In light of the recent market volatility and the ongoing inflation/rate hike/recession fears which led to a decline in the S&P by just over 10% for the month of April, market exposure to defensive sectors have been increasingly generating interest. With long term supply agreements and forward contracted PPAs generating stable cash-flows in largely regulated markets, one can’t get much more defensive than the utilities sector. That said, we hardly view the sector as reserved only as a place to hide in times of volatility and market corrections. Over the past few years, we have viewed the utilities sector as increasingly relevant given the emergence of ESG investing and more recently, given the emerging theme of energy independence. Though the US utilities sector is dominated by large behemoths with bundled exposure to power generation (largely thermal) and transmission, market forces and legislation from both the State and Federal levels have only recently provided a framework mandating 100% clean electricity generation by 2035 (a date as proposed by the Biden Administration). As of the end of 2021, 23 states have thus far enacted some form of 100% clean energy target with many other states still weighing their options. As such, since 2020 many of the utilities themselves have made announcements to phase out and de-carbonize their fleets, all in order to become compliant with the new regulatory environment and given the legislative mandates.
In a second pronged approach to playing the nuclear investment theme (the first prong being investments directly into the limited number of uranium producers and/or developers as outlined earlier on April 4th), we now also highlight our preferred US utility name – Constellation Energy Group (CEG), a company still underappreciated by the market (see the discounted multiples versus peers below) but with much re-rating potential as the story gets told and meets investor appetite for the changing times.
Constellation Energy ticks just about every check mark we look for in terms of ESG compliance, a dominant, low carbon generating profile and recurring cashflows given LT forward contracts extending to 2026 for fuel, coupled with LT PPAs. Having split from Exelon Corporation, CEG has already gained +55.8% since initial listing on the NASDAQ on January 19, 2022. Some of the specifics which make Constellation a focused and timely investment for the new-age ESG/energy independence landscape include the following:
CEG is the largest producer of zero emission (zero carbon) electricity in the U.S. As of 2021, 89% of electricity produced came from carbon free sources, including some smaller amounts from wind generation and solar. That said, CEG is by far the largest nuclear power operator in the U.S. Out of the 93 existing nuclear power plants, CEG operates 21 of those units (Duke Energy is in second place with 10 units). In MW capacity terms, 73% of Constellation’s fleet mix consists of carbon-free nuclear and renewables. To put things further into context, the company is responsible for producing approximately 10% of all carbon-free electricity in the country. Annually, the company supplies 215 TWh electricity and 1.6 Tcf natural gas to nearly 2.0M customers spread across 48 states. Dominance in the nuclear space cannot be underestimated here - not only does electricity produced by nuclear fission have a dramatically lower carbon output relative to any other source (15x higher with natural gas and approximately 30x higher with coal, on a gCO2/kWh basis), but note as well that nuclear has much higher capacity utilization rates (around 90%) than thermal gas plants (50-75%) or renewable plants (20%-40%) with additionally much less time in a given year lost to maintenance shutdowns. Lets also remember that nuclear power plants generate baseload capacity power. This makes all the difference as renewables cannot. Longer term, corporate plans are to become 95% carbon free by 2030, and fully carbon free by 2040.
Given the combination of secured LT fuel contracts (uranium purchased well in advance at term contracts) and LT PPAs signed, guidance for FY/2022 is for adjusted EBITDA between $2.35B-$2.75B along with FCF of between $1.85B-$2.20B at the run rate prices. This gives the company ample room to either re-distribute earnings (management has targeted a 10% annual dividend growth rate) or act as a consolidator, further adding to its nuclear generating inventory.
Other upside catalysts include the Section 45 Federal production credit (as introduced in last year’s Build Back Better Act) which would provide a $15/MWh credit for operating nuclear power plants. This is the incentive for nuclear power generation as part of President Biden’s larger clean energy target by 2035. Whether the production credit passes or not, it is on the table for later this year and does seem to have bi-partisan support. This further solidifies the fact that nuclear will need to play an even greater role if only to achieve the 2035 carbon-free goals. Any plans for carbon reduction will be greatly hampered without a incentivizing nuclear power production, this much is clear. Longer term, Constellation also began a pilot project to demonstrate the viability of clean hydrogen production. Given the advances in fuel cell technology (now ideally suited for stationary power production) and given that hydrogen is seen as a future replacement for natural gas in many industrial processes, cheap, baseload nuclear power can possibly become the most efficient way to generate (in a carbon free fashion) the needed hydrogen.
We see Constellation Energy Group as a still underappreciated company which is only now starting to make the rounds for investor presentations seeing as they only began trading less than 4 months ago. Drawing on themes of energy independence, ESG and the transition to a low carbon future, we think that CEG can be the flagbearer in all of these domains. We expect a re-rating higher as the story becomes better known.