|Shares Out. (in M):||866||P/E||14.6x||13.1x|
|Market Cap (in $M):||31,200||P/FCF||NM||NM|
|Net Debt (in $M):||19,800||EBIT||3,750||4,300|
Previously written up by snarfy in early 2013 at ~$32 / share, Exelon (EXC) remains an un-loved, somewhat mis-understood and under-valued long opportunity that has substantial leverage to the power market recovery + significant optionality to natural gas prices + heightened probability that regulators incrementally shift more favorably toward valuing clean reliable baseload nuke capacity. After suffering from years of power price compression, which led to a 40% dividend cut in 2013, all but one of the 23 sell-side analysts covering the stock had a hold or sell rating at the beginning of 2014 (as a result, stock looked like death sliding down from >$90 in 2008 to a low of $27 / share in early 2014 = in the process Exelon successfully shed >$40Bln of market cap + during this time period generated ~$10Bln of net income). Despite a ~30% bounce in the stock YTD, Exelon is still widely viewed as an ugly duckling and sell-side analysts have begrudgingly shifted their views from “sell / hold” to “hold”. On a go-forward basis, the market is under-estimating a couple important aspects including: (a) extent of the power market recovery (every $2 / MW hour move in power prices = >$4 / share of value), (b) gives limited to no value to natural gas price upside optionality (market generally views as $4.30ish commodity but every $0.50 equates to ~$5 / share of value) and (c) gives no value to Exelon re-positioning its nuke fleet (potential to add upwards of $5 - $10 / share of value but not factored into my estimates). Exelon presents a compelling risk-reward proposition with a total return potential of ~45% using conservative base case assumptions ($2 uplift to 2016E power prices + $4.50 natural gas) over the next 3 – 12 months and >80% applying $4 / MW hour uplift to 2016E power prices + $5 natural gas assumptions.
Exelon is a diversified utility, combining a regulated power and gas distribution company with an unregulated power generation company. On the regulated side, Exelon is the nation’s second largest regulated distributor of electricity and gas, with more than 6.6 million customers in Maryland, Illinois and Pennsylvania (this area of the biz is NOT the controversy and is generally viewed as providing $20 - $25 / share of value). In addition, Exelon owns the 2nd largest competitive power fleet in the US, comprising ~35 GW of capacity, including the nation’s largest nuclear fleet (this is the controversial segment and I believe is worth more than $30 / share using base case estimates and >$40 / share using upside estimates). As discussed below, three material and new dynamics have transpired that the market is largely ignoring:
- Early innings of a power recovery + natural gas prices provide upside optionality: every $1 move in power prices equates to >$200MM of additional profitability for EXC. Since the beginning of 2014, the market has generally taken up power price assumptions by around $3 / MW hour for 2016E estimates (this is generally the valuation year for unregulated power producers given “open” / un-hedged profitability gives a more accurate indication of health). In comparison, my base case estimates assume an additional $2 - $3 / MW hour ($400 - $600MM) and upside case estimates assume an additional $4 / MW hour (total $800MM versus Street). In addition, the Street generally assumes $4.25 - $4.35 natural gas (every $0.50 move is >$500MM). My base case estimates assume $4.50 natural gas and upside case assumes $5 natural gas. As a result, my base case EBITDA estimate for 2016E for the unregulated portion of Exelon is closer to $4.2Bln (versus the Street at around $3Bln). Capitalizing this differential at a punitive 8x multiple, implies ~$10Bln of additional value or >$11.50 / share of value.
- Capital allocation “penalty box” around Pepco deal is over-done and creates low hurdle for future allocation decisions (+ additional n-term clarity is growing): the market has taken an overly-punitive view of the recently announced Pepco acquisition … viewing it as expensive, time intensive, “doubling down” of regulated power with minimal accretion to earnings power (i.e. 10 – 20 cents / share * 14x multiple = a lot of work w/ execution risk and limited payoff according to the market). While some of these criticisms are legitimate, the market is (a) missing the fact that the acquisition incrementally improves the l-term ratings profile of the company (dividend coverage is the primary focus of agencies and this acquisition will augment dividend coverage), (b) initial perspectives by management have created a low-hurdle set-up to accretion and the deal will likely result in $2 - $3 / share of additional value (not factored into my estimates) and (c) there is significant balance sheet capacity for Exelon to focus on unregulated acquisition opportunity. Most topical is TXU and I’d assume management is focused on this opportunity given attractive Texas footprint, logical seller (distressed hedge funds are sellers subject to price), and has a coveted nuke asset (Comanche Peak) – in addition, Exelon bid for NRG in 2008 highlighting their interest in ERCOT market, making TXU a very logical alternative. Any additional clarity around unregulated acquisition opportunities be it TXU or others, would likely be well received by the markets.
- Carbon emissions regulations put EXC in enviable position and the market will likely be reminded of the potential value of carbon regulation on the earnings power of Exelon’s zero-emissions nuclear fleet in the n- to m-term (IL regulatory discussion n-term and broader carbon value discussion m-term): Exelon is currently losing $ on a handful of its nuke plants mostly with IL geographic focus (analysts have speculated these assets are losing a couple hundred million in FCF) and is in discussions w/ regulators to either close or improve the FCF profile of these assets. Over the next 12-months, more clarity is likely to come around putting a value on carbon or clean reliable baseload generation. While difficult to pin-point the timing and $ value uplift, this could ultimately translate into $5 - $10 / share of “free upside” value to Exelon currently ignored by the market (nor do I value in my base / upside case BUT has an increasing probability of being valuable).
FV approach: Summing it up and as discussed above, my base case assumes $22 - $23 / share of value from the regulated utility and ~$30 / share of value from the un-regulated assets (i.e. incremental $2 / MW hour uplift to 2016E power prices, $4.50 natural gas and $0 value to nuke renegotiations in IL = $4.2Bln of EBITDA and an 8x EBITDA multiple which implies a low-teens FCF yield w/ that multiple). In total, this equates to ~$52 / share FV (or ~45% upside) on base case estimates + dividend yield of ~3.4%.
Downside protection: At the current share price of ~$36 / share, implies less than $14 / share of value being ascribed to the un-regulated assets … this implies a ~$650 / MW value on Exelon’s ~35 GW of un-regulated capacity (while newbuild economics for nuke fleets are theoretical, the cost is easily north of >$1.5k / MW) and implies ~7x 2016E EBITDA factoring in the FCF generation over the next 2 years. This suggests the market either believes … (a) un-regulated assets deserve a discounted multiple (especially surprising given Exelon owns some of the highest quality nuke assets in the US) or (b) the prospects of a power market recovery are temporary and fleeting (an argument that I do not agree with). Regardless, creating Exelon’s un-regulated nuclear assets at ~7x EBITDA and >50% discount to newbuild (coveted low-cost assets) provides significant downside support.