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Summary

  • Planned acquisition will increase regulated operations and provide earnings stability.
  • Acquisition will also improve company’s risk profile.
  • The deal will also ensure cash flow certainty.
  • Dividends have in the past remained highly vulnerable due to weakness in unregulated market.

Exelon Corp. (NYSE:EXC) has had a rollercoaster ride since 2007, mainly because of a weakness in the unregulated power market. The 2012 merger of Exelon and Constellation Energy resulted in an increase in consolidated regulated operations to more than 50%, versus the prior level of almost 30%. In early 2013, Exelon announced a 41% dividend cut because of earnings and cash flow challenges it faced as a result of weak forward power prices.

Moving into 2014, U.S. utilities companies continue to divest their unregulated power operations due to uncertainty attached to forward power prices, and focus more on regulated operations. Exelon has announced it will acquire Pepco (NYSE:POM) in an attempt to increase regulated business operations. Exelon plans to acquire Pepco in an all-cash transaction, at a share price of $27.25 per share, which represents a 25% premium on Pepco's share price as of April 25, 2014. Exelon plans to finance the $7 billion deal with 50% debt and the remaining through up to $1 billion of cash from non-core asset sales and equity issuance. Duke Energy (NYSE:DUK), American Electric Power (NYSE:AEP) and PPL Corp. (NYSE:PPL) are among the other utility companies, which are considering the option to scale down their unregulated operations.

Exelon's proposed acquisition of Pepco is viewed as an initiative to increase regulated power operations, which will reduce its exposure to volatile unregulated operation (the proposed acquisition will increase Exelon's regulated exposure to 60%-65%). Also, the deal, if executed, will improve the overall risk profile of Exelon. The deal is expected to close in the second or third quarter of 2015, and is subject to approval by the state commissions, the FERC and the District of Columbia Public Service Commission.

Exelon and Pepco are anticipating $250 million in net synergies over the first five years of the acquisition, out of which almost 35% will be retained by the companies. Also, Exelon's management expects the deal to be accretive to earnings in the following year of the deal closure, and projects a $0.15-$0.20 per share benefit starting in 2017. The planned acquisition will also improve cash flows and support the company's dividends; Exelon currently offers a dividend yield of 3.5%.

Other than the increase in regulated operations, which will provide earnings stability, Exelon will benefit from regulated rate base growth. Exelon has already announced it will incur $15 billion of capital spending on its regulated operations over the next five years, and the inclusion of Pepco's regulated operations will bring an additional $8.3 billion in regulated rate base, which will strengthen Exelon's future rate base growth.

Last week, Exelon announced a planned offering of 50 million of common shares and 20 million equity units to fund the acquisition of Pepco, which could increase Exelon's shares outstanding by almost 9% by 2017. Through the share offering, Exelon could raise $2.6-$3 billion of proceeds to fund the proposed acquisition.

Other than initiatives taken to increase its regulated operations, Exelon is likely to benefit from an increase in energy and capacity prices. According to updated hedge exposure released by the company late last month, Exelon expects an increase of $350 million and $600 million in open gross margin in 2015 and 2016, respectively, because of an improvement in commodity prices of power and gas during the month of April. Also, Exelon will benefit from the recent increase in capacity prices to $120 per MW a day for 2017-2018, up from $59.37 for 2016-2017, as a result of the recent PJM auction.

Final Words
In my opinion, Exelon's plan to acquire Pepco, in an attempt to increase its regulated operations, will provide earnings stability and improve its risk profile. Also, the deal will provide cash flow certainty, as regulated operations have a more stable revenue base, and support dividends offered by the company, which in the past have remained highly vulnerable because of a weakness in the unregulated market. In an attempt to increase regulated operations exposure and achieve a reduction in earnings volatility, Exelon is paying valuation premium on Pepco shares; Exelon plans to purchase Pepco stock at a forward P/E of 20.8x (based on consensus 2015 EPS estimates of $1.31 for Pepco and an acquisition stock price of $27.25), versus the utility sector's forward P/E of 16.6x.

Source: Exelon Corp: Aiming For Stability