Hang On to This Utility

 | Sep 17, 2012 | 5:30 PM EDT
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During the last nine months, Exelon's (EXC) shareholders have had a rough ride. A year ago, in August, I recommended Exelon when it was priced at $40.72 per share. Today the stock is below $36, but it pays $2.10 in dividends, or 5.9%. Still, there is much more value to Exelon than just the payout.

Exelon is a unique utility holding company. It owns three separate electric-distribution companies serving the metropolitan areas of Chicago, Philadelphia and Baltimore, and each subsidiary owns regulated assets governed by state utility commissions. If Exelon can manage state affairs properly, its regulated assets should provide shareholders solid returns with minimal risks.

Exelon also operates the nation's largest fleet of commercial nuclear power plants, with 10 commercial nuclear power stations and 17 reactors located within Illinois, Pennsylvania and New Jersey. According to the Nuclear Regulatory Commission (NRC), Exelon owns 19,074 megawatts and manages 21,794 megawatts of nuclear power capacity. But the financial performance of this fleet is simply astounding.

For the three months ended June 30, Exelon's management team exceeded industry averages by a landslide. According to the Nuclear Energy Institute (NEI), Exelon's average production cost of $18.48 per megawatt hour puts the company in the first quartile of all the nation's commercial nuclear plants. Its average capacity factor of 93.4% exceeds the industry average of 89%. These performance numbers make Exelon's nuclear fleet a cost leader.

Going forward, the only generators that can beat Exelon nuclear plants' production costs on a round-the-clock basis are modern combined cycle gas turbines. But gas turbines can only achieve cost leadership if they can find someone to deliver natural gas to their sites for $3.10 per million British thermal units or less. Other than some Calpine (CPN) units, there are not many combined cycle gas turbines in Exelon's service areas, and it is unlikely many new units can be built.

Exelon's nuclear units have two distinctive advantages. First, they are the cost leaders in round-the-clock power production. As Harvard's Michael Porter points out, cost leaders win in the long haul. Further, within the deregulated power markets in which Exelon operates, production costs determine the dispatch order and gross margins.

The second advantage is that Exelon owns the barrier to competition that no other utility can overcome. The book value of Exelon's 19,000 megawatts of nuclear power capacity is approximately $17 billion. The ability to build a competing fleet -- that is, to design, permit and construct a fleet of new nuclear power plants -- would cost a competitor more than $130 billion and about 15 to 20 years' time. But even if a competitor were to successfully build a competing fleet, their levelized costs would be orders of magnitude higher than those of Exelon's fleet.

Combining these two advantages leads to a third: Exelon completely owns the cost leadership position. Only wind and solar power can threaten its cost advantage.

It gets better. Exelon believes its competitive position will only improve over time. It believes tens of thousands of megawatts of coal plant capacity will be retiring between now and 2015. The retirements will come about because old coal-fired boilers are fundamentally uneconomic and new Environmental Protection Agency regulations are helping to push them over the cliff.

Of course, solar and wind power have significant production cost advantages over nuclear. When these renewable energy units operate, they shave locational market-clearing prices and lower local gross margins.

The loss of margin may explain why renewable energy is a threat to Exelon. Exelon is active in NEI's lobbying efforts to convince Washington policymakers that the nuclear-power industry needs special regulatory and financial concessions. It also may explain why Exelon took a seemingly bizarre position against wind power.

As reported by Wind Power Monthly, the American Wind Energy Association (AWEA) recently ejected Exelon from its ranks. AWEA said Exelon had been acting in a way that was "inconsistent with our mission" by leading an "organised campaign against the industry's number one priority," the federal production tax credit.

Renewable energy's threat to Exelon is manageable. As more wind and solar comes on line, Exelon's will adjust its revenue strategies. Already, Exelon stands to receive more revenue from capacity auctions as regional grids demand more from shrinking fleets of base-loaded plants.

It will take time for Exelon to reach fighting strength. The company has to digest its recent acquisition of Constellation Energy. By 2015, capacity auctions are set to become more attractive as old coal exits the power markets. As it is, Exelon can count on higher revenue from PJM's 2015/2016 capacity auction; the price for capacity has already been set at $136 per megawatt day.

Exelon is bigger and stronger than its quarterly filings suggest. But it is best owned by long-term investors -- and these folks should buy on the dips, cost-average down and bank incredible dividends.

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