Buy Exelon and Get Constellation Energy for Free

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Shares of nuclear power plant operator Exelon (NYSE: EXC) look cheap after fears of an upcoming dividend cut sent the price tumbling. The stock traded near $36 as October came to a close, but it now sits below $30. Although the company faces near-term headwinds, the stock appears undervalued given its strong competitive position in nuclear power and its recent acquisition of the second-largest retail power base.

Exelon's power generation fleet consists mainly of nuclear- and gas-fired plants in the U.S. and Canada. It is perhaps the lowest-cost provider of electricity in the U.S., which puts it in the best position to take advantage of rising rates in deregulated markets. The nuclear plants come with a bit of a moat; it takes at least seven years and billions of dollars to build one after clearing all regulatory hurdles. Exelon's nuclear assets are unmatched by any other U.S. company, which gives it one of the cleanest fleets in the country. In addition, the company is adding solar and wind projects that will expand its renewable energy capacity by more than 600 megawatts in Q4 2012. As a result, the company will likely benefit from stricter EPA regulations that will further discourage competition.

Despite the favorable long-term outlook, the stock dropped substantially in reaction to a likely dividend cut due to lower-than-expected power prices in 2012. Management has said that maintaining its investment-grade credit rating is priority number one, so, barring a near-term surge in prices, the dividend will likely be cut in Q1 2013.

Comparables

Exelon currently sports a 7% dividend yield, compared to 3.5% for NextEra Energy (NYSE: NEE), 5.2% for Entergy Corp (NYSE: ETR), and 4.7% for Public Service Enterprise Group (NYSE: PEG). Assuming Exelon cuts its dividend in half (which is the worst-case scenario), its yield will drop to 3.5%, which would put it near the bottom of the group. However, Exelon deserves to trade at a premium relative to its competitors. Entergy is currently involved in a dispute with the Nuclear Regulatory Commission regarding a license extension and proposed cooling towers for its nuclear plants. Public Service Enterprise Group is concentrated in New Jersey; in addition to the impact of hurricane Sandy, the overall decline in wholesale prices has hurt the business worse than most. But PEG's stock has not yet priced in these headwinds. NextEra is well-positioned for most future scenarios and is the best trading comp for Exelon.

Constellation Energy

The most exciting aspect of Exelon is its recent acquisition of Constellation Energy. Exelon paid $7.9 billion for what was at the time the largest retail power base in the U.S. Constellation's retail base provides a counter-cyclical hedge against wholesale prices and may also provide synergies by using Exelon's power generation to serve retail customers. The following valuation demonstrates that investors who buy today are getting this acquisition for free.

Valuation

Exelon's pre-Constellation business has demonstrated a remarkably stable pre-tax return on tangible invested assets throughout the business cycle. It averages close to 7% and has been as high as 10% recently. Assuming a 6.93% pre-tax return on tangible invested assets, the company should produce $3.56 billion in pre-tax income on average throughout a business cycle. This may be a bit conservative; the company hasn't produced a lower pre-tax number since 2006. Applying a 7x multiple to this figure gives a value per share of $29.18. The stock recently traded at $29.33.

Constellation has had volatile earnings since 2008, but a cycle-average $1.2 billion in pre-tax earnings is a safe bet given the upside from synergies with Exelon's low-cost power generation capabilities. Applying a 7 multiple to this figure gives a value of $8.6 billion, or $10.12 per share. The combined entity is thus worth at least $39.30 with substantial upside in the case of an improving wholesale market.

Conclusion

Exelon earns huge margins on its nuclear power plants and is positioned to take advantage of a rebound in electricity prices. However, its retail business will hold profits up during a downturn in prices, offering the counter-cyclical force that management had been seeking for nearly a decade. The stock is down due to selling by dividend investors, so it's worth a look for long-term investors looking for an entry into the sector.


titans8904 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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