Exelon Corp Peps Up

Exelon Corp’s (NYSE: EXC) $6.9 billion all-cash takeover offer for Pepco Holdings (NYSE: POM) has gotten a mixed reception from investors.

The Wall Street Journal’s Liam Denning described the deal as a “pricey hedge” against Exelon’s slumping merchant power operations.

Meanwhile, three widely followed analysts upgraded the stock to a buy, citing the addition of stable utility revenue. The research departments at three other brokerages, however, have attached a sell rating to the company. Analysts from 13 other firms rate the stock a hold.

After factoring in the addition of Pepco’s regulated assets, Standard & Poor’s and Moody’s Investors Service maintained their credit ratings for Exelon. But Fitch Ratings put the Exelon on “Negative Watch,” asserting that the change in the company’s business mix isn’t “meaningful” and citing an expected increase in debt to complete the purchase.

The prospective merger has spurred a dozen investigations by deal-chasing legal firms seeking to build a case that the takeover isn’t in the interest of Pepco’s shareholders.

Politicians and editorial writers have also weighed in on the proposed transaction; most agree that Exelon will improve Pepco’s less-than-savory operating record. But many commentators worried about a potential job losses and higher rates for customers.

More important for investors, the merger will have a profound impact on Exelon’s shareholder returns. The deal pushes Exelon closer to restoring regular dividend growth, which, in turn, could propel the stock into the mid-$40.00s–a price last seen before the power company slashed its dividend by 41 percent in February 2013.

Dividend Cut: Time to Buy

In a recent installment of Income Insights, we tackled the dual nature of dividend cuts, which, in some instances can harbinger further trouble or the start of a turnaround.

However painful, a reduced payout better positions some companies for future growth, creating a buying opportunity for savvy investors. (See Dividend Cuts: The Best of Times and the Worst of Times.)

At Conrad’s Utility Investor, we took the latter view when Exelon slashed its dividend, and many investors headed for the exit; we added the stock to our Aggressive Income Portfolio on July 31, 2013, and sit on an almost 22 percent gain.

Our investment thesis rested on several factors:

• Exelon had a credible plan to move forward, which entailed managing weakness in the wholesale power market while investing in its still-steady regulated businesses.
• Earnings from the company’s regulated utility and existing wholesale supply contracts covered the reduced dividend, insulating the payout from further price deterioration in unregulated power market.
• The firm’s debt burden appeared manageable after the dividend cut.
• Executives had warned that weakness in North American wholesale power prices could force the company to reduce its dividend. When management made the painful call, the stock’s price already reflected this reality.
• Insiders evidently didn’t share analysts’ bearish outlook for the company, having stepped up their stock purchases.
• Elevated short interest further set a low bar of expectations that would be easy for the company to surpass.

We stuck to our guns at the beginning of 2014, when bearish sentiment toward Exelon peaked. Conventional wisdom held that wholesale power suppliers had entered a death spiral of falling sales because of solar-power adoption and rising interest rates.

As we argued in What’s Interest Rate Sensitive and What’s Not, utility stocks aren’t bond substitutes; their growth prospects and stock performance correlates more closely with economic growth than moves in interest rates.

And many power companies–including Exelon–stand to benefit far more from their large-scale solar projects than they were hurt by the distributed model pushed by SolarCity Corp (NSDQ: SLCTY) and the rollout of rooftop solar panels. (See The Smarter Bet on Solar.)

We also noted that Exelon’s earnings had stabilized and met management’s guidance since the dividend cut.

Exelon’s shares began to rally in early 2014 and gained momentum after the company announced fourth-quarter results in February and purchased a leading Midwest natural-gas marketer in March. The settlement of a long-standing dispute with Electricite de France (Paris: EDF, OTC: ECIFF) also gave the stock a boost.

The day before Exelon announced its proposed takeover of Pepco, the acquirer’s stock was up 33 percent on the year.

Three days later, Exelon is still the top performer among the 205 essential-services names covered in my Utility Report Card.

