When investment premises change, the investor must change his or her thinking along with it. This can be a challenge, since it often entails admitting that you have misjudged the original backdrop.
Indeed, in the case of Exelon Corp. (EXC), one of the largest U.S. utilities, it's time for some agonizing reappraisal for this author. There was little to be happy about after the most recent conference call. Despite an EPS beat, earnings quality was weak. Revenues were terrible. Expectations set out in the Q2 conference call didn't materialize.
Then, it was all overshadowed when CEO Christopher Crane set the stage for a dividend cut. The share price cratered on high volume over the next two trading days.
Exelon: One-Year Price and Volume
Click to enlarge images.
In this article, I will offer a look at:
- Where my original thesis was called into question
- Assessment of the current situation
- Analysis and my investment plan for this stock going forward
Original Exelon Investment Thesis Questioned
About two months ago, I outlined an investment thesis for owning Exelon stock that was published on Seeking Alpha. A synopsis of the thesis is quoted directly below.
Exelon has a good balance sheet, generates strong operating cash, and management is committed to maintain the generous 5.5 percent dividend. The merger with Constellation will take some time. However, the union will be successful. Most utility mergers end up well. Merger integration doubts coupled with a short-to-medium term earnings decline have caused the share price to lag its peers.
Investors are being paid to wait. The strong dividend returns will ultimately converge with underlying share price capital appreciation and provide investors with a handsome long-term total return. (highlights added for emphasis)
The highlighted sections of the original thesis can no longer be reconciled with the most recent facts. In addition, another underlying premise requires examination that was understated or overlooked before: the strength and credibility of senior management.
The rationale for maintaining that the dividend was safe had been largely based on a review of both the financials and management statements. Management comments from the Q4 2011 earnings conference call held on Jan. 25, 2012, included the following:
We are keenly aware that to all of you, the dividend is an absolutely critical part of our value proposition. It's what makes it possible for you to hold on with us while we work our way through the gas and power price trough. Our cash flows and credit metrics support our dividend and capital programs even as we accept a higher payout ratio. Chris Crane, who will answer most of the questions today about future performance, believes, as I do, in the continued importance to the dividend. Simply put, we get it. And he is as committed as I am to maintaining it. (emphasis added by author)
CEO Christopher Crane reinforced this position during the Aug. 1, 2012, earnings conference call:
In the meantime, we remain committed to our investment-grade balance sheet and our dividend. Exelon is the best-positioned company in the industry.
Then he backtracked during the earnings telecom last week. I'll provide more on that below.
Given this development, the fundamental investment thesis has broken down. It's time to re-evaluate the new facts and circumstances.
Analysis of the Current Situation
The recent conference call highlighted several significant corporate issues. My intent, as an investor, is to review them and offer a cold, "fish eye" assessment and then determine an action plan.
At the top of the list was commentary by Crane that indicated a dividend cut was possible, unless the power generation market improves. The underlying driver is for Exelon to maintain an investment-grade credit rating on its subsidiary companies.
Utilities borrow a lot of money. If the agencies downgrade Exelon, debt service costs will increase. Interest expense is a big part of its expense structure. Exelon is now "investment grade." A downgrade of a notch or two could put it into the "junk" category.
So what does that mean?
In 2013, Exelon management is expecting a $3 to $6 per megawatt improvement in the retail power market to materialize for the out years 2015 and 2016. Management is less concerned with the impact of short-term power rates or capital expenditures on the dividend.
Now let's talk about our financial priorities and some actions we have taken as a result of the volatility we've seen in the markets and to give ourselves some more opportunity. So turning to Slide 6, our #1 priority is to remain investment grade across all our registrants. Our investment grade rating is fundamental to the business, given our sizable collateral requirements, our counterparty and customer relationships and our significant nuclear capital expenditure.
In close proximity of importance, our next financial priority is returning value to the shareholders through our dividend. We understand the importance of the value of the dividend to our shareholders.
Here is a copy of slide six, referenced above.
Later during the same earnings conference call presentation, Crane further emphasized the link between forward power prices and the status of the dividend:
It is, of course, also possible that the power prices will not recover as completely or as rapidly as our fundamental views suggest. In that regard, with the actions we've taken, we have time to see how things play out. But if they do not play out favorably in the next 6 months, revisiting our dividend policy will be in the range of options for preserving our investment-grade rating that management and the board will need to consider. (emphasis added)
As stated, it should be emphasized that he was not talking about short-term power rates. He was talking about forward power rates -- into the 2015-16 time frame. However, expected improvement was expected in six months or so -- in 2013.
These points were not lost on the Street analysts. During the Q&A session of the Q3 conference call, Crane shared more on the metrics around possible dividend cut. Here are two more excerpts from the Q3 2012 transcript:
We've been given some flexibility by the rating agencies because they think this is a stress period. But if something structurally change there and you're dealing with a 90% payout on a dividend for a long run and we have to question if we're getting value. You don't want to live on the edge. There is potential volatility, but I think we have time to watch it going into 2013. (emphasis added)
So what we've done in the past, we have a more traditional payout strategy for the utilities, 65% to 70%. And that resonates well as we benchmark to other regulated entities. On the growth side for the competitive part of the integrated, we have tried to benchmark more of the yield and keep track with the sector and the yield. Now since we've got a little bit more damage with the gas and our concentration in NiHub, our yield is 5.9%, last time I looked at it where the others are probably 1% lower, if not more. So we're outpacing the yield. Now we get this $0.70 back, it's a different conversation. And we're more sensitive to the upside. And that's what -- we just got to reaffirm with -- in our policy as we look at this, is that the right thing? We think we're hitting the stress low, and we think the recovery is there. (emphasis added)
As an adjunct to these comments, the current financial situation is not dire. The balance sheet remains adequate. Operating cash flow is strong. Exelon has generated about $4.5 billion operating cash through the first three quarters of 2012. Nonetheless, capital spending is high. Free cash flow is positive, but inadequate to cover the current dividend. Exelon had planned to borrow against it's largely solid financial position for the near term to finance both the dividend and significant capital projects. The ratings agencies have stepped in and questioned this given the uncertain prognosis for the forward power rate curve. It's important to note that over a third of Exelon's revenues come from power generation vs. the regulated utility business. The company is largely unhedged in these out years. Lower-priced hedges will be the option unless the curve improves.
