Exelon: Rate-Base Scale, Cost Management Drive Upside Potential (NASDAQ:EXC)

Exelon Corporation (NASDAQ:EXC) is a Chicago, Illinois-based electric utility – the largest in the United States – with nearly 11 million customers and six regulated utility subsidiaries. The firm primarily maintains a presence in Illinois and the US East Coast.

Through these activities, Exelon has recorded FY23 revenues of $21.73bn – an increase of 13.89% YoY – alongside a net income of $2.33bn – a 7.28% increase – and a free cash flow of -$2.71bn – an 18.80% decline largely driven by cash outflows in investing activities.

Introduction

While Exelon remains the largest regulated electric utility in the United States, the underlying dynamics that drive its success remain the same; the utility has committed itself to a fourfold strategy to enable long-term sustainable value. These four include the maintenance of Exelon’s peerless transmission and distribution network, supporting the continuance of its rate base, alongside the pursuit of operational excellence, ensuring maximal cost-recovery and consumer satisfaction through reliability, embedding sustainability in Exelon’s organization by remaining a T&D pure play with more operational flexibility and more ESG inclusionary attitudes, and ultimately undergirding all of this with financial discipline, maintaining a risk-averse balance sheet and striving for organic growth over costlier or riskier M&A activities.

Through this, Exelon seeks to engage with a stronger growth outlook, meeting its projected EPS CAGR of 5-7% through to FY2027 and thereby ensuring greater shareholder returns, committing to a ~60% dividend payout ratio growing in congruence with EPS.

Due to the company’s unique market positioning, moderate undervaluation, and disciplined capital deployment, I rate Exelon a ‘buy’.

Valuation & Financials

Trailing Year Performance

In the TTM period, Exelon’s stock – down 9.77% – has underperformed relative to both the utility industry, as represented by the Utilities Select Sector SPDR Fund (XLU) – down 3.56% – and the broader market, as represented by the S&P 500 (SPY) – up 30.85% in the same period.

While the utility industry as a whole underperformed the broader market owing primarily to higher interest rates – which made the capital-intensive investment in utility operations more difficult and lowered the risk-adjusted attractiveness of dividend stocks – Exelon was devalued more than the rest of the industry.

Due to the smaller magnitude of this deviation, I believe Exelon’s underperformance of the utility industry, while materially affected by the higher input costs of operating in higher cost regions, can be narrowed down to ‘noise’ in the market, though Exelon would be disproportionately affected by reduced transmission volumes of electricity.

Comparable Companies

The utility industry, by its very nature, remains highly geographically distributed – as such, any given utility faces minimal direct competition. The latter idea remains true for Exelon as well. As such, I sought to compare Exelon to other large regulated utilities across the US, which face similar price and sales dynamics to the company. This group includes the Oakland, California-based natural gas and electricity company, Pacific Gas & Electric Company (PCG); the Columbus, Ohio-based electric utility that operates across the Eastern Interconnection, American Electric Power Company (AEP); the Minneapolis, Minnesota-based multiutility, Xcel Energy (XEL); and the Rosemead, California-based Southern California-servicer, Edison International (EIX).

As demonstrated above, Exelon’s trailing year price action is largely in line with the peer average, demonstrating the generally poor performance of larger-scale utilities over the past year. Despite this similarity, I believe Exelon is in a better position than its peers given its multiples-based value and growth capabilities.

On a multiples basis, Exelon is generally valued similarly or lower to its peers, with a forward and trailing P/E of ~15, the second-lowest P/S, the second-lowest P/CF, but the lowest P/B demonstrating greater balance sheet resilience and financial discipline than peers.

In terms of growth, Exelon maintains the third-lowest PEG ratio along with middle-of-the-pack ROE and ROA, but the second-lowest debt/equity ratio of the group, further demonstrating the company’s commitment to financial resilience.

Exelon additionally maintains a 3.96% dividend, maintaining its targeted payout ratio of ~60%.

Valuation

According to my discounted cash flow valuation, at its base case, the net present value of Exelon should be $38.93, up from a current market price of $37.14, representing a 5% undervaluation.

My model, calculated over 5 years without perpetual growth built-in, assumes a discount rate of 9%, accounting for Exelon’s debt-heavy cap structure whilst incorporating a lower equity risk premium and the firm’s financial discipline. Moreover, I estimate a conservative 5% revenue growth rate for the 5Y going forward, assuming a lower propensity for black swan events to affect underlying earnings.

Additionally, I projected the maintenance of extant margin levels – estimating an average operating margin of 22% and projected capex using Exelon’s professed capital investment plan.

Exelon is Investing in the Continuation of Scalability & Margin Expansion

A component overarching many major regulated utilities’ strategies has been the confluence between its investments and the investments of public funds – Exelon is no different in this regard. The firm is investing heavily in grid modernization and resilience across the board, aiming to comply with federal and state regulators, reduce opex, and ensure reliability for consumers. As of recent, an example of this drive for alignment with government priorities is through Grid Resilience and Innovation Partnerships, which have already supported $150mn in federal funding.

Exelon’s general capex strategy is well-positioned to take advantage of government interest in the area, with a $34.5bn capital investment plan focused on enhancing extant transmission and distribution infrastructure while attracting public and private investment for green and renewables investment. Through this, Exelon seeks to expand their rate base to ~$73.9bn, representing a 7.5% CAGR over the next 4 years.

Alongside this scalability, Exelon is aiming to support general margin expansion, by ensuring efficacious cost management below the rate of inflation. For instance, Exelon’s standardization of structure and operations affords customers affordable prices while giving the firm more pricing flexibility, thus margin flexibility.

Wall Street Consensus

Analysts generally support my positive view on the stock, estimating an average 1Y price target of $38.41, an increase of 5.05%.

Even at the minimum projected price of $36.00, analysts predict investors will remain positive on the stock net of dividends.

I believe analysts see the market as overly hesitant about the stock and its industry and believe Exelon to be a highly resilient income asset in line with my own beliefs.

Risks & Challenges

Higher Rates May Reduce Growth Potential and Attractiveness

Although rates are projected to either remain stagnant or be reduced in the coming few years, the era of cheap capital of the past decade is unlikely to return for a while. As such, with bonds and other fixed-income securities offering stable, lower-risk income returns going forward, the risk-adjusted attractiveness of companies like Exelon is diminished; this dynamic may then be reflected in greater stagnation for Exelon’s stock price. Beyond that, with the debt volumes Exelon maintains and its ambitious capital plans, the firm faces higher costs from debt-based financing going forward.

Regulatory and Compliance Volatility May Inhibit Strategy

Exelon has positioned itself to adjust for the ongoing and future electrification and green-ification of the economy and electricity sector; these strategies have also enabled Exelon to benefit from ESG inclusionary indices and ETFs, lowering equity costs. However, Exelon faces multisided risk in that many public bodies are shunning ESG while others are accelerating climate goals, making balance between different policy orientations precarious at best for Exelon.

Conclusion

Looking forward, Exelon is a strong, stable income stock with built-in potential for scale and margin growth driven by its own capital investment strategy and macro trends.