Time to Sell Exelon

 | May 12, 2014 | 5:30 PM EDT
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Since the beginning of the year, Exelon stock is up more than 30%. Its first quarter booked a slight improvement over the previous year. But there appears to be trouble under the hood of its consolidated statements, and it could be serious. It may be time to sell Exelon (EXC).

Here is the good news: Year over year, Exelon's top line showed incredible improvement. Revenues were up by almost 19%. Net income jumped from a slight loss to $90 million. Bottom-line earnings increased by only 2%.

Here is the first surprise: It is not earnings; it is cash flows. Exelon's cash flows from operating activities declined 80%, to $165 million from $859 million. Its free cash flow remains positive.

Exelon earnings are mediocre; however, an 80% drop in cash flows signals a serious problem. A quick look at Exelon's consolidated statements does not reveal a problem. Investors have to look at Exelon's subsidiary statements. There, they will find a problem: Exelon's nuclear fleet appears to be in deep trouble.

To appreciate the problem, investors should understand Exelon's position. With 23 nuclear power plants in its portfolio, Exelon operates the largest nuclear fleet in the nation. It is almost twice as many as the number two position, which is owned by Entergy (ETR).

Exelon Generating operates 17 reactors in Illinois, Pennsylvania and New Jersey. Exelon also has ownership interests in four other nuclear plants in Maryland and New York. All of Exelon Generating's nuclear assets are unregulated. All rely on the deregulated power markets for top-line revenues.

The replacement cost of a nuclear power plant is approximately $6.5 billion, or $150 billion for 23 reactors. Exelon's book value for their 23 reactors is approximately $20 billion. Based on recent experience with the Kewaunee and Vermont Yankee plants, Dominion Resources (D) and Entergy learned the market value for their used nuclear plants was zero. Today, it seems reasonable to assume the market value of Exelon's units could also be close to zero.

Exelon's shareholders face a write-down risk of up to $20 billion. To avoid risk of write-down, Exelon's fleet must perform financially. At a minimum, it must generate positive cash flows. It should also deliver earnings.

Here is a second surprise. Like everyone else, Exelon Generating saw a bump in revenues from the polar vortex. Quarterly revenues jumped to about $4 billion in 2014 from about $3 billion in 2013. Notwithstanding unexpected burst in revenues, Exelon Generating's losses almost doubled to $206 million in 2014 from $121 million in 2013.

Here is a third surprise and it's is a big one. Exelon Generating's net cash flows provided by operating activities are in free-fall. Year over year, their cash flows dropped to negative $169 million from positive $506 million.

These numbers are stunning. A billion dollars in extra revenues generated negative cash flows. This is not sustainable.

At the same time the company is struggling with its nuclear units, Exelon is warning government officials and the investment community that it may be forced to retire several nuclear plants decades early. According to the Chicago Tribune, "Exelon said last month that unless market conditions improve, it will announce plant closings by the end of this year."

Last March, the Tribune reported that Exelon's plants in Illinois have not covered costs since 2008. Among the newspaper's findings:

  • Clinton is in the worst financial shape. Power prices plummeted to $22 in 2009 from $42 per megawatt-hour in 2008 and have held below $29 ever since. Clinton's operating costs are between $45 and $55 per megawatt-hour.
  • The Dresden plant is faring the best of the Illinois plants, but it still is not profitable. In 2010 and 2011, the plant earned $33 per megawatt-hour, with costs ranging between $35 and $40 per megawatt-hour.
  • Quad Cities and Byron have been hit the hardest by "negative" price conditions. Quad Cities paid the grid operator to take its power 8% of the time. Byron paid out 7% of the time.

This is one state and seven out of 23 reactors. It is reasonable to assume Exelon is facing similar challenges with other plants in other states. It seems at least half of Exelon's nuclear fleet is in near-term danger of retirement.

To be clear, retirement means decommissioning and dismantlement. For shareholders, it could mean billions of dollars in potential asset write-downs. This might explain Exelon's sudden interest in buying Pepco Holdings (POM). Last week, I advised selling Pepco. This week I advise selling Exelon. While you are at it, sell any positions in Entergy.

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