by Aaron Levitt | May 1, 2014 1:31 pm
Nothing could be as boring as the utility sector. After all, the sector is responsible for delivering essential services; even in times of duress people need to heat and cool their homes and keep the water and electricity flowing. That fact has made utility companies a steady source of dividend income for decades.
But sometimes even the most boring sectors can produce some excitement.
Shareholders of Maryland-based utility Pepco (POM) certainly got some excitement on Monday when larger rival Exelon (EXC) offered to buy out the firm at a 20% premium to its Friday closing price. The announcement of the deal sent POM stock up nearly 18%. The deal is also pretty exciting for suffering EXC stock investors as well.
In an effort to provide some excitement to its shares, Exelon is making a bid to become more boring. And ultimately, that’s a good thing for the struggling utility.
For investors, the time to bet on EXC stock could be now.
For Exelon the tale is one of finding balance between its regulated and unregulated operations.
When we tend to think about a utility company, its power or water treatment plants come to mind. And given that these facilities provide a vital and fundamental need for society, they often come with a heap of government regulation — anything from environmental standards to what a utility can charge its customers per unit of water, natural gas or electricity. All in all, these regulated operations form the backbone of the industry.
But sometimes this just isn’t enough.
To produce higher returns than what can be achieved via regulated power plants, some utilities have taken the plunge and have added nonrelated assets — sectors like banking, retail operations and real estate development. While Exelon hasn’t gone that far, it does have a hefty dose of unregulated merchant nuclear power plants. Those plants have been hit with lower prices for the electricity generated as energy-efficiency measures and dwindling consumer demand have taken hold.
All in all, Exelon managed to miss earnings per share estimates for three of the past five quarters amid declining revenues. EXC’s worst sin was that it was forced to cut its dividend in the face of these losses. That’s a major no-no in utility land, and shares of EXC stock where punished hard.
With the buy of POM, Exelon will increase its stable regulated asset base even further. Pepco’s main operating area is in the mid-Atlantic and Northeast, with customers in New Jersey, Delaware, Maryland and Washington, D.C. The Pepco purchase follows EXC’s buy of regulated utility Constellation Energy for $7.9 billion back in 2011.
Combined, the new utility will have nearly 10 million customers across 47 different states and a rate base of about $26 billion. After the deal closes, Exelon would overtake Duke Energy (DUK) and become biggest power company in the United States.
Aside from that monster size, EXC will be able to boost its share of regulated utility assets by 5%. By adding POM, Exelon will now receive more than 65% of its revenues from regulated sources. What’s more, the deal should be almost instantly accretive to EXC’s earnings. That accreditation should also provide a nice boost upward to Exelon’s future earnings as Pepco currently charges less than what regulators allow them to charge for electricity – that is, EXC has plenty of wiggle room to raise rates in its newly acquired territories.
That flexibility will ultimately strengthen EXC stock and its dividend.
Other positives include the fact that Exelon will now have the scale and scope to better improve its infrastructure, system reliability and storm response.
Some analysts have questioned the price at which Exelon is paying for Pepco, considering how high share prices in the utility sector have gotten over the last few years. Those questions managed to send EXC stock down about 5% on the news.
That drop provides a nice entry point for investors looking for some utility muscle to power their dividend portfolio.
And the recent buy makes EXC a great choice. The newly acquired regulated asset base will help fund dividends and create a more “stable” utility. Meanwhile, EXC’s roughly 35% exposure to unregulated power-generating assets will provide a nice boost when power prices return. Essentially, investors are now getting the best of both worlds — growth and income — from one stock.
That 5% drop also pushed EXC stock down below the average P/E for the utility sector. Exelon can now be had for a trailing price-to-earnings ratio of 17 and forward of 15. While that’s not super-cheap in terms of a historical metric, it does provide a nice entry point considering how transformative the Pepco deal is for EXC stock.
The icing on the cake is EXC’s 3.4% dividend … a dividend that should once again start growing in the future as POM’s regulated assets start churning out earnings for Exelon.
All in all, the deal is making EXC stock an interesting utility choice.
At the time of publication, Levitt had no positions in the stocks mentioned.
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