Exelon Corporation (NASDAQ:EXC) is expected to deliver significant free cash flow in the next three years. Management is undertaking a significant number of corporate transactions, which are expected to push the company’s EBITDA margins up in the future. If we also add that capital expenditures are expected to increase, and emissions are decreasing, in my view, demand for the stock will likely increase. In any case, under my DCF model, future free cash flow would justify a higher price mark.
Exelon is a utility services holding focused on the generation, delivery, and marketing of energy.
Exelon is currently undertaking a significant number of corporate transactions that are expected to enlarge the company’s EBITDA margin, and diversify its business model. With this in mind, it is a great moment to have a look at the business.
On February 21, 2021, Exelon’s Board of Directors approved a plan to separate the Utility Registrants and Generation, creating two publicly traded companies. Exelon completed the separation on February 1, 2022. Constellation was newly formed and incorporated in Pennsylvania on June 15, 2021 for the purpose of separation and holds Generation. The separation represented a strategic shift that would have a major effect on Exelon’s operations and financial results. Source: 10-Q
According to a recent presentation to investors, Exelon’s distribution of energy appears quite diversified. 65% of the business is related to electric distribution, 12% comes from gas delivery, and electric transmission accounts for 21%. In my view, the larger the number of transmission and distribution types, the less volatile will Exelon’s EBITDA margin be.
In my view, we will likely see an increase in the investment interest for Exelon as more market participants notice how the utility industry is evolving:
On November 15, 2021, President Biden signed the $1.2 trillion Infrastructure Investment and Jobs Act (IIJA) into law. IIJA provides for approximately $550 billion in new federal spending. Categories of funding include funding for a variety of infrastructure needs. The Registrants are analyzing the legislation and considering possible opportunities to apply for funding, either directly or in potential collaborations with state and/or local agencies and key stakeholders. Source: 10-Q
The company also announced a rate base growth of 8.1%, as consumer needs and industry trends continue to contribute to investment growth.
In my opinion, the most important is that management is increasing its capital expenditures, which indicates that there is significant optimism inside the organization:
Exelon’s Financial Estimates Are Beneficial After The Separation
Analysts are expecting decent growth after 2022. Analysts believe that sales growth will likely decrease in 2022 as Exelon executed the separation from Constellation (CEG). However, once that transaction is done, sales will likely increase between 4.8% and 3.6%. The EBITDA margin will likely also increase from 23% in 2022 to 42% in 2024. Finally, estimates also include positive free cash flow exceeding $1.4 billion from 2022 as well as growing net income. With these figures, most investors would accept noting that the separation will likely benefit Exelon’s financial figures.
In my view, the changes in the EBITDA margin and operating margin may fluctuate quite a bit in the future as they did in the past. I invite investors to have a look at the previous table with financial stats about Exelon. I believe that in the worst-case scenario, Exelon could report figures close to -4% sales growth and an EBITDA margin of 25%. These are figures that are not that unlike.
If The Company Grows Like The Global Utilities Market, The Implied Valuation Will Likely Be Equal To $52
If Exelon successfully improves reliability and operations, and customers obtain better experience, sales growth will likely grow as the market does. Let’s keep in mind that in the last annual report, management promised to invest in electric system improvement projects, which will most likely help Exelon remain an innovative peer:
The utility registrants anticipate making significant future investments in smart grid technology, transmission projects, gas infrastructure, and electric system improvement projects, providing greater reliability, improved service for our customers, increased capacity to accommodate new technologies, and a stable return for the company.
The Utility Registrants anticipate investing approximately $29 billion over the next four years in electric and natural gas infrastructure improvements and modernization projects. Source: 10-k
I am also quite optimistic about the fact that Exelon expects to reduce its operations-driven emissions by 50% by 2030. In my view, with many fund managers currently looking for utilities exhibiting low emissions, the demand for the stock could increase significantly in the next decade. Besides, if governments commence to increase taxes related to emissions, or incentivize net zero emissions utilities, Exelon will likely benefit:
In August 2021, the Utility Registrants announced a “path to clean” goal to collectively reduce their operations-driven emissions 50% by 2030 against a 2015 baseline, and to reach net zero operations-driven emissions by 2050. This goal builds upon Exelon’s long-standing commitment to reducing our GHG emissions. Source: 10-k
With the global utilities market growing at close to 7.2% from 2021 to 2030, Exelon may experience similar growth in the coming decade. Taking into consideration this information, I assumed sales growth of 6.1%:
The global utilities market is expected to grow from $4230.3 billion in 2020 to $4534.38 billion in 2021 at a compound annual growth rate of 7.2%. Source: Global Utilities Market Report (2021 to 2030)
I also assumed an EBITDA margin of 32%, which is significantly lower than what analysts are expecting for the years 2022, 2023, and 2024. Also, with a conservative effective tax of 17%, changes in working capital, and growing capital expenditures, my results included 2032 free cash flow of $2.7 billion:
Now, if we assume a weighted average cost of capital of 4.8%,and a terminal EV/EBITDA of 12.3x, which is the median for the sector, the implied equity should be $51 billion. Finally, the implied fair price could be $52:
Best Case Scenario Includes Investments In Renewable Energy And A Valuation Of $105
Under my view, if Exelon continues to adopt the requirements from states in which the company operates, the company will not pay fines. Note that the company remarked mandates for procurement of renewable or clean electricity. In the best-case scenario, Exelon may receive credits from governments to invest in alternative energy resources, and sales growth could trend north:
The Utility Registrants comply with these various requirements through purchasing qualifying renewables, implementing efficiency programs, acquiring sufficient credits, paying an alternative compliance payment, and/or a combination of these compliance alternatives. The Utility Registrants are permitted to recover from retail customers the costs of complying with their state RPS requirements, including the procurement of RECs or other alternative energy resources. Source: 10-k
Besides, under this case scenario, Exelon will continue to sell assets that are not aligned to the best interest of the company. In this case, I assume that Exelon will obtain a decent amount of cash to invest in other projects that management finds more profitable. As a result, I would expect an eventual increase in the EBITDA margin; up to 40%. In this regard, let’s mention that Exelon sold a significant number of business models in the last five years:
On April 28, 2021, Generation and ReGenerate entered into a purchase agreement, under which ReGenerate agreed to purchase Generation’s interest in the Albany Green Energy biomass facility.
