Fixed-Income Vs. Equity: The Exelon Corp. Example

Jan.15.12 | About: Exelon Corporation (EXC)

Exelon Corp. (NYSE:EXC) is a very unpopular utility stock at the moment. Down 8.0% year-to-date, EXC is the worst performing utility on the board. The announced merger with Constellation Energy Group, Inc. (NYSE:CEG) carries with it the deal risk of all utility transactions (considering the trouble it is experiencing in getting over the finish line as a result of regulatory hurdles), and is moving through the regulatory process (early 2012 is the expected close as per the last check).

As a result of low natural gas prices (and the resulting impact on power markets) and the roll off of hedges, consensus is forecasting a steep drop in EBITDA year-over-year, with 2012 EBITDA forecast at $5.2 billion versus the 2011 EBITDA forecast of $6.4 billion. (The merger with CEG doesn't help the cliff, as EBITDA is forecast to drop $200 mm for CEG in 2012 over 2011 as well). Analysts (such as BAML on Friday) are dropping recommendations and not supporting the stock. Highlighting the bearish tone, EXC has an almost 6.0% short-interest (quite high for a utility), and is trading close to the 5-year low of $37.63. The bottom-line here: this is a very out of favor stock that has performed quite poorly for several years.

EXC does have one thing going for it-- the $2.10 annual common dividend, working out to a 5.25% dividend yield as of the time of this writing. Let's assume that the dividend is "safe", in that management has no incentive to cut the dividend and that the financial performance of the company will support the payout (with or without the completion of the CEG merger). Let us also assume that the core businesses of EXC (distribution of electricity in Illinois and Pennsylvania, as well as the ownership and operation of a lot of nuclear assets) isn't going away. When comparing the dividend yield of EXC against the yield on the company's long-term bond-- despite the investing community hating the stock, the poor performance over the past several years and the headwinds for growth in EBITDA-- I think a strong case can be made at this price to own the equity for yield relative to the company's outstanding holding company bond for income-focused investors.

The $500 mm EXC 5.625% of June 15, 2035 is currently priced at 109.9, with a yield to worst of 4.908% (the bond is a bullet, so the yield-to-worst is the stated maturity). The dividend yield on the common is 5.25%. The question: would you rather pay $109.9 today, for a bond that matures in 23 years, yields 4.908% and will-- at best-- give you back $100. Or, would you rather buy the stock, consider it "bond-like", get paid 5.25% (with the potential for dividend growth) and, maybe, see real capital appreciation during the back end years should the underlying fundamentals of the company improve?

The risk (the EXC enterprise has fundamental trouble due to any host of factors) is at least equal to the reward (over the longer-term, the price of the stock appreciates at even a modest pace, thereby providing a far outsized return relative to the bond). That is especially true considering the duration of the bond (13 years, which highlights the substantive interest rate risk of a longer-dated maturity) versus the potential direction of the stock in the event that overall equity market conditions improve and there is a bull market somewhere over the next, say, 10-15 years (assuming of course, that EXC equity does not correlate to rates cleanly, like utilities do sometimes, and can decouple).

When you look at the equity as a bond surrogate, and run a dividend discount model using the 30-year Treasury as the risk-free rate, the stock is worth $72 per share. Assuming rates hold this low for a long-time is foolish, but the point is that if one believes the dividend is stable for the foreseeable future (which I believe it is) the value proposition here is beyond the fundamentals. You are simply viewing EXC as another form of income-based investment, like a corporate bond, with the trade being core stability of principal versus the ability to participate in upside. With a long-term perspective, this seems like a no brainer.

I spend a lot of time thinking about the risk / reward of fixed-income versus equity instruments. With the dividend yield on the S&P 500 at over 2.0%, and the yield on the 10-year UST sub-2.0%, it is worth spending time thinking this way. Even (to superior) yield for long-term upside potential is an appropriate income-based strategy. So the next time you think about buying that muni or corporate bond (or heaven forbid, UST), look at some of the opportunities around equities. With the right focus and perspective, there is some real value to be had here.

Disclosure: I am long EXC.