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Exelon: a dividend stock with some risk but likely capital appreciation [ClearOnMoney]
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Exelon: a dividend stock with some risk but likely capital appreciation

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Investment

Exelon: a dividend stock with some risk but likely capital appreciation

11 Oct 2010 by Jim Fickett (dead links removed 29 Mar 2013)

Exelon is currently paying a 4.9% dividend, and is often put forward as a vanilla dividend utility stock, but the story is more complex than that. A large fraction of Exelon's profits come from its nuclear merchant power division, which has fixed costs but earns revenues that depend on the wider electricity market and hence the price of fossil fuels. Thus revenues were high when natural gas was expensive, and have fallen since. I think Exelon is a fairly safe way to bet on coming increases in the gas price, and will buy. If you don't want to bet on the gas market, you should probably look elsewhere for dividend stocks.

Returns

Exelon was formed by a merger in the year 2000. Since then it has paid a reasonably dependable dividend, and given volatile but, overall, solid returns:

(The annual dividend is shown. Total returns assume purchase at the end of 2000; collection, but not reinvestment, of dividends; and sale at the end of the year shown. All data not otherwise attributed are from the company's SEC filings and Annual Reports.)

The dividends have been a big part of the overall return. If you had bought at the end of 2000 and sold at the end of 2009, the dividends would have provided a 46% return and capital appreciation 41%. In any case, not too many stocks provided an 87% return over that period.

Growing the business

Exelon is a holding company for three businesses. Two are utilities – ComEd in Illinois and PECO in Pennsylvania. The third is merchant power, that is, a power generation company that sells electricity on the open market. The generation business is primarily nuclear; Exelon is the largest nuclear operator in the country.

The business has grown. The following graph shows the growth in overall revenue, operating cash flow, net income, and cash dividends paid.

Most of the growth has been in the generation business, where net income has grown from $0.5 billion in 2001 to $2.1 billion in 2009. One important factor in this increase was improved productivity – reactors went from running below 50% of capacity to running at 93% of capacity. Another was uprating, where equipment upgrades increased the capacity of existing reactors, with a result equivalent to adding another reactor.

Growth continues. Uprating plans will add the equivalent of another reactor in the next few years, a large solar farm came on-line in Chicago this year, and the company just bought a large wind farm from Deere.

Looking forward, there are two main questions:

  • Is the dividend likely to be dependable?
  • Why did the stock price drop in 2009, while the overall market rose, and where might the price go next?

Both of these questions hang, in turn, on two main issues: the state of the company's retirement plan, and the effects of the natural gas price. I'll take these up in turn.

Retirement plan funding

There is no one standard way to look at the condition and affordability of retirement plans. In this section I look at Exelon's plan from a few different perspectives, with the aim of discerning whether there are major problems with the overall obligation, compared to the company's balance sheet, and also to see how future contributions to the plan might affect income (and hence stock price) and dividends.

First the basics: In 2006 the company switched non-union employees to a defined contribution plan. However many union employees remain in the defined benefit plan, which has large future obligations. My analysis starts with the following values from each year's filing:

  • present value of future obligations
  • current value of plan cash and investments
  • company contributions to the plan

Some companies, like the old General Motors, were insolvent for years before they went under, because the retirement plan obligations were monstrous compared to the company's balance sheet. This is not the case for Exelon. Unfunded retirement plan obligations (present value of future obligations less current value of cash and investments) as of end 2009 were $5.8 billion. This compares with long term debt of $11.0 billion and total liabilities of $36.5 billion. The retirement obligations are a significant fraction of liabilities, but they are not going to sink the company.

The present balance sheet looks OK, but what about the future? In some public and private plans obligations have grown far faster than revenue, as too much was promised and workers earned unaffordable benefits. It is a little bit complicated to evaluate Exelon on this score, because acquisitions and divestitures have changed the set of covered employees. To get a rough idea, one can scale obligations to company revenue. This ratio has stayed in the range 0.62 to 0.90, and most of the variation has been due to changes in the discount rate used to convert future obligations to present value. So it does not appear that Exelon is allowing unrealistic promises to build up, increasing problems for later.

Now look at income. Again scaling everything to revenue, on average unfunded obligations have been 24% of revenue, but were at 34% of revenue at the end of 2009. Taking the point of view that unfunded obligations should at least not outpace revenue, company contributions should have averaged about a third bigger than they were. That works out, at the current size of the company, to about $200 million per year more that the company should probably be contributing to the plan. This is a rough estimate, and depends on the assumption (see below) that 2009 revenues are fairly typical. But looking at the consequences of a $200 million annual increase in costs can at least give some idea of the scale of the issue.

Let's look at two consequences. First, income is being overstated to some extent, because plan contributions are being put off to the future. Current income is overstated by about 7%, and this means that the “real” price/earnings ratio is 11.9 rather than the stated 11.3. At a P/E of 11.9 the company is still fairly valued.

