The merger of Exelon (EXC) and Constellation (CEG) creates the No. 1 competitive energy provider, with one of the industry’s cleanest, lowest-cost power generation fleets and one of the largest customer bases in the United States. The combination will integrate two complementary upstream and downstream businesses, matching EXC’s power generation fleet with CEG’s customer-facing business. The result will be a balanced business mix of 50/50 regulated utilities and competitive generation. The combined entity will benefit from increased scale and financial strength. In layman’s terms, the merger will promote earnings stability and increase regulatory bargaining power.
The new EXC will be the number one independent power producer (IPP) in the United States with more than 34 gigawatts of power generation, 19 of which come from its nuclear fleet. The company is also one of the cleanest energy providers; about 55 percent nuclear, 24 percent natural gas and 8 percent renewable. A changing regulatory environment that favors clean generation sources will ultimately work in EXC’s favor.
The merger has been a drag on stock price. The share exchange ratio that EXC offered CEG is moderately dilutive to current EXC shareholders. As in other stock offer acquisitions, notably the recent Kraft-bury (KFT) merger, what might be bad for existing shareholders is often a good opportunity for new investors.
Numerous Risks to Consider and Rebuttals Thereof:
The Oversupply of Natural Gas
According to a recent Bloomberg article, “The U.S. is the closest it has been in almost 20 years to achieving energy self-sufficiency.” In the state of the union address, President Obama talked enthusiastically about America’s 100 year supply of natural gas. “Everybody knows” that natural gas prices are going to stay low for the foreseeable future and this naturally is a drag on the profit potential of IPPs. With abundant supplies making gas the cheapest option for new power generation,EXC recently scrapped plans to expand capacity at two nuclear plants.
The market is assuming unreasonably low long term gas prices. EXC is priced as though gas spot prices will stay below $3 per mcf in perpetuity. However, the Nymex Henry Hub futures curve hits $4.50 beginning in mid-2014 and only increases from there, which would imply much more bullish expectations about the long-term picture for natural gas. Furthermore, thanks to announced pull-backs in production by the likes of Chesapeake Energy (CHK), the rationality of competitors may be counted on to provide a floor for gas prices at competitive levels consistent with the costs of recovery, production and distribution.
Calpine (CPN) as a Case Study in the Futility of Predicting Commodity Prices
Think back to the year 2000, which apparently is farther back than most market participants are capable of reflecting. The new Republican era of deregulation had just begun. The spot price of natural gas had been hovering above $2 per mcf for most of the last decade. Regulatory concerns about clean power generation were gaining steam. What better time to bet on cheap, clean, natural gas-fired power plants?
CPN took that bet and spent $18 billion to create what was the nation's largest independent fleet of gas-fired power plants. Things didn’t work out as planned. Most notably, the price of natural gas skyrocketed. Before the hurricane season of 2005, gas was near $6 per mcf, almost triple the 10 year average. After the hurricanes, it spiked to $14 per mcf. CPN’s investors got crushed. Now things have come full circle and natural gas is cheap again, forever, just like last time.
Does Moore’s Law Apply to Solar Cells?
In 14 and a half seconds, the sun provides as much energy to Earth as humanity uses in a day. That factoid ought to explain the interest in developing solar power for commercial use.
Moore’s Law dictates that the number of components that can be placed on a chip doubles every 18 months. More practically speaking, the amount of computing power you can buy for a dollar has roughly doubled every 18 months, for decades. That’s the reason that the phone in your pocket has thousands of times as much memory and ten times as much processing power as the famed Cray 1 supercomputer.
Indeed, averaged over 30 years, the trend is for an annual 7 percent reduction in the dollars per watt of solar photovoltaic (PV) cells. As you can see in the graph above, if this trend continues solar will reach grid parity in the year 2020.
Utilities Like Newspapers in 2000 http://www.gurufocus.com/news/142139/utilities-like-newspapers-in-2000-an-industry-primed-for-disruption
I wrote that article, concluding that IPPs will face severe headwinds trying to sell their energy into spot markets flush with cheap renewable energy. I haven’t made an abrupt about face. Rather, I’ve developed a more nuanced understanding of how renewable energy sources work in the context of our existing infrastructure.
From the original article I offer you this. First and foremost, utility customers are captive in a way that newspaper customers never were. The option of installing solar photovoltaic cells will most certainly change the way we pay for electricity, but the technology lacks the scalability necessary to free us from the grid.
Second, regulators and state budget makers have an extremely vested interest in insuring that utilities earn back their invested capital. Utility regulators are charged both with ensuring that utility customers get service at a reasonable cost, and also that utility investors will continue to be willing to provide capital for necessary utility investments. If the rapid adoption of alternative energy were to threaten utility solvency, regulators would be forced to take action.
I would now like to add two more points.