This feature–available exclusively to Conrad’s Utility Investor subscribers–includes my monthly comments on all 205 stocks and my proprietary Quality Grades to help you understand the risks associated with each name. (Not a subscriber? Learn more about signing up for a risk-free trial.)

And given the 4 percent short interest in Exelon, analysts’ negative opinion of the stock and lukewarm reaction in the financial press, the company still faces a low bar of expectation.

Here’s why:

• Few if any investors expect Exelon to increase its dividend in this lifetime. A return to growth would be a major surprise, potentially sending the stock considerably higher. A similar scenario transpired last year with Buckeye Partners LP (NYSE: BPL), which delivered a 67 percent return after increasing its dividend.
• Exelon estimates that buying Pepco will immediately add $0.15 to $0.20 to its annual earnings per share. This forecast calls for the company to pass through about two-thirds of an expected $250 million in synergies to customers. Even if further concessions cut this figure in half, Exelon’s payout ratio would still fall to less than 50 percent.
• Earnings generated by regulated operations will cover the company’s existing dividend, insulating the firm against contract expirations in the wholesale market.
• Exelon has hedged 75 percent of its anticipated power output in 2015, and the closure of coal-fired plants continues to tighten generative capacity in the firm’s service area.
• Over the next five years, Exelon will spend almost $21 billion on upgrades and expansions to its regulated asset base; these investments should translate into earnings growth, the primary fuel for eventual dividend increases.
• Regulatory and shareholder approvals could be faster and easier than most expect.

A Clear Path

The Federal Energy Regulatory Commission (FERC) took its sweet time approving Exelon’s tie-up with Constellation Energy. But that deal attracted additional scrutiny because it consolidated generating capacity in the Mid-Atlantic region.

In contrast, Pepco doesn’t own any power plants and generates the majority of its earnings from regulated transmission and distribution; joining forces with Exelon has no implications for the power market.

In fact, Exelon plans to sell $1 billion of its thermal-fueled power plants to finance the deal, further diminishing its share of regional electricity generation.

These factors should help the deal obtain approval from the US Dept of Justice, though the utility will also need regulators in the District of Columbia, Delaware, Maryland, New Jersey and Virginia to sign off on the merger. Exelon expects to file these applications by the end of June.

By law, FERC has 180 days to deliver its ruling. Management expects the Dept of Justice and Virginia to approve the deal within this time frame. The law requires a vote in Maryland within 225 days of the application, and the other jurisdictions are expected to follow roughly the same time frame.

In other words, the merger could close within nine months. For their part, Exelon and Pepco have managed expectations by forecasting that the deal will go through as late as the third quarter of 2014.

The key to speeding up that timetable will be forging settlements with commission staff and other interveners and avoiding as much controversy as possible.

Fortunately, Exelon has many weapons at its disposal to succeed, having shepherded the Constellation deal through FERC and Maryland two years ago. Politicians, regulators and other officials are also anxious to hear how the company will improve Pepco’s checkered operating history.

A promise to bury power lines in the District of Columbia has already drawn favorable comments from outgoing Mayor Vincent Gray. And his replacement would almost certainly embrace thus move.

As for Pepco shareholders, Exelon’s cash offer of $27.25 per share would be the highest price the stock has fetched since prior to the 2008 stock market implosion.

We don’t expect any rival bids to jeopardize the deal. Prior to the announcement of Exelon’s proposed takeover, the risk to Pepco’s dividend was on the rise. Exelon’s offer also came out of a confidential bidding process that included Public Service Enterprise Group (NYSE: PEG).

If Pepco’s shareholders get too greedy and Exelon walks away, Pepco’s stock price would plummet to the mid-teens.

Should this deal succeed, the prospective return for holding Pepco is basically a year’s worth of dividends ($1.08 per share) plus capped appreciation to $27.25 per share. That meager take may induce some to sell now and avoid risk of the deal falling through.

As for Exelon, buying chronically underperforming Pepco at barely 1.5 times book value is a step toward restoring dividend growth in 2015–and adding to the stock’s impressive performance in 2014.

Thus far, our gains in Exelon reflect the company beating low expectations; going forward, any upside will come from the market coming around to the opportunities created by its acquisition of Pepco.