Power generation and utilities holding company Exelon Corporation (NYSE: EXC) is no stranger to income investors. The stock pays out an above-average dividend yielding over 3.6%, which is supported by a strong and predictable operating cash flow year in and year out. And thanks to the nature of its business -- regulated utilities and an expansive portfolio of competitive power generation -- the dividend is relatively safe. In fact, shareholders have received a payout each quarter for several decades.
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But the dividend is not the company's chief concern. Despite a 27% gain in 2016 -- 32% with dividends included -- Exelon Corporation stock has struggled to return value to shareholders outside of its quarterly payout. The stock has lost 43% in the last decade, which improves to a loss of just 14% when dividends are included -- far below the returns of the S&P 500 in that period.
That means investors not persuaded by the dividend may not bother to consider buying Exelon Corporation. However, while a recent history of lackluster performance is indisputable, a closer look at management's long-term strategy and diversification initiatives provides a strong case for all investors to considering buying the stock.
Image source: Getty Images.
Reversing an ugly trend
One of the chief reasons for the stock's ho-hum performance in the last 10 years is simple: Growing revenue is not resulting in gains in net income.In 2006, each dollar of revenue resulted in $0.25 of net income, but that slipped to just $0.036 in 2016. The trend has resulted in the largest gap between revenue growth and net income growth in the company's history.
Regulations and competition have been significant factors in this trend, but investors have worried that the company wasn't doing enough to combat industry headwinds. That forced management to act, and full-year 2016 financial results and future guidance demonstrate important signs of progress against long-term goals. Two factors are expected to lead to improving operations.
First, Exelon Corporation will spend substantially less on utilities operations and generate significantly more revenue in the next four years. After a large push to improve reliability in recent years (which lowers long-term costs), total capital expenditures for utilities are expected to fall 8.6% from 2017 to 2020. Meanwhile, rate base growth is expected to result in a 29% increase in revenue during the period.
Management expects full-year 2017 EPS from utilities in the range of $1.40 to $1.70, which is easily above the $1.12 achieved last year. Current expectations call for GAAP EPS from utilities to steadily increase to $1.70 in 2018, $1.80 in 2019, and $1.90 in 2020 (using the midpoint for each yearly range). The exact numbers are almost guaranteed to change, but nonetheless demonstrate confidence that the business will change for the better.
Image source: Exelon Corporation.
Second, the generation business is expected to perform substantially better than previously thought. That's almost entirely due to the quickly changing fortunes of the company's nuclear fleet. Exelon Corporation tried in vain to convince the state of Illinois to include carbon-free nuclear operations in its Clean Energy Standard, which would have provided a small subsidy for atomic energy. After the company held firm on its plan to close two power plants in the state in 2017 and 2018, the Illinois State Legislature agreed to provide a Zero Emission Credit (ZEC) of $0.01 per kWh from nuclear generation.
There are strings attached to the ZEC, but when combined with a similar incentive in the state of New York, it provides quite a bit more breathing room. Exelon Corporation updated its guidance through 2019 to include an additional $2.8 billion in gross profit compared to earlier scenarios that factored in the closing of the two nuclear power plants.
It's important to note that even with the ZEC in Illinois and New York, the generation business will see its gross profit decline from 2017 to 2019 -- it will simply decline less than previously expected. That said, an earnings benefit will be derived from a planned decrease in capital expenditures. Management expects to spend $2.85 billion on generation this year, but just $1.85 billion in 2020.
A combination of decreasing capital expenditures, increasing reliability, and improved gross margin will lead to an expected $6.8 billion in free cash flow generation between this year and 2020.
Image source: Exelon Corporation.
Roughly half will be dedicated to debt reduction for generation and holding companies, which shouldn't be overlooked. Exelon Corporation spent $1.5 billion on interest expenses alone in 2016 -- a more than $500 million increase from the prior year. The other half of the $6.8 billion in free cash flow will be invested in growth opportunities and the continued improvement of utilities.
What does it mean for investors?
Successful execution of management's plan for healthier, more robust operations outlined above should provide plenty of reasons for Exelon Corporation stock to rise in the next several years. That certainly would be welcomed by shareholders that have struggled with dismal stock performance over the last decade. It also builds a strong case for any investor with a long-term mindset to consider buying shares.
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