The capacity factor of a power plant is a ratio of the actual output of a power plant produced over a period of time compared to its output if it had operated at full capacity. For example, a solar power plant obviously can not operate at full capacity 24 hours a day. The industry average capacity factor for existing solar PV power plants is 0.2. Therefore, a solar power plant rated at "100-megawatts" would have a net capacity of just 20 MW (100 MW x 0.2 = 20 MW). In contrast, a 100 MW nuclear power plant in the United States typically has a capacity factor of about 0.9(100 MW x 0.9 = 90 MW). Thus, one must build 4.5 times the initial capacity of solar power production to garner the net capacity of one nuclear facility. This helps level the playing field somewhat for EXC’s existing power generating fleet.
Old Power Plants Never Die
More importantly, power plants simply do not die. They don’t even fade away. They get refurbished, re-permitted, and re-commissioned. As far as we know, the may last forever. Re-commissioning is a way to avoid “not in my back yard” problems, and it simplifies other issues such as transmission and distribution.
All power plants tend to get a little less efficient over time, this is called degradation. Nuclear facilities degrade at an estimated rate of about 0.2% per year, which compares favorably with the estimated rate of 0.5% per year for solar PV. Thus, if we combine this knowledge with what we learned about capacity factor above, you can start to see the scale to which one must invest in solar to reach parity with existing incumbents. Where the associated costs of carbon emissions is not a factor, such as with nuclear power generation, there is increasingly little incentive to replace existing power plants.
There is no doubt in my mind that PV systems will be directly price competitive with existing energy sources. However, I have altered my view of the role of renewable energy, which I consider as the most rational source of future additional capacity input, but not as a substitute or replacement for existing facilities. Specifically, clean baseload generating assets like nuclear plants are unlikely to be supplanted by renewable sources.
Levelized Cost of Electricity (LCOE)
LCOE is an apples to apples comparison of the cost of all the useful energy produced by an installation over its total life.
As you would expect, the key difference between nuclear and fossil fuels is the cost structure. Nuclear facilities require large upfront costs but little expenditure for fuel. On the other hand, fossil fuel plants require relatively little capital investment but have high fuel costs. Nuclear energy becomes increasingly more cost efficient over time. If you factor in an assumption of 3% fuel inflation the cost advantage for nuclear energy becomes parabolic. The charts below suggest that solar energy would take 37 years to achieve parity with nuclear energy production.
Impact of inflation on energy output cost
Weather can have a material impact on EXC's business. Baltimore Gas and Electric Company recently announced that its customers will experience a decrease of 16% in their heating bills compared to last year, due to warmer than expected weather. That is a huge hit to the company’s bottom line, but one that will average out over the life of the utility assets. At EXC, both ComEd (Illinois) and PECO (Pennsylvania) experienced significant storms this year. These storms cost the company millions of dollars in lost revenue and additional expense to restore operations. Severe storms, warmer than expected weather, and low natural gas prices have joined forces to make this winter one of the worst for EXC, but it has also made for an attractive entry point for new long term investors, who understand the principle of reversion to the mean.
EXC has a lot of debt. They operate in a capital intensive business, so this is somewhat to be expected. The combined entity will have approximately $5 Billion in pension liabilities, and $3.7 Billion in regulatory liabilities. Much ado has been made about EXC’s underfunded pension. As of 4Q11 the fund is 83% funded and plans have been outlined and acted on to achieve full funding, including a $2 Billion dollar contribution at the beginning of 2011.
The company also maintains a nuclear decommissioning fund, but it seems unlikely that they would ever be called upon to decommission a plant. I’ve already outlined my thesis on re-furbish, re-commission and re-permit. EXC’s debt load is certainly a negative, but ultimately a manageable one, given the company’s history of generating free cash flow.
Recently, the US approved of its first new nuclear operation in 34 years. This event significantly reduces the risk of increased regulation of nuclear facilities in the aftermath of the Fukushima tragedy. Thus removing one more burden from the stock price.
In response to volatile markets and rising energy prices, some states that had been planning to deregulate their power markets are now reconsidering, eliminating an area of growth. Talk of re-regulating Maryland's power markets would impact shareholder value. With an even mix of regulated and competitive assets, it seems reasonable that regulatory risks would have a neutral impact on EXC’s overall earnings potential. EXC stands to gain substantially from tougher regulations on carbon emissions.
Interest Rate Risk
Academically speaking, the bond rating of a utility's debt has a strong influence on its equity sensitivity to interest rates. The common stock of highly rated utilities is more interest rate sensitive than that of lower rated utilities. This is consistent with investors valuing utility stocks as predominantly income oriented securities. Once the rating of the debt is controlled for, the debt level of the utility is positively correlated with interest rate sensitivity. Additionally, larger utilities are found to be more interest rate sensitive than smaller utilities.
To put it more simply, the basic assumption in investing in utilities is sell on inflation, buy on deflation, and hold on stagflation. Regulated utilities feel the most pain during high-inflation periods with their mostly fixed rates, required infrastructure investments, and constant financing needs. Independent power producers (renewable or traditional) rely on demand growth to reward their high up front investment costs.
