Exelon (EXC) is the most hated utility stock, as it has seen significant stock price erosion and there has been management indication about a possible dividend cut. Utility stock owners are mostly interested in a high, stable and growing dividend yield. Even the distinct possibility of a dividend cut is heresy for this class of investors. So it is not surprising that the Exelon stock is down, almost 30% from its 52 week high of $43, even as other utility stocks like Southern Company (SO), Dominion Resources (D) and Duke Energy (DUK) remain near their 52 week highs. What was interesting was the earnings for EXC came better than expected in its most recent quarterly results. This generally sparks a rally in a beaten down stock, but for EXC this led to a sell-off because of dividend concerns.
Brief introduction about Exelon
Exelon Corporation is one of the largest utilities in the US, with 35 GW of power generation capacity. What is different about EXC is that it has one of the largest portfolios of solar and wind energy farms. If global leaders finally wake up to global warming realities, then Exelon Energy will be one of the biggest US beneficiaries. Exelon merged with Constellation Energy in March 2012, in a ~$8 billion merger. The combined entity has business activities in 47 states, the District of Columbia and Canada.
Why we like Exelon Energy
- Valuation - Exelon trades at a significant discount to its peers, with a forward P/E of 11.5x and a trailing P/S of 1.17x. The P/B is also much lower than industry average at 1.15x. The lower valuations are due to its lower operating ratios, compared to the general utility industry. Its operating margin at 13.1% is lower than industry average at 19.5%, while its net margin at 6.5% is also lower by 2 percentage points.(Source Yahoo Finance and Morningstar)
- Clean energy assets - Exelon is one of the lowest carbon emitting utilities in the US, as it generates 62% of its power from clean energy. If a carbon tax is introduced in the US, Exelon will benefit massively. This upside risk is not being priced in the stock; however, more natural disasters like Hurricane Katrina may force even hardened climate change skeptics to change their stance. Even World Bank is getting concerned about the dangers of global warming. A Democrat administration is a positive of Exelon stock in our view. Exelon gets only 6% of its power from coal power, unlike the 40-60% range which is normal for other large US utilities. Coal is under attack for its numerous disadvantages, and other US utilities are being forced to spend billions of dollars to clean up their massive coal power plants. Exelon has used the wind industry downturn to opportunistically acquire wind energy assets cheaply. However, the low natural gas prices have made these acquisitions look bad.
- Sentiment - The sharp drop in the stock price has created a general aversion against EXC amongst its major class of investors. Investors think that Exelon is incapable of turning around and stop the decline in earnings. This has been priced in the stock price, which is trading at low P/E and P/S multiples. This creates an opening for opportunistic traders and investors who can benefit if the company manages to clean up its act. Note a lot of the criticism against management is not accurate, as the company has faced macro headwinds beyond its control.
- Merger synergies with Constellation Energy - Exelon merged with Constellation Energy, which added a significant number of retail and wholesale consumers. The merger has received the Global Energy strategic deal award by Platts and is expected to realize cost benefits of ~$625 million by 2014. At the current annual revenue run rate of $33 billion a year, this implies a net margin improvement of ~2% a year.
- Natural gas prices will not stay abnormally low - Exelon has been one of the biggest victims of low natural gas prices, being forced to sell its merchant nuclear power at low prices. However, many people think that these abnormally low NG prices will not remain so in the future as NG starts being used more in transportation and exports. NG supply is also getting reduced as producers reduce the number of drilling rigs. Exelon has been forced to hedge power prices at lower levels in order to reduce these risks.
- Very high nuclear energy dependence - Exelon depends on nuclear energy for 55% of its generation capacity in an era when nuclear energy is facing increasing aversion in many parts of the world due to the Fukushima accidents. While nuclear energy has its advantages in the form of no carbon emissions and low costs, the tail risk of a nuclear accident is great. German utilities are facing testing times as the German public has forced the closure of nuclear reactors in that country.
- Debt - Exelon has a lower debt/equity ratio than its peers at 90%, compared to industry average at 120%. However, due to lower margins and earnings, the company is being forced to cut dividends in order to reduce its debt burden. This is being done to maintain its investment grade BBB debt ratings. The company has a total net debt of ~$18 billion.
- Dividend cut - Exelon is paying an annual dividend of $2.1, which is quite high compared to its current earnings of ~$2.85. Exelon CEO has said that he may be forced to cut the dividend if earnings do not improve in the next 6 months. This led to a sharp fall in the stock price, which has resulted in the dividend yield becoming ~7.2%. Even if Exelon cuts its dividends by 40%, the dividend yield will be higher than the industry average at 4.2%.
Stock Price Performance
Exelon has badly underperformed the market and the general utility sector in the last one year, losing 28% compared to the flat returns given by other big US utilities like Southern Company and Duke Energy. Over the last 5 years, EXC has been one of the worst performers losing 65%, as low power prices debased its earnings power. In this period, S&P 500 gave a 5% return while other utilities gave a ~8-10% return. Most of the stock decline in the last year came after the management indicated the possibility of a dividend cut. The stock price has declined from ~$37 on October 31 to ~$29 now.
We think that Exelon stock has been hammered a little too much because of dividend cut concerns, making it an attractive investment. The stock has been sold to dividend investors though the company reported a better than expected earnings. The company has been trading more like a small cap stock than a large utility stock. Despite its current troubles, investors would do well to remember that this company is one of the largest utilities, with a monstrous 35,000 MW of power generation capacity. It is not going to go out of business or start losing money. There is potential for stock price appreciation based on merger synergies with Constellation Energy and possibility of natural gas price increases. Its clean power assets are also not being given due value because of the climate change being put on the backburner.