We wrote an article a number of months ago arguing that Exelon (EXC) was more than fully valued in the $35-36 range and that investors should wait until the low 30s to enter. Part of our view was predicated on the idea that the dividend was safe, albeit funded with debt. Since then, much has changed. The dividend was put on notice during the third quarter's conference call and subsequently cut to 31 cents per share per quarter just recently; the cut takes effect in Q2. We were lucky enough to have exited our original (small) long position, soon after our "negative" article was published, as we began to view the odds of an equity dilution or dividend cut more likely. Going forward, while we do not see EXC as an obvious short candidate, we do think there are other names in the utility space that have more attractive valuations. As such we've recently put on a pairs trade: Going long Southern Company (SO) vs EXC as we believe their valuations, in terms of dividend yields, should compress over the next few months.
Recently, there have been a number of articles (here, here, and here) that argue for a much higher valuation for EXC versus its current market price now that the dividend cut has been announced. Much of it is predicated on either a significant rise in electricity prices, which is not in the cards based on electricity futures, or on a dividend discount model without consideration of the fundamentals. While EXC has definitely improved its outlook recently, mainly through increased debt issuance in 2012 and reduced capital expenditures going forward, the company will still remain cash flow constrained for the next few years. In particular, recent guidance for 2013 showed that, to maintain a stable cash balance, $850mn in net financing (i.e., more debt or equity) will be required in 2013 while, in 2014, the company should be cash flow flat. This is a big improvement from back in September when the company was guiding to $2bn in net financing needs for 2013 alone. The company is making great strides towards improving its balance sheet, which includes a fairly large underfunded pension, and its free cash flow. While the net financing for 2013 will likely be in the form of debt, investors can not rule out a dilutive equity offering as EXC's leverage remains quite high.
With the new dividend of $1.24 per year, EXC is currently priced at about a 3.9% yield. While this is a bit under the yield of XLU (the utility ETF has a yield of 4.15% pre-expenses), it is much lower than many of Exelon's peers. Looking at comparables (e.g., Duke (DUK), Southern Company (SO), PPL (PPL), American Electric Power (AEP), PG&E (PCG)), they trade with an average dividend yield of 4.4%. Given Exelon's current state of affairs - grappling with a huge merger, pension under-funding, tax restatements, constrained cash flow, we feel that EXC should trade with a similar yield at the least. This would imply EXC should trade in the high 20s as it did when the dividend cut first came to light or, alternatively, Exelon's peers should trade higher in price to reflect Exelon's lower dividend yield. Given the outlook for dividend growth with EXC (i.e., none), one could make an argument that EXC should have a higher yield versus other comparable utilities.
Exelon's balance sheet still looks fairly leveraged. They have about $18bn in debt but they also have about $8.5bn in pension obligations, $12bn in deferred income taxes, and about $9bn in asset and nuclear fuel retirement obligations. All total, non-current liabilities amount to $49.5bn - a hefty sum. Tangible equity is about $20bn, leaving a long-term liability/tangible equity ratio of 2.48. This is fairly high for a utility, especially compared to SO whose "leverage" stands at 1.85 with no goodwill or intangibles. To put this into perspective, SO would have to issue 12bn of new debt to have an equivalent leverage.
Southern's balance sheet will become more levered going forward as SO's recent presentation states they will issue about $9bn over the next 3 years. Some of this will go to transitioning away from coal in their generation stack, which currently stands at 36% of the mix. We actually view the ability to leverage the balance sheet as a weapon today given current depressed market conditions. SO should be able to comfortably maintain the dividend, using free cash flow, and they are forecasting continued dividend growth of about 4% per annum. While we are not particularly keen on the utility sector on the whole, we find SO to be a well managed and reasonably valued company within the sector.
We have nothing in particular against Exelon. In fact, we give them credit. They are doing all they can against a tide of difficult issues but, without a substantial rise in electricity prices in the near-term, they will continue to face headwinds into 2015. With over 50% of their generation supply derived from nuclear, we are concerned about their cost structure vis-a-vis natural gas - they generate only 29% from gas. This is in contrast to SO, which generates 17% from nuclear and 45% from gas. EXC is in a deleverging mode. It will be difficult for them to fuel significant growth as they cut capital expenditures and preserve liquidity over the next few years. On the other hand, with a stable and growing dividend and a balance sheet that can enjoy further leveraging, SO is in an enviable position in today's depressed electricity market. Based on the premise that SO and EXC should trade at equivalent dividend yields at a minimum, we target SO for $50 per share and EXC at $28. We'll take either one.
Additional disclosure: We are Short EXC and Long SO