Description

Constellation Energy Corp (“CEG”) is the largest clean energy company in the United States, producing over 10% of the country's carbon-free power. Its fleet is comprised of approximately 21,000 MWs of nuclear capacity spread across 13 locations. Exelon Corp (“EXC”) spun out CEG in early 2022 to separate its regulated utility cash flow stream from its highly volatile nuclear assets that are directly exposed to fluctuations in power pricing. Just like many spinoffs, Exelon shareholders ascribed an extremely low multiple to the nuclear business and believed the significant cash flow should be heavily discounted to account for the risk that the company could exhibit cash burn in a downcycle. 

CEG’s early days as a public company also coincided with the war in the Ukraine, leading to renewed interest in the nuclear market. While there has been a favorable change in sentiment towards nuclear, this is not the primary reason for the investment case. Rather, the resiliency of the cash flow stream has fundamentally changed in its short duration as a public company. Currently, CEG has a guaranteed trough earnings stream (~8.5% yield) and enormous unregulated upside to merchant power. How is this possible you ask? We have the Inflation Reduction Act (“IRA”), which was signed into law last summer, to thank.

To better understand how this bill came about, one needs to go back to the depths of COVID. The IRA was initially deemed to be a stimulus bill when job creation was at the forefront of the political agenda. With time, its name changed and became synonymous with Biden’s goals to 1) create jobs for working-class people in the US and 2) accelerate the green energy initiative. It is both ironic and impressive that this shared goal received support from two very different factions of the Democratic party (blue-collar factory workers and CA/NY green initiative liberals). When the bill finally made its way into law, the subsidies were vast and sizable with unique credits that benefitted a whole host of industries (solar, nuclear, electric vehicles, coal, nitrogen, hydrogen, etc.).

With respect to the nuclear component of the IRA, there was another factor at play. Politicians had witnessed the energy crisis in Europe and concluded that our nation cannot afford to compromise baseload power in the form of nuclear capacity. This logical and frankly appropriate assessment paved the way for language that dramatically extended the life of existing nuclear assets, guaranteed jobs in the industry, and ensured every producer had a floor price per MWh irrespective of the actual price of power. The floor price ensures that nuclear capacity will likely never close in this country and will remain a core staple of power generation for decades to come.

In a world where 10-year treasury yields are ~3.75%, you can buy a business that gives you an ~8.5% yield with PPI like inflators, an option on hydrogen production, all the upside of spot power pricing down the road with the kicker of a delayed ~$500mm of EBITDA step up in 2027 as well. That strikes me as the type of investment that deserves a place in the portfolio.    

The Mechanics:

The IRA bill has a basic calculation, whereby below $45/MWh they receive a subsidy that increases until it’s maxed out at $15/MWH. So basically, there is an effective floor holding FCF generation flat below $45/MWH but providing full upside potential with higher power prices. Additionally, this floor increases via inflation as noted below. Specifically, Nuclear Production Tax Credits (PTC) are calculated based on the price of the gross receipt vs. the baseline. The baseline price is $25/MWh, and the maximum subsidy CEG can receive is $15/MWh. The subsidy CEG receives is calculated as the max subsidy ($15/MWh) minus 80% of the difference between the gross receipt and baseline price. At a $35/MWh gross receipt price, the subsidy would be $15/MWh – (($35/MWh - $25/MWh) *80%) = $7/MWh. This would allow CEG’s subsidized price to be $42/MWh (see chart below) at a $35/MWh market price. The Nuclear PTC also grows with inflation, and CEG recently showed this impact in a slide deck where the PTC floor would increase to $57 by 2032 at a 3% inflation rate.

Source: Internal Estimates, Public Filngs

Source: Constellation Energy Public Filings

Cash Generation:

Source: Internal Estimates

Hydrogen Opportunity and Other Drivers:

CEG also has an additional opportunity in clean hydrogen due to the passing of the IRA. Under the IRA, there is a $3k/kg tax credit for clean hydrogen. CEG has not yet laid out concrete plans for this yet, but there are numerous ways they can benefit such as 1) hydrogen by wire 2) co-located electrolyzers to make hydrogen at CEG sites, and 3) power fuel cells with hydrogen and run hydrogen back through the fuel cell and produce energy to the grid when it is needed. For example, if you look at some estimates of the EBITDA lift from diverting just 5% of CEG’s nuclear capacity to hydrogen, it could result in an incremental ~$300m of EBITDA at $40MWh floor pricing. 

On the 4Q earnings call CEG announced their first commercial hydrogen production facility that will cost $900m over 3 years and produce 33,450 tons of hydrogen. They expect hydrogen production to begin in 2026 and are comfortable with a double-digit return threshold. 90% of the hydrogen produced will be sold through offtake agreements with customers co-located at the facility.

The company struck what was in hindsight a poor deal with the state of IL that caps realizations for the power ($34.50/MWh) at a level below the floor in the IRA. As a result, the company will see a large step up in EBITDA by approximately $500mm in 2027 when that deal expires. While we are many years out, it is something investors can adequately predict.  

Fair Value:

CEG is often thrown into the bucket of IPP producers, which does not make much sense to me. Its fees are guaranteed, and that base cash flow is being valued at a significant discount to regulated utilities. There are many ways to go about valuing the earnings stream, but if one believes a reasonable valuation is 12-13x EBITDA on floor EBITDA, you get approximately $115-125/share or some 40% upside. 

Other Key Things to Consider:

1. While no one is going to build in the US anytime soon, the stock trades at <50% of replacement cost.
2. M&A: There are very few companies that have the ability to get through the approval process to buy and manage a nuclear fleet. While this is not baked into sell-side models, any such deal is likely to be well received by investors. If you look at a recent note by Wells in January, the analyst suggests a hypothetical purchase of a 5 GW facility would be 15% accretive and increase value by 6-7%.
3. Capital Return:  The company currently has an anemic dividend and should generate several billion of cash over the next few years. The accretion from buying back stock with excess cash is quite significant and dramatically raises the sustainable base FCF if you believe they can reduce shares at these prices.
4. Recent Weakness: The stock was a strong performer last year following the announcement of the IRA bill, but has recently underperformed as natural gas pricing has declined. At the current valuation, investors are ascribing no upside from this earnings stream when there is a strong case to be made for higher power prices in time. Firstly, at current prices most public US natural gas producers cannot generate cash. This suggests spending will likely contract and in turn supply growth of natural gas. Further, the LNG market was temporarily impacted by one of the largest natural gas export terminals, Freeport LNG, going down last summer. When factoring in the return to service of this facility coupled with the significant LNG exports set to come online in 2024/2025, there is likely considerable long-term upside for natural gas. 

Disclosure: At the time of publication, the author of this article holds a position in CEG.  This article expresses the opinions of the author. The author has no business relationship with any company whose stock is mentioned in this article.

The author of this article has a long position in the company covered herein and stands to realize gains in the event that the price of the stock increases. Following publication, the author may transact in the securities of the company, and may be long, short or neutral at any time.  The author of this report has obtained all information contained herein from sources believed to be accurate and reliable.  The author of this report makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information or with regard to the results to be obtained from its use.  Any projections, forecasts and estimates contained in this report are necessarily speculative in nature and are based upon certain assumptions. Accordingly, any projections are only estimates and actual results will differ and may vary substantially from the projections presented. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this article or any of the information contained herein.  This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

Rerating on base earnings stream as IRA bill goes into effect.