Exelon Corp's (EXC) share price took a hit of almost 20% due to the uncertainty surrounding its dividend payment which has created an overhang on the shares. The current pressure on the shares will be eased once the management makes an announcement on the fate of dividends. Also, the stock is trading at a discount to its peers with a forward P/E of 11.5x and EV/EBITDA of 6.3x. I believe the share price has bottomed on dividend concerns and will increase from here onwards.
Exelon Corp is an electric and gas utility and owns the largest unregulated nuclear fleet in the U.S. The company has a strong regulated business and its retail business is growing. On 12th March, EXC completed its merger with Constellation Energy.
Currently the company is surrounded by the uncertainty regarding maintaining its current dividend. I believe a dividend cut is possible since EXC is committed to strengthening its balance sheet and thereby maintain an investment grade credit rating. EXC has a debt to equity ratio of 90% and strong interest coverage of 6x. The company is targeting a FFO-to-debt ratio to be in the range of 25% - 27% in order to maintain an investment grade credit rating, in accordance with S&P's integrated merchant utility investment grade guidance.
The market is anticipating a dividend cut which, as stated earlier, has brought the stock down by almost 20% since its 3Q earnings release. At current market price the stock offers a dividend yield of 7.1%. Management of the company has stated that it might cut its dividend if power prices do not improve in the coming six months and also indicated that a decision on the dividend cut will be made in first half of 2013. Given the pressure the uncertainty has created on the shares, I believe the management will come out with a decision by March 2013 to restore investor confidence.
EXC does not hold many options to maintain its current investment grade credit rating; either the company has to issue new equity or cut its dividend (also note that the management has already lowered its CAPEX for coming years). Given the current low share price, equity issuance will not be a desirable option and a dividend cut seems to be highly likely. Also, the current high payout ratio makes the dividend cut a viable option. Present circumstances reflect dividend reduction in the range of 35% - 45%. Revised dividend yield is likely to be in range of 4.1% - 4.3%, resulting in a more sustainable payout ratio of 50% - 60%.
If the company cuts the dividend by 35% - 45%, annual cash flow savings of $700 - $900 million are expected which will be used for debt reduction. From 2013 to 2015, $4.2 billion of debt is expected to mature.
90% of EXC's generation is hedged for 2013 but the percentage will fall to 59% in 2014 and to 22% by 2015. Given reduced hedging for 2013 and 2014, if power prices increase in the future, EXC stands to benefit from the resulting gross margin expansion.
EXC at current valuations seems to be trading at discount to its peers. EXC currently has EV/EBITDA of 6.3x and forward P/E of 11.5x against its peers' averages of 8x and 14.5x respectively.
EXC has a significant regulated business exposure that is why it is subject to federal and regulatory agencies laws, which can have significant impact on the company's financial performance.
I am bullish on the stock as recent price drop makes a good entry point for the investors. Dividend cut is highly likely and I believe all the factors are priced in.