Let me first state the position I'm coming from in writing this article: I don't own any Exelon (NYSE:EXC) stock, and I don't intend to in the future. Nevertheless, as someone interested in both income and conservative investing, I have found the stock's story over the past five or so years to be quite interesting because it has run contrary to what most investors would expect from a "conservative" utility holding. The typical expectation for an American utility is supposed to be something along these lines: you get a stable stock price, a 3-5% dividend yield, and predictable earnings and dividend growth that is supposed to be a little bit higher than inflation.
Unfortunately, as long-term shareholders of Exelon know all too well, the company hasn't stuck to the script. After the stock price hit a high of $92 in 2008, it has been nothing but bad news since then as prices have taken a dive to below the $30 mark five years later. The earnings per share have fallen from a high of $4.29 in 2009 to an estimated $2 per share by the end of 2012. With utilities, you're not supposed to see the stock price fall to a third of what it once was as the earnings have collapsed to half their previous highs. Utilities worth tens of billions of dollars just aren't supposed to do that.
And, of course, there's the dividend. Although this company has by no means been a dividend growth stock, it did assemble a decent track record of annual dividend growth in the 2000s until freezing the dividend at $2.10 per share annually from 2009-2010 (where the dividend has remained ever since then). And with management publicly contemplating a dividend cut, investors are about to lose the only solace provided by this company over the past five years. The easiest thing to do would be to take the loss, deploy the funds elsewhere, and move on from this nightmare performance. But the answer may not be that simple because of this: the news of the upcoming dividend cut may have very well caused this stock to become undervalued, so that investors who typically aim to follow the "buy low, sell high" mantra might be violating that logic by selling low.
After all, there are several things that may portend an improvement in Exelon's earnings power (and consequently, ability to support a meaningful dividend) in the coming years.
First of all, the Baltimore Gas and Electric subsidiary of Exelon is requesting a rate increase, the hearings of which began on January 4th, 2013. If Baltimore G&E gets its request granted, it will be able to charge residential electric consumers about an extra $6.62 per month and residential gas consumers about an extra $4.26 per month. If granted, this increase would let the Baltimore Gas and Electric subsidiary make an additional $200 million.
Furthermore, Exelon's earnings seem to be a bottom in terms of hedging on energy pricing. The company is currently caught between a rock and a hard place because all of the old hedges at high prices have come to an end, and price per megawatt hour is expected to increase $3-$6, meaning it is worth considering whether current earnings are bottoming out.
Now, the frustrating thing is that the dividend is probably going to be cut by a meaningful amount. From an income investing standpoint, this is where the conjecture becomes more art than science. My crystal ball is no better than yours, but here is what I anticipate. Last June, the CEO of Exelon said that the dividend was safe. Now, he is saying that the dividend may need to be cut to prevent the company's credit rating from being downgraded to junk status (if synergies from the Constellation merger don't materialize and/or power prices don't pick up, the present dividend payout could reach 90% of the earnings at the depressed levels).
My speculation is that if the company needs to cut the dividend, it will be a significant slash because no management team wants to deal with cutting the dividend twice in a short period. Furthermore, if the dividend gets cut to a low base, it enables the management to shore up support by giving investors 10% or so dividend increases in the period that follows (the best case study of what this approach looks like is General Electric (NYSE:GE) after the financial crisis). I suspect that the $0.525 quarterly dividend might get cut to $0.25 per share, or $1.00 annually. That would free up the dividend commitment to about half of the past twelve months' earnings, which would give management the wiggle room to focus on maintaining or improving the credit rating and raising the dividend by a meaningful amount going forward. At the present price of $30, a $1.00 annual dividend would offer investors a 3.33% yield.
If your investment objective is to own a stock that will raise your annual income each year, then removing Exelon from your portfolio probably makes sense. But for value investors that only take income into consideration as one of many factors, the decision is more complicated. Analysts estimate that once Exelon clears all of its costs from the Constellation merger and prices pick up a bit, earnings per share ought to be around the $3.50 range. And if the company trades at its historical valuation of 13x earnings, this company could be a $45.50 stock in two to three years.
Before you sell your Exelon shares in disgust, consider whether you believe management's argument that historically low power prices are due to increase modestly in the next couple of years. Consider whether you think the Baltimore Gas & Electric subsidiary will get that $200 million rate increase. Consider whether you accept my hypothesis that the dividend might get cut in roughly half and then rise by a steady clip after that. While this stock may have become anathema to pure income investors, it may have created an opening for the patient capital of pure value investors.