could add $0.17 to $0.25 to earnings per share. More information is available from the article “Exelon: Nuke Reliability Worth An Additional $5 A Share,” published last October. There is also concern the Northeast is facing a shortage of generating capacity due to the ongoing closing of coal plants and the December 2014 shuttering of the Vermont Yankee nuclear plant. According to EXC’s presentation, about 20MW of generating capacity is expected to be closed in the Northeast between 2012 and 2016, with half that capacity closing this year. Many blindly claim adding to intermittent load solar- and wind-generating capacity or building new natural gas generating facilities will offset closed base-load coal and nuclear generating capacity. However, the reality is intermittent-load is a poor replacement choice for base-load and due to pipeline constraints there is a potential shortage of natural gas in the Northeast, as demonstrated during the winter of 2014. Even the grid manager in the Northeast acknowledges the conundrum of available power and pipeline constraints. The report “ISO New England 2014 Regional Electricity Outlook” states: The capacity that will replace New England’s retiring generators is likely to be a combination of renewable and gas-fired resources. However, the relationship between renewables and the conventional resources needed to ensure grid reliability presents a puzzle: more wind and solar power creates a need for fast-starting, flexible resources that can take up the slack when the wind stops or the clouds roll in. New natural gas generators will likely fill this role, with their relative ease of siting and typically lower fuel costs-but this will further strain natural gas pipeline capacity. Most new pipelines to the gas-starved Northeast would traverse the State of New York, which recently banned fracking. For example, the Constitution Pipeline from the Marcellus to the Northeast has received FERC approval but awaits State environmental approvals. The opposition to the pipeline through N.Y. could delay the project. The region currently has five major pipeline systems and seven new projects have been proposed. However, several of them have stalled because of ferocious opposition. From two NY Times articles here and here : A year ago, the governors of the six New England states agreed to pursue a coordinated regional strategy, including more pipelines and at least one major transmission line for hydropower. The plan called for electricity customers in all six states to subsidize the projects, on the theory that they would make up that money in lower utility bills. However, in August, the Massachusetts Legislature rejected the plan, saying in part that cheap energy would flood the market and thwart attempts to advance wind and solar projects. That halted the whole effort. According to National Grid (NYSE: NGG ), the gas and electric utility for a majority of the Northeast, the lack of natural gas generating capacity and the lack of pipeline capacity is a contributing factor in higher electricity rates. Connecticut’s rate of 19.74 cents per kilowatt-hour for September was the highest in the continental United States and twice that of energy-rich states like West Virginia and Louisiana. The lowest rate, 8.95 cents, was in Washington State, where the Columbia River is the nation’s largest producer of hydropower. For the coming winter, National Grid, the largest utility in Massachusetts, expects prices to rise to 24.24 cents, a record high. The average customer will pay $121.20 a month, a 37 percent increase from $88.25 last winter. The lack of electric generating capacity is and will continue driving up the price for electricity, which will positively affect EXC. Based on beta and yield, EXC is current valued in line with other large-cap electric utilities. EXC has a beta of 0.50 vs. an average of 0.54 and offers a yield of 3.3% vs. an average of 3.3%. However, EXC is trading at a P/E of 15 vs. an average of 19, or a 20% discount based on its P/E ratio. In addition, while the average electric utility is expected to grow earnings by 4% to 6% annually, EXC could far exceed this rate based on higher pricing of its merchant power. Returning to ROIC, EXC has historically far surpassed its peers in generating returns based on their total capital structure. This is a direct result of their exposure to commodity power pricing. As the company has turned to a more regulated profile, their historic double digit ROIC has understandably declined. With higher profitability in their merchant power segment, investors should expect to see ROIC increase to the high single digit range of 8% to 9%. This level of ROIC will still be on the higher end of their peers. Morningstar offers their unique analysis on EXC: Bulls Say: Low-cost nuclear power plants run year-round and generate large profits even with currently depressed power prices. Exelon benefits more than any other utility from rising coal and natural gas prices, higher electricity demand, and environmental regulations on fossil fuel power plants. If gas and power prices remain low for many years, the Constellation acquisition in 2012 could prove prescient. Bears Say: Exelon’s performance depends on volatile power prices that fluctuate based on natural gas prices, coal prices, and regional electricity demand. Acquiring Constellation’s no-moat retail business and narrow-moat distribution utility in 2012 diluted Exelon’s wide moat. Many of Exelon’s growth projects come with regulated or contracted returns, reducing shareholders’ leverage to a rebound in power markets. It should be noted last week Morningstar downgraded EXC from “4 stars” to “3 stars,”, which is considered as neutral. The most likely reasons in the recent run-up in share prices. While not as cheap as a year ago when I penned the article “Exelon: Selling At 10-Year Lows” (or the four subsequent articles) suggesting investors buy in the $28 range, EXC still offers an 11% to 18% potential capital gain based on a 2-year target price between $42 and $45. Adding a 3.3% yield would generate annual returns of 7% to 10%. While not a barn-burner, this total return should be adequate for utility investors. Author’s Note: Please review full disclosure on author’s profile page.