Ask 100 investors why they own utilities stocks, and I'll bet the overwhelming majority will have the same answer: "For the dividend." It would not surprise me if there are scores of investors who would dump their utilities in a heartbeat if rates in the fixed income universe were higher. I even know a few such investors. With that said, should anyone be surprised that when Exelon (EXC) said the following during its Q3 2012 earnings conference call, the stock began a nosedive that took it down 22.91% from its November 1 high to its November 23 low?
Our #1 priority is to remain investment grade across all our registrants. Our investment grade rating is fundamental to the business, given our sizable collateral requirements, our counterparty and customer relationships and our significant nuclear capital expenditure.
In close proximity of importance, our next financial priority is returning value to the shareholders through our dividend. We understand the importance of the value of the dividend to our shareholders.
Our third priority is to invest in growth opportunities, smartly deploy growth capital to value -- to provide value to our shareholders.
In order to fulfill our top priorities and sustain certain investments, which benefit from the anticipated market recovery, we've adjusted our capital spend plans.
Exelon laid out its top three financial priorities, and then went on to say that it is scaling back on priority number three in order to ensure priority number one is not at risk. If cutting back on priority number three (capital spending) is not enough to protect priority number one (investment grade rating), then priority number two (the dividend) is next on the chopping block.
That rightly makes investors very nervous. After all, dividends are a big part of the value proposition of investing in utilities. It was bad enough that dividend growth did not seem to be on the horizon for Exelon. Add in even the threat of a dividend cut, and a large group of investors will look elsewhere.
Of course, playing Monday morning quarterback is a great way to get a perfect passer rating. But for Exelon investors who plan to stick with the company's stock, I think it is worth understanding that company executives often leave subtle clues in conference calls that some investors pick up and others do not. Exelon is no different.
On Exelon's Q4 2011 earnings conference call, the following was said:
We are keenly aware that to all of you, the dividend is an absolutely critical part of our value proposition. It's what makes it possible for you to hold on with us while we work our way through the gas and power price trough. Our cash flows and credit metrics support our dividend and capital programs even as we accept a higher payout ratio.
The quote demonstrates that Exelon understands the dividend's role as being critical to shareholders sticking with the company.
Fast forward to the Q2 2012 earnings conference call and the following was said:
I said at our Analyst Day, we have the right strategy, the right platform, the right set of assets and the right leadership to manage through the market downturn and deliver unparalleled upside when the markets recover. In the meantime, we remain committed to our investment grade balance sheet and our dividend.
Notice the reference to "investment grade" in the same sentence as the mention of the dividend. The words "investment grade" were not even mentioned once in the Q4 2011 call, let alone mentioned in close proximity to the dividend. I think that was a clue management provided. So what changed between January and August 2012 that might have led to the change in language? Moody's.
From what I can tell, equity investors do not spend enough time perusing the credit research provided by Moody's and S&P. On March 12, 2012, Moody's concluded its rating review that began on April 28, 2011, by downgrading Exelon's and Exelon Generation's debt. Additionally, Moody's added a negative rating outlook to the downgrade announcement. In the press release, the word "dividend" was mentioned eight times, including in the following quote from A. J. Sabatelle, Senior Vice President at Moody's: "Of particular concern to Moody's is the manner in which the expected negative free cash flow will be financed in light of Exelon's sizable common dividend and capital spending program."
Then, on June 11, 2012, Moody's again placed the ratings of Exelon and Exelon Generation under review for possible downgrade. In that press release, Sabatelle had the following to say: "Today's rating action follows our assessment and concerns with Exelon's financing plan outlined last week, which contemplates debt financing 100% of the expected negative free cash flow over the next few years caused by weakened operating cash flow, a sizeable dividend, and a substantial capital investment program." The word "dividend" was mentioned seven times in a relatively short press release.
I think it is a reasonable assumption that once the review got under way, threatening Exelon with its second downgrade of 2012, the company got the message. Another downgrade would have taken Exelon's senior unsecured debt to Baa3 (at best), just one notch above junk, and Exelon Generations' senior unsecured rating to Baa2 (at best). The good news for Exelon shareholders is that just days after the company announced the removal of $2.3 billion from its 2012 to 2015 capital spending plans, Moody's confirmed Exelon's and Exelon Generation's credit ratings. The bad news is that the rating outlook is still negative.
At this time, shareholders who are concerned about Exelon's dividend policy should do three things:
First, follow all press releases from Moody's and S&P regarding Exelon's credit rating. If any of the credit rating agencies put Exelon under review for downgrade, know that more capital spending cuts and/or a dividend cut are on the horizon.
Second, understand that a lack of concern among bondholders about a downgrade is not necessarily a good thing for shareholders. Currently, Exelon's and its subsidiaries' bonds are not indicating any type of serious concerns about a loss of investment grade ratings. But the confidence being expressed by the bond market does not necessarily reflect confidence that recent capital spending announcements are enough. Instead, it could be an indication that the bond market is completely confident in Exelon's willingness to cut the dividend by however much is necessary to maintain the investment grade rating.