Higher interest rates are basically a net neutral for an IPP, in so far as higher rates can be associated with higher GDP expectations. First, higher rates impose on new capacity projects, acting to stabilize price markets, because new supply can not come on line quickly enough to satisfy an increase in demand. Second, rising rates squeeze margins at integrated utilities, helping to drive up the spot price for energy consistent with the rate of inflation. These factors help to offset the increased cost of revenue created by higher rates.
EXC has one of the top management teams in the industry, and this will continue after the merger with CEG. The efficacy of the management is evident in the operating results. EXC has achieved an operating capacity greater than 93% for nine consecutive years (versus the nuclear utility industry average of 90%) and every penny of that out-performance drops to the bottom line. Furthermore, current CEO John Rowe was an early adapter of clean energy policies and has helped EXC become a leader in clean energy, renewables and smart grid technology.
Unfortunately the management does engage in some controversial activity. EXC has chased after mergers at far less attractive prices than the current CEG merger. Most memorably, EXC failed in a hostile bid to buy rival NRG Energy (NRG) in 2009. Clearly management believes energy prices will be higher in the future than they are today. CEG also chased after rising IPP prices in the bull market of 2008 and ended up having to cut its dividend to cover its loses. With both companies trading at less than half of their peak values, investors are able to buy these assets at rates far below what both management teams acquired them for.
EXC has good reason to make a large acquisition. Doing so allows them to drive internal growth and reduce competitive pricing pressure. In essence, EXC’s IPP business will be able to take advantage of its regional monopoly status to sell energy to CEG’s regulated holdings.
Utility stocks are in essence, infinite duration corporate bonds. In many ways, EXC is the sum of its dividend policy. Chris Crane, current COO and soon to be CEO, as well as all of EXC’s board members, are acutely aware that their job security rests on the number 0.525; the current quarterly dividend distribution. From the most recent quarterly transcript, “We are keenly aware that to all of you the dividend is an absolutely critical part of our value proposition. It's what makes it possible for you to hold on with us while we work our way through the gas and power price trough.” And later, “Simply put, we get.”
As you can see in the EXC is trading near the bottom of its historical valuation on a number of metrics. Post merger EXC will be trading at less than 5 times cash flow. Using a DCF calculator, EXC is expected to grow earnings no faster than 3%, about the rate of inflation. This represents a tremendous discount to peers.
|Fair Value:||$ 38.69||$ 28.37||$ 10.23||$ 13.3|
|Margin Of Safety:||-1%||-77%||-67%||-62%|
The combined utility will have a market cap of around $34 Billion. Southern Company (SO) is investing $14 Billion to build a 1,100 MW facility in Vogtle, Georgia. EXC has 10 such nuclear facilities. Implying a replacement value of $140 Billion just for that part of the business (about 55% of production). In short, you couldn’t reproduce EXC’s assets at any price, even if you wanted to.
Heads I Win, Tails We’ll Call It Even
Currently EXC offers an excellent dividend income and is fairly valued at trough earnings of around $3 per share. If energy prices remain depressed, then you are buying a monopoly company at fair value and should expect to earn the market return for the utility sector. There are two reasonable catalysts that will drive EXC’s earnings above the rate of inflation, thus creating significant upside to the share price; natural gas futures and carbon emission legislation.
The fair value of EXC really depends on long term projections for energy prices. Which is unknowable. Natural gas futures project increased prices, and an increase in gas prices will translate into increased earnings for EXC. Cap and Trade, or really any form of tax or regulation on carbon emissions, will drive earnings and create a competitive advantage for EXC.
Heads I Win, Tails Its Chance
Investors consistently overstate their ability to judge future events and this leads to mispricing. Since, “everyone knows” that natural gas will be cheap and abundant for eternity, IPPs are vastly oversold. This flies in the face of all demographic information regarding increased per capita energy consumption and finite fossil fuel capacity. The discount between investor expectations and historical rates for energy prices has created an opportunity to buy EXC near its historical lowest valuation.
The Bull Case
- Ultra-low cost nuclear power plants that provide constant baseload capacity translates into reliable free cash flow generation
- EXC benefits more than any other utility from rising fossil fuel prices
- Although cap and trade may be dead, increasing regulation of emissions will still result in substantial benefits
- EXC is the undisputed leader in competitive power markets
- Closer pairing of supply contracts (CEG) and generation assets (EXC) will lower costs and win new supply customers
- Despite the economic downturn, electricity demand should continue to outpace supply additions
- The merger will greatly reduce earnings volatility, even if power prices remain weak
My thesis is simple, even if I took a complicated route to explain it. EXC is a monopoly. They own critical infrastructure assets that provide essential services to their customers. The company is currently in an earnings trough due to weak power prices. Any rebound in power prices or regulation regarding emission controls will immediately benefit the company. Current share price offers investors an excellent opportunity to own these assets with very low risk.