Avoid Exelon For Now

| About: Exelon Corporation (EXC)
This article is now exclusive for PRO subscribers.

Dividend investors often rely on high yields to produce their profits, attaching less importance to the fate of their principal. Even when investing long term for dividends, however, it often pays to think about the near-term performance of an investment. Ideally, one can reposition their capital into some other investments once headwinds become apparent and conserve a greater proportion of their principal.

Take Exelon (NYSE:EXC) as a textbook illustration of my point: I've seen the advice over and over for current investors to hold their shares and keep taking the dividends--even for new investors to buy and hold just because of the ~7% yield, but that is simply not very good advice. There are so many other high yielding investments to be found that would also offer a greater chance of preservation, if not gains on my principal that it makes no sense to sink money into a stock on a downward trajectory that likely still has room to fall.

Exelon is an electric utility giant that holds the largest nuclear generation capacity in the country. Exelon's woes have already been well documented on SeekingAlpha here, here, and here--and there's been plenty to talk about. Rather than beating a dead horse and rehashing the bear case in full I will try to be succinct here.

source: finviz.com

Macro factors currently seem to be against the company. According to the U.S. Energy Information Administration, assuming a return to more normal weather than experienced in 2012, electricity should see an annual decline of around 0.3% for residential consumption in 2013. This is not good news for U.S. electric utilities. Additionally, natural gas prices remaining low preferentially benefits most of EXC's competitors who have a greater percentage of their generation tied to fossil fuels. For the nine month period ended September 30 of 2012, output from fossils and renewables accounted for only around 25,000 GWhs out of a total production of about 130,000 GWhs, or only around a fifth of total production.

Exelon's merger with Constellation in March of 2012 has wreaked havoc on its margins. A look at the company's earnings report reveals that Baltimore Gas & Electric, which EXC gained from the merger, was by far its worst performing subsidiary in 12 Q3, posting a net income loss of $4 million while PECO and ComEd posted incomes of $122 million and $90 million respectively. BGE's performance may improve as EXC works to better incorporate it into its business structure, but I think a large increase in its net income relative EXC's other subsidiaries in the immediate future is unlikely, leaving it to drag on EXC's margins in the near term.

The juicy dividend is all but definitely going to be cut. Not only has management openly warned that it may need to reduce its dividend payment to maintain the company's credit rating, but its excessively high payout ratio and declining year-over-year EPS lead to the same conclusion.


2008 2009 2010 2011


$4.10 $4.09 $3.87 $3.75 $2.83

Utility Dividend Payouts

Company Payout Ratio Yield %
Exelon 112% 7.1%
Dominion (NYSE:D) 103% 4.1%
Duke (NYSE:DUK) 95% 4.8%
Southern Company (NYSE:SO) 76% 4.6%
NextEra (NYSE:NEE) 45% 3.5%

Source: S&P Capital IQ Report

As the numbers show, EXC's dividend rate has stagnated since 2008 for a clear reason: the company is less profitable on a per share basis than it once was. Exelon has both a high dividend rate and payout ratio relative to its peers, meaning that its attractiveness as an income source is a result of distributing too much cash to its shareholders. As things currently stand the dividend looks unsustainable will probably be trimmed back significantly in 2013.

Some claim that the dividend cut has already been "priced in" by the market and the stock has bottomed out after declining almost 30% in 2012, but as a wise man once said, "nothing is ever totally priced in until it actually happens." Plus there remains all sorts of speculation over how much the dividend might fall. I believe that the dividend yield will be cut more than most shareholders anticipate because of the headwinds previously discussed and so that management does not find itself in the same position of announcing another dividend cut in the future. Look for the stock price to fall when management announces the cut. A clearer negative catalyst is hard to come by.

Down But Not Out

The picture I've painted for Exelon may appear bleak, but when all is said and done it is still one of the largest energy utilities in the country and has a diverse production portfolio. The company's management would be doing the responsible thing in cutting the dividend to maintain a favorable credit rating, which actually bodes well for Exelon in the long run. I view its present problems as a great opportunity to pick up a stake in a venerable, dividend paying utility at a cheap price. Watch for fallout from an announced dividend cut to create a buying opportunity. EXC's dividend may not be as juicy as it once was, but its cheap price means you can probably add some capital appreciation onto those dividends long term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.