On July 31, 2018, Generation entered into an agreement with Holtec and its indirect wholly owned subsidiary, OCEP, for the sale and decommissioning of Oyster Creek located in Forked River, New Jersey. Source: 10-k
In the best-case scenario, I assumed sales growth of 7.5% from 2024 to 2032, an EBITDA margin of almost 40%, and operating margin of 23%. The result includes 2032 free cash flow of $5.5 billion, and 2032 EBITDA of $13.7 billion:
Under this case scenario, I would expect investors to buy more shares. The demand for the equity will likely increase. As a result, the cost of equity and cost of debt will likely decline. We can also use a larger EV/EBITDA multiple because Exelon’s EBITDA margin increased. In sum, with an exit multiple of 13.5x, the implied price would be close to $105:
Worst-Case Scenario Would Include Commodity Risks And Hedging Failure, And Would Imply A Valuation Of $30
Even taking into account that Exelon executes hedging operations, traders may fail to eliminate all the commodity risks. Besides, hedging traders may also have to pay premiums, which could become very expensive under certain circumstances. As a result, I expect a decline in the company’s EBITDA margin:
Generation uses a variety of derivative and non-derivative instruments to manage the commodity price risk of its electric generation facilities, including power and gas sales, fuel and power purchases, natural gas transportation and pipeline capacity agreements, and other energy-related products marketed and purchased. To manage these risks, Generation may enter into fixed-price derivative or non-derivative contracts to hedge the variability in future cash flows from expected sales of power and gas and purchases of power and fuel. Source: 10-k
Exelon reports a significant amount of goodwill from previous acquisitions. If accountants believe that Exelon may not obtain expected synergies from the M&A operations, goodwill may be impaired. As a result, free cash flow expectations will likely decline. If journalists or equity researchers notice this, the company’s stock price will likely decline:
Long-lived assets represent the single largest asset class on the Registrants’ statements of financial position. In addition, Exelon, ComEd, and PHI have material goodwill balances. The Registrants evaluate the recoverability of the carrying value of long-lived assets to be held and used whenever events or circumstances indicating a potential impairment exist. Factors such as, but not limited to, the business climate, including current and future energy and market conditions, environmental regulation, and the condition of assets are considered. Source: 10-k
Under the previous assumptions, I used sales growth close to -4% from 2023 to 2027, EBITDA margin of 33%, and operating margin of 23%. Also, with conservative changes in working capital and growing capital expenditures, 2032 free cash flow will likely be close to $2.07 billion.
With a weighted average cost of capital of 5% and an exit multiple of 12.5x, the implied equity valuation will likely stay close to $29.5 billion. The implied stock price would be $30:
Healthy Balance Sheet
With $92 billion in assets and liabilities worth $98 billion, Exelon’s balance sheet looks quite healthy. Note also that Exelon reports $2.4 billion in cash, so I wouldn’t expect a liquidity risk any time soon.
I would expect changes in Exelon’s balance sheet once the company operates independently after separation from Constellation. With that, I believe that it is worth mentioning that Exelon does not have any interest in Constellation. The valuation of the Exelon will not increase if Constellation’s stock price increases:
On February 1, 2022, Exelon completed the separation through a pro-rata distribution of all of the outstanding shares of our common stock, no par value, for every three shares of Exelon common stock held on January 20, 2022, the record date of the distribution. We are now an independent, publicly traded company listed on the NASDAQ exchange under the symbol “CEG”, and regular-way trading began on February 2, 2022. Exelon no longer retains any ownership interest in CEG Parent or Constellation. Source: Constellation’s 10-k
With regards to the liabilities, Exelon reports long-term debt worth $35 billion, which is a significant amount. With that, in my view, if management continues to report beneficial deals, and free cash flow trends north, the company will likely pay its debt:
Exelon Corporation does not only expect to deliver significant FCF in the next three years. In my view, the company reported a significant number of transactions, which may push the company’s EBITDA margins up. I also assumed that the company will likely obtain new cash to invest in more profitable projects. In sum, I believe that there is significant upside potential in the stock price.