With Power Prices at a Multi-year Low, We’re Looking at Excelon Corporation (EXC)

At a current price in the mid $38s, we think Excelon Corporation (EXC) provides investors a steadily growing 5.4% dividend yield with a “free call option” on rising power prices.

With the just completed acquisition of Constellation Energy, EXC became the largest power retailer in the United States.  At $38.50 and a dividend of $2.09, the stock trades with a 5.4% current yield.  The dividend is well covered with estimated trough 2012 earnings of $3/share (a payout ratio of 70%).

EXC is essentially two distinct businesses.  The first is a regulated utility that earns a fixed return.  The second is a merchant power generator that sells power on the open market.  EXC’s power generation is primarily nuclear.  With current power prices near multi-year lows, we expect one third of 2012’s earnings (and half of EBITDA) to come from the regulated utility side of the business.  This is a very stable, slow growth business.  The regulated utility will likely earn a 10% return on equity (set by regulators) and grow earnings at 5% a year through growing its “rate base” (i.e. property, plant, and equipment).

Absent any improvement in power prices, we would expect to earn a 6-12% annualized total return on our EXC investment.  Current market expectations for future power prices and the extent to which EXC “locks in” their future selling prices will determine where in the 6-12% range our returns fall.  If future power price expectations were to match today’s low levels, our return would be closer to 6%.  If EXC were to “lock in” their sales at today’s future price expectations (the market expects prices will be higher next year and the year after), we would earn closer to 12%.  Either way, this is a significantly better return than we expect from the S&P 500 from the current, 1400 level.  We would also expect the business to be less volatile than the overall US economy and the stock’s price level to be less volatile than the S&P 500.  EXC fits several of the “high-quality” business dynamics we described in our fourth quarter 2011 quarterly letter.  But that is not the end of the story.

Power prices are near multi-year lows primarily because natural gas prices are at multi-year lows.  Natural gas provides the majority of peak usage power in the US and thus determines domestic power prices.  When demand for power increases above a certain threshold, natural gas power plants come online and provide power.  Nuclear is one of the lowest cost sources of power and thus when power prices increase, EXC’s margins expand.

Natural gas prices are at multi-year lows because of the recent shale gas revolution.  In the mid to late 2000s, entrepreneurs and engineers discovered technology and techniques to extract significant quantities of gas from sources that were never accessible before (cost effectively).  This has led to a massive increase in natural gas supply as lessees were required to drill in order to hold leases (even if the drilling was not economical).

Commodity prices typically trade at their marginal cost of production.  Reasonable estimates of all in cash costs for natural gas are closer to $6/mmBTU than the current $2.50/mmBTU spot price.  We believe there are three primary drivers that will lead to higher natural gas prices over the next few years:

  1. As leases become established, uneconomical drilling will likely stop.
  2. When new Environmental Protection Agency (EPA) rules go into place in 2015, a large number of old coal-based power plants will become uneconomic and thus come offline.  This will increase demand for natural gas.
  3. When the economy begins to recover (albeit very slowly by our analysis), a rise in industrial production will also increase the demand for natural gas.

Increased power prices could easily lead to $5/share earnings for EXC and a stock price of $50-60/share.

Outlook:  long EXC.

The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this blog will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

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