Holding on to Exelon

31 Mar 2013 by Jim Fickett.

Government subsidies for wind are causing a problem for some Exelon power plants, but the problem is not a major one for the company as a whole. Checking up on a previous concern, the retirement plan is expensive but also not a major problem. Valuation overall is reasonable at the current price, and I still expect a recovery in gas prices to help the company, and the mood of investors, so I will continue to hold.

In a recent post (Negative electricity prices) I described how government subsidies allow wind farms to operate at a profit even when there is no demand, leading at times to negative wholesale prices for electricity. Naturally, baseload generators like Exelon are not happy with this situation. Since one cannot easily shut down and restart a nuclear power plant in short order, Exelon ends up paying the grid to accept its electricity, at least at some times and in some places:

[Exelon]'s Byron nuclear plant in Illinois, [Exelon Corp. Chief Executive Christopher Crane] said, is in a negative pricing scenario 16 percent of the time.

How widespread is this problem? It is hard to tell, as Exelon does not provide any more detail than is in brief quotes in news articles. However there are good reasons to think that cheap natural gas, rather than wind, remains Exelon's central problem. Although in a few locations wind power is a substantial fraction of the market, in the country overall wind only provides 3% of the power, while natural gas provides about 30%. And since Exelon sells power in 31 states, it seems likely that their market overall resembles the national market fairly closely.

This view is supported by the tenor of the 2012 annual report, recent presentations, and the transcript of the most recent earnings call, which all emphasize cheap natural gas as the main challenge, and which project gradually rising electricity prices over the next few years.

Overall I think that in the next couple years, as the natural gas market hopefully normalizes, Exelon will be helped. Over the next decade or two, the wind subsidies are an issue that could grow, and should be watched closely.

Of course all utilities, not just Exelon, are strongly affected by regulation and environmental law, and a major part of the business is managing regulatory/legal risk, and keeping a good relationship with lawmakers. Exelon has so far done this job dependably well, and is currently fighting to prevent uncompetitive bidding in wholesale markets.

When I bought Exelon stock in 2010 (Exelon: a dividend stock with some risk but likely capital appreciation), I argued that the company needed to be contributing more to the retirement plans. In 2010 and 2011 the company did some catching up, making contributions of over $3 billion. The unfunded obligation (i.e. the current actuarial obligation minus the current value of assets), measured as a fraction of revenue (to account for the company growing), is now back to almost exactly its long-term average. Exelon, unlike most governments and some companies, is dealing with this obligation, and not allowing it to get out of hand.

It is never completely straightforward to calculate a realistic price/earnings ratio. Here I look at three variations, looking at both net income and free cash flow.

1. The most pessimistic variant is to look at the most inclusive free cash flow calculation, including all acquisitions in capital expenditures. With this calculation, the average free cash flow over the last 12 years is $1.45 bn. With a market capitalization of $29.48bn, this gives a P/FCF of about 20.
2. Average net income over the last 12 years is $1.88bn. This gives a P/E of about 16.
3. In attempting to calculate a value for P/FCF, one should really only look at capital expenditures that maintain the operating condition of the company. This is hard to do; one approximation is to add back to free cash flow any increases in the book value of the company. Over the last 12 years, book value increased, on average, $1.21bn/yr. Using, then, $1.45bn + $1.21bn for an estimate of maintenance-level free cash flow gives a P/FCF of about 11.

Given that significant investment did go to growing the company, the very conservative P/FCF of 20 is definitely too high. Given the extent to which either net income or book value can fail to reflect reality, it is hard to tell whether the P/E of 16 or the P/FCF of 11 is closer to the truth. Overall I would say that Exelon is probably not far from fair value currently. This is in contrast to most dividend stocks, which are currently popular and somewhat overvalued.

If you look at some general resources for stock information, you will see a very high, and misleading, dividend yield for Exelon. The company has announced that the dividend will be reduced to conserve cash. The yield with the current stock price and the new dividend is 3.6% – still quite healthy.

The average “true” (counting only required capex) free cash flow over the last twelve years was, as outlined above, somewhere in the range $1.45bn to $2.66bn. The average dividend over the last 12 years was $1.09bn. So historically the company has kept the dividend to a sustainable level (sometimes by lowering it). Reducing the dividend is quite unpopular, of course, and Exelon went to considerable trouble to try to make sure the new dividend is low enough that it will not have to be lowered again – a number of very negative scenarios were projected forward, and a dividend level chosen that was affordable in all of them. Probably the current dividend is quite safe.

Over the next few years, I think the natural gas price will rise before financial repression ends, implying that Exelon is more likely to become overvalued, medium-term, than undervalued. So I will continue to hold. And, in case I'm wrong, on the whole I think Exelon is a well run company, and one I wouldn't mind holding long term.