There are several other new developments, none of them positive:
- First, Hurricane Sandy may have a short-term negative impact on the company's operations in Philadelphia and Baltimore.
- Second, cash and earnings at ComEd, the largest regulated utility under the Exelon umbrella, reported lackluster results despite record heat and drought in the Midwest. Commonwealth Edison is the primary electric provided for the Chicagoland area. In addition, an unfavorable regulatory ruling against this utility has caused a deferral of up to $450 million capital expenditures into the out years.
- Third, at the 2012 analysts' day, Exelon management had anticipated 20% growth in commercial volumes from 2011 to 2014. Reflecting the current market dynamics, company execs now project only 9% volume growth 2011 to 2015.
Bottom Line: Exelon management has determined that maintaining an investment grade credit rating is paramount. Short-term power generation retail rates and capital expenditures are not the drivers. The longer-term power rate curves and the credit agencies are the keys. Watch an important financial metric: the funds-from-operations-to-debt ratio. The corporate figure should stay above 27%.
Crane did not announce a dividend cut. However, the discussion outlined a scenario where this could happen. He noted that if the out-year power market improved $3 to $6 per megawatt as planned, the situation would be diffused. Exelon has little control over the market. Therefore, all Exelon and its investors can do is watch and wait. Apparently, company management will give the markets about six months to firm up or it will consider taking internal action. This includes cutting the dividend payout. My experience says that these warnings often become self-fulfilling.
An Investor Plan Going Forward
There are several things to consider going forward:
- Investment capital considerations
- Expectations and risk tolerance
- Likely outcomes
In my situation, I'm already invested in Exelon. I initiated a position a few months ago and have averaged down the cost basis through three subsequent purchases. I believe the shares are looking a bit oversold now, and they will very likely be so at $31. I might purchase shares once more at about $31. I will be in no rush to do so.
My decision to purchase more (or for another investor to start a new position) must include forward expectations. Here's where I shake out:
During the conference call, company management indicated that a traditional utility payout strategy is 65% or 70%; it also noted that a 5% dividend yield is reasonable. The current Exelon 2013 EPS consensus forecast is $2.62. Using this figure as a guide, one could suggest that if a cut is made, an annualized cash dividend of $1.70 is in the ballpark. If one accepts a benchmark 5% yield, the corresponding share price is about $34 a share. Since most utilities only want to cut the dividend once, I believe the directors will cut back more than that to be safe. Hence, a $31 price target is my maximum before investing any more capital.
The price now appears to have such a dividend cut baked into it. While I believe a cut is likely, it's not a 100% given yet, nor should the issue be resolved for another quarter or so. Therefore, unless I choose to harvest a 2012 tax loss, I do not plan to exit my position.
For an investor seeking ultimate preservation of capital as first priority, this view may be unacceptable. Exelon no longer has a normal, lower-beta utility risk profile. While one could surmise that the shares are near a bottom, it would be foolish to assume this is an absolute. A dividend cut overhang and associated risk remains with these shares for the foreseeable future.
I see two other big picture fundamentals:
First, Exelon is not about to go bankrupt. This is not the concern. It is too big and generates too much cash for that. The balance sheet and cash flow statements are not in disarray. A poor business climate, induced by a weak power generation market and the unfortunate location of the company's regulated business geography (Chicago, Philadelphia, and Baltimore) are causing problems. These issues will not last forever. Power rates will perk up in the future, along with the economies of these major metropolitan areas.
Second, and importantly, management remains culpable. They are not bystanders. The management team has a demonstrated a flat spot. Their handling of this dividend issue has been weak.
How can company leaders stand up (twice) and tell investors the dividend is safe, then within a couple of quarters turn around and warn these same investors that it's not? Unacceptable. The rating agencies do not flit in and out of corporate offices, especially during major merger and transition activity. They are an integral part of the process. Management is accountable for handling and communicating with investors clearly. While the dividend discussion was rightly acknowledged early, I see a falling down in the reversal process from one quarter to the next. This calls to question my faith in the executive suite. There are too many well-run, well-managed companies out there to fiddle around with inexperienced leadership.
To be fair, the integration of Exelon and Constellation is complex and far-reaching. That point should not be lost. However, investors judge a utility company by its dividend.
I will be watching for the following in upcoming quarters:
- Fewer "one-time adjustments" and "restructuring" costs baked into the EPS. This is acceptable early on during a major merger or acquisition, but after that it can become a management crutch to explain away poor operating performance.
- Realization of expected merger synergies; meeting or exceeding the run-rate targets set out by senior management.
- An improvement in the bottom-line results for the power generation business commensurate with an improvement in natural gas prices. I will watch for line-of-sight results.
- Clear talk about the rating agencies, associated financial metrics, and the dividend.
Disclosure: I am long EXC.