Background
Exelon (EXC) is one of the biggest power generation companies in the US. It consists of 2 parts: the power generation and the regulated power utilities. The power generation segment operates a fleet of 11 nuclear power plants, the largest and most efficient in the country, and contributes 75% of the company’s revenue. The power utilities, comED and PECO, contribute the remaining 25% of revenue.
Exelon’s management has a history of making shareholder friendly decisions. It has repurchased $1.3B of shares since 2007 and paid out $1.32B/year of dividends in the same time frame. In terms of its cost structure, Exelon has hedged 90-93% of its power generation in 2011, 67%-70% in 2012, and 32%-35% in 2013. And it also has long-term purchase contracts for Uranium. With a relative stable cost structure, one doesn’t need to worry too much about margin volatility.
In April 2011, Exelon announced a merger with Constellation Energy Group (CEG), a $14B energy producer with 12,000 Megawatts of generating capacity. The merger is waiting for approval, but it’s expected to pass. Because the company has such stable cost structures and the demand for electricity is very inelastic, its earnings and revenues have been relatively stable while offering a 5% dividend with potential future increases.
Oasis In A Thunderstorm
The equity and fixed income markets have seen volatilities that we have not experienced in decades. For example, the Dow had its first non-triple digit close since Sept 23rd last Friday. Despite such market volatilities and the Japanese nuclear disaster, Exelon stock has held up relatively well. It has been trading between $40 and $44.
What is surprising is that Exelon’s stock correlation with S&P 500 is only -0.07 YTD. This figure is more significant considering the correlation between individual stocks and S&P is at 0.8, the highest ever. The YTD performance of Exelon has also significantly outperformed that of S&P and Dow (chart 1).
In a market where volatility is the norm, Exelon has become an oasis of stability. For people who are looking for capital preservation without the gut-wrenching ups and downs, Exelon offers what you are looking for. Considering the trading range I mentioned earlier, the best strategy to buy the stock is to place a GTC limit order with price target of $40 to $40.50 instead of buying it at Friday’s closing price of $41.93.
Chart 1
click to enlarge
Dividend Supported By Strong Cashflow
Exelon’s 5% dividend is definitely on the high end. When considering a company’s dividend, one must look at its sustainability. If the management is using debt or cash to increase or maintain dividends, such situations are definitely not sustainable. Even if the management is using the FCF to pay the dividends, if the ratio of dividend payout to FCF is greater than 80%, the company might not have much left over to fund future growth. We are seeing that kind of ratio in a few telecom companies such as Telefonica (TEF).
Exelon has averaged $2.5B/yr of free cash flow in the last 4 years. As I previously mentioned, it pays $1.3B/yr for dividends, this makes the dividend payout to FCF ratio a healthy 52%. It is leaving plenty of room to fund its operations and its pension, which I will mention later. Exelon is also leaving considerable rooms for dividend hikes.
Bullish In Either Boom Or Gloom Economic Cycles
Electricity is like food, people need it regardless of the economic cycles. With food, people can shift to cheaper substitutes, but there is only one type of electricity, so the demand for electricity is extremely inelastic. Whether boom or gloom times are in the cards, Exelon will always have a stable customer base and demand. If the economy unexpectedly takes off, the price of oil will go up, Exelon with its large renewable fleet is bound to benefit from the lower fuel cost structure than its competitors. If the economy stays gloomy, the demand for Exelon’s products won't be reduced.
In fact, if the economy stays slow or even contract, inflation is bound to come down and the 5% dividend yield will become even more attractive to investors who are getting next to nothing in all other investments.
Potential Risks
As with all investments, there are potential risks involved. One risk that stands out is Exelon’s $5B under-funded pension. In Q2 2011, the company had to contribute $2.1B to its pension. The company is projecting 8% growth rate for its retirement liabilities. Such growth rate seems very optimistic considering its portfolio mix is 50% in fixed income, 30% in equity and 20% in alternative investment.
I personally do not see any fixed income or diversified equity portfolio returning 8% anytime soon. Unless the company's 20% alternative investment really takes off, Exelon will need to lower its 8% forecast and contribute more than the $5B shortfall. However, with its $1B+/year FCF net of dividend payout, the company should be able to at least maintain its dividend and fund future growth even if the pension projection falls short.
The second risk is natural disasters. As we have seen in Japan, unexpected disasters can have catastrophic consequences on the environment and the companies affected. TEPCO was nearly destroyed by the recent tragic earthquake in Japan. While the consequences of this type of disasters are high, the chances of them happening are extremely low. Prior to TEPCO, there has never been a nuclear meltdown that’s caused by natural disasters. We can assume the probability of another disaster of similar scale happening is extremely low, especially if you assume such occurrences are under a normal distribution.
Conclusion
In conclusion, Exelon's stocks offer stability that is hard to find while paying a sustainable 5% dividend. Its stock is fairly valued with little downside risks in any economic scenarios.
Disclosure: I am long EXC.
