As the largest nuclear power plant owner in the United States, Exelon (EXC) long has been a profit machine and an industry-leading source of shareholder value creation. But power prices have crashed hard since their 2008 highs and appear stuck at current levels for at least the next two years. That has resulted in a sharp drop in Exelon's returns, a 41% cut in the dividend in 2013, and a shift in strategy that has increased earnings contributions from the countercyclical retail supply and regulated distribution businesses.
Even with increased earnings diversification following the 2012 acquisition of Constellation, Exelon can't escape its overwhelming leverage to Eastern and Midwestern U.S. power prices, which drive almost half of earnings and are tightly correlated to natural gas prices. The low operating costs and clean emission profile of its nuclear fleet make Exelon the utilities sector's biggest winner if our outlook for higher power prices and tighter fossil fuel environmental regulations materializes. Exelon's world-class operating efficiency ensures it will be able to capture that upside.
As the nation's largest wholesale generator and retail supplier, Exelon's profit machine relies on Eastern U.S. power markets remaining deregulated. In the decade following deregulation, Exelon struggled with rate caps and other profit-limiting regulation. Those are gone, but we expect politicians and regulators will continue to monitor customers' electricity bills and could intervene if power prices skyrocket. Fast-falling power prices have encouraged states to deregulate and let customers benefit from those low market prices.
We estimate Exelon's regulated distribution utilities will contribute almost half of consolidated earnings by 2015, up from just 20% during the commodity peak in 2008, as the utilities take advantage of improving regulation. After years of woeful performance, ComEd is set to benefit from Illinois state legislation passed in late 2011 that implements formula rates that adjust annually to support as much as $2.6 billion of capital investment between 2012 and 2022.
Exelon's One of Two Utilities With a Wide Moat
Considering Exelon's full suite of businesses, we think its position as the leading nuclear power producer in the U.S. makes it one of only two utilities with a wide economic moat.
All nuclear operators have two primary competitive advantages. First, nuclear plants take more than seven years to site and build, cost several billion dollars, and typically face community opposition. These are significant barriers to entry, giving operators an effective low-cost monopoly in a given region. In addition, Exelon's large fleet gives it scale advantages that allow it to add capacity at its plants at a fraction of the cost and risk of a greenfield project, generating even higher returns on capital. It is unlikely a competitor would be able to earn sufficient returns on capital by building a nuclear plant in close proximity to any of Exelon's plants.
Second, no other reliable power generation source can match the cost or scale of a nuclear plant. Nuclear plants' low variable costs and low greenhouse gas emissions relative to competing fossil fuel power generation sources like coal and natural gas reduce substitution threats. As long as electricity remains a critical energy source in the U.S., we expect nuclear plants will maintain a substantial low-cost advantage and generate high returns on capital. To monetize this competitive advantage, Exelon must continue to have access to wholesale power markets. Any reregulation of its generation fleet would shrink its moat.
We believe Exelon's regulated distribution utilities deserve narrow moats. Regulatory caps on profits offset the service territory monopolies and network efficient scale advantages. Utility regulation in the U.S. aims to fix customer rates at levels that ensure capital providers earn fair returns on their investments while keeping customer costs as low as possible. We believe this regulatory compact ensures Exelon's utilities will earn at least their costs of capital in the long run.
We believe Exelon's retail supply business has no economic moat. Retail power and gas markets are highly competitive with virtually no barriers to entry, switching costs or product differentiation. Although customers are sticky, retailers mostly end up competing on price.
Political Developments Are Key
Investors should pay the most attention to political developments that would reregulate competitive electricity markets in the Midwest and Mid-Atlantic. Even though sharp increases in power prices would result in an earnings windfall for Exelon, it could lead politicians and regulators to pursue price caps as they did when markets first deregulated. Although we think this is unlikely in the current environment, it could have a substantial negative impact on our fair value estimate. If market power prices are capped or regulated, Exelon loses its primary profit source.
Reregulation also would destroy Exelon's retail business. Although that business is still a relatively small source of consolidated earnings, it would eliminate Exelon's effective hedge against its generation fleet, potentially leading to more volatile earnings.
As Exelon's regulated utilities generate a greater share of earnings, investors will be subject more acutely to the state and federal regulatory risk that all distribution and transmission utilities face. Illinois and Maryland are two historically tough regulatory environments, and punitive rate decisions could have a material impact on earnings and growth.