Recently, a friend suggested we give the utility stock Exelon (EXC) a look given its decent dividend yield and its lackluster performance of late, particularly versus the sector. I guess he figures we're a glutton for punishment as the stock has lost about 20% while the utility sector has, or should we say had, been on fire. Well at first blush, we were intrigued enough to take a small position and go into research mode. It seemed to us that they were just another victim of the meltdown in natural gas prices back in the spring and yet they hadn't received any reprieve from the recent rebound. In addition, we read that Izzy Englander's Millenium Partners took a sizable stake and we know they are pretty astute at that shop. Further, there was some other SA research that presented a decent investment thesis. And last, we like the idea of owning a high-income investment with an option on power prices going back up again.
Exelon is an energy (electricity) producing company that gets about half of its revenue like a traditional electric utility and the other half in the so-called competitive markets, where prices fluctuate with demand and other competing resources. And that is the rub. With most of its energy being produced from nuclear plants, Exelon has had a hard time competing with utilities that use natural gas or coal, as their input prices have declined precipitously. While coal is not a major competitive threat, given the retirement of old coal-fired plants underway, the onslaught of cheap natural gas has forced EXC to compete with much lower margins (down nearly 40% in $/MWh). We can't really blame management for that. Listening in to their conference calls and presentations, they seem to be in line with investors with their vow to retain the dividend during this rough patch. In addition, Exelon is still digesting the recent merger with Constellation Energy and, as usual, initial costs will hopefully bear fruit later.
Earnings have declined from about $4/share in 2011 to an estimated $2.7 a share. There dividend is $2.1/share so the coverage there looks ok. However, dividends come from cash and its cash flow that is king and that is where we see risk. Do we envision a dividend cut? NO. Why? Because management has basically said they are hell bent not to cut. Of course, cynics will say, "well that is what GE (GE) said too." Well, until all options are exhausted, including possible dilution, we will take management at their word.
Above we show the Source and Uses of Cash for EXC for 2012 and 2013 based on Exelon's projections. Based on their 2012 guidance, operating cashflow is $5.4bn, which is net of the close to $1bn in interest payments, mostly from their $18bn in long-term debt. Total debt, including short-term and current long-term, is $20bn so their ratio of debt/EBITDA is in the high 3s which is getting up there. Adding in other obligations, including pension, would present an even higher ratio. Suffice it to say that any meaningful increase in debt should bring more serious investor, and rating agency, scrutiny. Based on Exelon's numbers, they will need to issue about $1.1 bn in new debt this year as well as refinance about $800mn coming due. To the best of our understanding, they've done at least half of that if not more.
Next year in 2013 is where things get interesting. First, we assume that base case their operating cashflow increases to $5.5 bn and that they receive $250mn from a tax settlement with the IRS that was pushed back from 2012. Of course, much will depend on power prices although they are quite well hedged for 2013 (> 80%), so we don't see a major shift. Their ambitious capital expenditures, however, and larger dividend needs (a byproduct of the Constellation merger), will require a sizable funding need of close to $2bn along with the $1bn to be rolled over in 2013. Effectively, over the next two years, the dividend will be paid for by issuing debt (or equity) or spending cuts.
It is no doubt in our mind that 2012, 2013, and potentially 2014, will be trying years for this company. Management has basically said so recently, when they stated that the trough in free cashflow will be sometime in 2014/2015. They will probably need to cut back on some capital spending, most likely renewable projects, but much of their spend is necessary given various infrastructure needs. Recently, on their 2nd quarter conference call, the CEO stated that any growth expenditures will likely come from equity issuance with the return on equity balancing out the dilutive effects. Of course, this implies that investors who own the stock are ready and, most importantly, able to invest more dollars pro-rata.
We believe the company will strive very hard to maintain the current dividend but the dividend will not be "yield'' until 2015 at best. Until then, dividends will simply be return of equity. We suspect that Exelon will have to issue some form of convertible bonds, and/or preferred, or directly issue additional common shares to maintain the dividend. We believe that the rating agencies and investors will look unfavorably on a substantial increase in fixed rate debt in 2013 without some form of equity issuance also. While capital spending could probably be cut by $500mn, we view a dilutive offering as probable. This will probably come in the form of a convertible preferred share offering, possibly privately placed. We see little dividend growth prospects until beyond the trough in free cashflow and, as such, EXC should probably trade in the range of other higher yielding stocks. While we own some EXC here at $36, we believe that a $30-31 target over the next 6-12 months will provide investors a more lucrative entry point.