Third, spend time figuring out where exactly Exelon's stock will go if a dividend cut looks likely to occur. I say "looks likely" rather than simply "occurs" because the market will attempt to price in ahead of time the prospect of a dividend cut. I think that the recent declines have done this to some extent, but not to the extent that many shareholders may think. If Moody's or S&P were to put Exelon under review for downgrade, I think the stock would eventually fall to $25 per share.
From a price-to-earnings ratio perspective, $25 per share (and maybe lower) would be easy to justify. A utilities stock in danger of cutting its dividend should no longer be compared with its peers in terms of traditional valuation metrics. As a result of the role that dividends play in the value proposition of utilities stocks, many investors will not care if the stock looks "cheap" from a P/E perspective. Instead, they will simply sell first and ask questions later. Additionally, when examining a long-term chart of Exelon, the $24 to $25 region seems like a place that the stock will at least initially find support based on historical support and resistance levels. The last reason I think $25 would be a near certainty for Exelon if the company were put under review for downgrade is that the possibility for a further downgrade would most likely guarantee additional speculation regarding a dividend cut.
Also of importance, should the broader market experience a big sell-off before Exelon were put under review for downgrade, the stock would likely experience downward pressure that would change the $25 price target for Exelon under a "review for downgrade" scenario. In that case, based on long-term support and resistance levels, I think the $20 to $22 region would be on the radar.
On the positive side, if Moody's were to raise Exelon's outlook (not credit rating, just outlook) without a need for any additional changes to capital spending or the dividend, the stock would, in my opinion, head right back to the $36 area. That was the area from which it began its nosedive on November 1, 2012. To get the stock back to the $40 to $45 region, I think you will need either a substantial rally in the broader market (a rising tide can lift all boats) or a combination of no dividend cut and a trough in Exelon's financial metrics.
I would be remiss if I didn't comment on how much Exelon might consider cutting the dividend should the need to do so arise. In the Q3 2012 earnings conference call, CEO Christopher Crane, when asked about how Exelon thinks about its payout ratio, mentioned a "more traditional payout strategy" of 65% to 70%. With a forward earnings estimate of around $2.55, a 65% payout would put the dividend at $1.6575. On the day prior to the Q3 2012 earnings conference call, Exelon's stock closed at $35.78. Based on the current $2.10 dividend, it was then yielding 5.87%. The market's expectations about Exelon's business prospects were such that a nearly 6% yield was demanded of the stock. If the dividend were cut to the $1.6575 mentioned above, the stock would need to trade at $28.24 to have a comparable yield. With the stock recently bottoming at $28.40, others might have picked up on this.
But I do not think Exelon would only cut the dividend to $1.6575 (a 65% payout based on current forward consensus earnings estimates). I think the cut would be deeper. Here's why:
First, Exelon would want to make sure it only had to cut the dividend once. A dividend cut is a big deal. You don't want to have to do multiple dividend cuts. Therefore, you need to cut in a way that makes it all but certain there will not be an additional cut. If the company wanted to keep the payout ratio around the 65% mentioned by Crane, it could also simultaneously lower guidance.
That leads me to the second point: There is no guarantee Exelon will meet its forward earnings estimates. I recognize the possibility that Exelon could beat expectations, but under a scenario in which a dividend cut were being announced, earnings would likely also be heading lower. All Exelon would need is to anticipate the possibility of earnings falling to $2.25 over the next couple of years for the dividend to be cut to $1.4625 (65% payout) and the stock to fall to $24.91 (5.87% yield).
Moreover, under a scenario in which earnings were falling more than the consensus estimates, the market would likely demand a higher yield from Exelon than it had prior to its Q3 2012 earnings report. At $1.4625, you would have a payout ratio of 57.35% based on a current forward earnings estimate of $2.55. A 57% payout seems reasonable given the desire to only cut the dividend once as well as the following:
The third reason I think the dividend cut, if it occurred, would be deeper than a 65% payout based on a current forward earnings estimate of $2.55 is that the company would want to leave room to grow the dividend in the future. With dividend growth investing being all the rage in today's day and age, Exelon would certainly want to make sure it sets itself up for future dividend increases.
And fourth, I think Exelon would want to send a clear message to the credit rating agencies that it is very serious about maintaining an investment grade rating. By cutting the dividend to levels below a 65% payout ratio (based on today's estimates), Exelon can help send that message.
It is for these reasons that I think the dividend would be cut by more than many investors would expect should the rating agencies (Moody's, in particular) put pressure on Exelon to do so. When the market knows there is bad news on the horizon, a company must act strategically to set itself up for future success. If Exelon is forced to cut its dividend, it would need to do so in a way that ensures the following: the dividend is cut only once; enough room is left for future dividend increases; the rating agencies are satisfied enough to move the ratings outlook to stable or positive; and future earnings estimates are also brought low enough that investors can be confident the company will beat expectations going forward. While in the short run that would likely cause tremendous additional pain for shareholders, in the long run, it would eventually put a solid floor under the stock price and set investors up for future success.
Disclosure: I am long Exelon's CUSIP 30161NAC5. I have no other positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.