The second consequence is that dividends should probably be lower. If we take $200 million off of current dividends, that would cut the dividend rate from 4.9% to 4.3%. 4.3% would still be a healthy dividend.

In sum, Exelon is not being entirely straightforward on the real cost of its retirement plan (in which choice it has plenty of company), but if we subtract from earnings what it would take to really keep up with obligations, it does not make a big difference to the attractiveness of the stock.

Exelon is a bet on natural gas

Perhaps the single most important point you need to consider regarding the value of Exelon is that the company's overall strategy depends on fossil fuel prices rising. They have bet hugely on nuclear; as of 2009 the generation division provided 78% of profits, and the generation portfolio was 93% nuclear, 5% coal, 1% oil, 1% gas, and 1% renewable. In 2010 more renewable capacity was added, but the portfolio is still overwhelmingly nuclear.

Thus their generation costs are essentially fixed, while their revenues depend on prices in the wider market, which is largely fueled by coal and gas. That is why their revenues were very high in 2007 and 2008 – high natural gas prices had worked through to the electricity market.

I think this is a very good strategy for the long term. However the oversupply of shale gas has worked strongly against the company in the short term, and that is the main reason for the recent poor performance of both revenues and the stock price.

A short review of why the natural gas price will go up

I have written several times about why I think natural gas prices are unnaturally low right now and will rise. The following is a concise summary of the case, with a couple new points added.

Supply is likely to come down:

  • Gas wells deplete quickly and production requires constant new drilling
  • Shale gas, which gets all the attention, is a small fraction of the market, and conventional drilling is being cut back due to lack of profit
  • For now rig deployment is level and below the 10-year average
  • Much of current drilling is forced by the legal requirement to make recent leases productive, and is almost certainly not profitable
  • Many gas companies are switching their emphasis to oil and natural gas liquids, to get better profit
  • Total overproduction over the last few years has only been a 1.5 months' supply, and production has been in a decelerating trend since 2006

Demand is not far below supply, and will rise in the long term:

  • Demand over the last 12 months actually exceeded supply; part of this was due to a hot summer, but it shows supply and demand are not so far out of balance
  • Cheap gas has already resulted in power companies switching some production from coal to gas. Current projections for new capacity suggest gas will significantly increase its share, at the expense of coal
  • LNG import terminals are being retrofitted for export

Exelon's hedging and revenue projections

Exelon attempts to smooth out fluctuations in the highly volatile energy markets by hedging a large fraction of their power sales several years ahead. For example, at the end of 2009 they had hedged prices for about 90% of 2010 production, 70% of 2011 production, and 40% of 2012 production. This means that changes in the wholesale price of electricity affect revenues with a significant delay.

According to the most recent (Q2) investor presentation (slides and transcript),

  • auctions for future power sales hit their lowest price for the 2012/2013 season, and then recovered for 2013/2014, and
  • projected 2010 earnings are down about 10% from 2009
  • the net effect of electricity prices on the company will be negative in 2012 but positive averaged over the next few years

Of course all such analysis contains considerable uncertainty. With that caveat, it would appear that Exelon might have to reduce the dividend temporarily in 2012 but, even with low gas prices, the company will not suffer significantly more damage than has already occurred.

How can this be? The investor presentation makes the point that even with cheap gas, and with no cap and trade, costs for coal plants are increasing significantly due to other environmental regulation.

In Exelon's base-case scenario, then, revenues probably do not increase significantly for several years, but neither do they take a significant further hit. In other words, if you want to know what the cheap gas future looks like, expect a dip in 2012 but, long term, look at 2009 results: strong earnings and a 4-5% dividend.

In what I think is a more realistic scenario, where the gas price rises, Exelon's profits will rise as well, and the stock price will go up.

Conclusion

Despite many articles putting Exelon forward as a vanilla dividend stock, it is not that. Earnings are volatile and depend strongly on fossil fuel prices and environmental legislation.

In the consensus scenario, where natural gas remains cheap for many years, probably Exelon earnings and dividends will remain healthy, but this depends on projections which are more than a little uncertain. In any case, in this scenario earnings will take a dip in 2012 and it might make sense to wait until then to buy.

In the more likely scenario where gas prices rise in 2011, Exelon is likely to do very well. Because much of future production is hedged, the positive effects of a rise in the gas price may be delayed, but they will come. In this case, dividends are likely to remain healthy and, due to rising revenues, the price of the stock is likely to rise as well.

All told, if you don't want to bet on the gas market, you should probably look elsewhere. But if you agree that gas prices will rise, Exelon stock is a low-risk way to bet on that change.

I have a small position in Exelon, less than 1% of the portfolio, that I bought long ago. Barring any major surprises, I will bring that position up to 3% tomorrow.