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Robert Abbott
Robert Abbott
Articles (848)  | Author's Website |

Exelon: Is It a Reasonable Bond Substitute?

This utility offers better than average profitability and a modestly undervalued stock price

September 18, 2020 | About:

Looking for a bond substitute in the form of a stock that's considered quite safe but paying a higher yield than bonds?

Exelon Corporation (NASDAQ:EXC) may be a fit, in my opinion. As a utility services holding company, it enjoys something of a monopoly thanks to regulators. As a utility with more than 10 million customers, it has a solid base. Additionally, because it operates six regulated utilities in Illinois, Pennsylvania, Maryland, New Jersey, Delaware and Washington, D.C., it is somewhat diversified.

According to its 10-K for 2019, its revenue is derived from two sources:

  • The regulated utilities.
  • Exelon Generation Company, LLC, a company that generates, delivers and markets power in competitive markets (the latter through another Exelon company, Constellation).

The company sees growth in both areas. On the regulated side, it expects to invest roughly $26 billion over the next four years in modernization and infrastructure improvements. That should lead to higher base rates in the future.

For the competitive energy businesses, it reports:

"Generation's long-term growth strategy is to ensure appropriate valuation of its generation assets, in part through public policy efforts, identify and capitalize on opportunities that provide generation to load matching as a means to provide stable earnings, and identify emerging technologies where strategic investments provide the option for significant future growth or influence in market development."

Financial strength

Exelon financial strength

A quick glance at the financial strength table tells us that Exelon has a lot of debt, and all but one of the metrics lag the industry. It also suffers in comparison to its own history.

However, this is an industry that runs on heavy capital investment, and investment capital is available because shareholders know that regulators have the utilities' backs. Still, comparing unfavorably to the competition isn't a good sign.

The interest coverage ratio is low by industry standards, with the industry having a median of 3.62, more than a full point above Exelon.

The Altman Z-Score is in the distress zone, but GuruFocus data shows this is not unusual for the industry.

More worrisome is that the weighted average cost of capital (WACC) is slightly higher than the return on invested capital (ROIC), indicating value deterioration.

In short, while Exelon receives a low financial strength rating, its metrics are comparable with those of the industry.

Profitability

Exelon profitability

The margins are in the middle of the industry pack and sufficient for the firm to generate a respectable return on equity (ROE) of 8.22%.

The three-year revenue growth rate of 1.5% is low and compares unfavorably with other industry players and Exelon's past history.

The Ebitda growth rate is four times as large, suggesting the company is becoming more efficient, and earnings per share have grown even more at an average of 35.5% per year over the past three years.

Valuation

Exelon GF Value

The GuruFocus system considers Exelon to be modestly undervalued, which is reasonable given it is closer to the most recent low than the most recent high.

We could reach the same verdict with the price-earnings of 13.14, which is slightly lower than the 10-year median of 14.38.

The PEG ratio suggests overvaluation, at 2.39, on a scale in which 1.0 equals fair valuation. This ratio is calculated by dividing the price-earnings ratio by the five-year Ebitda growth rate (which is 5.6%). Had the growth rate been higher, or the price-earnings ratio lower, the PEG ratio would have been closer to fairly-valued.

Because Exelon has only a 1 out of 5 predictability rating, a discounted cash flow (DCF) analysis is not expected to be reliable.

Dividend and share buybacks

Exelon dividend

For many investors, the dividends will be the focal point. The current yield is 4.19% and we can expect it to go higher; in the second-quarter report, Exelon promised annual dividend growth of 5%. It has been close to that over the past three years, with average dividend growth of 4.7%.

The dividend payout ratio is 55%, meaning there is still some room to raise it for dividends or share buybacks.

The forward dividend yield of 4.25% is slightly higher than the trailing 12-months yield of 4.19% because of an increase in February, from $0.3625 per quarter to $0.3865.

Looking forward, the five-year yield-on-cost is 4.93%. That's what investors can expect if they buy and hold the stock for the next five years and management increases the dividend at the same rate as it has for the past five years.

Shareholders expecting a boost from share buybacks will be disappointed. Exelon has a negative ratio on repurchases, meaning it has been issuing more shares than it has bought back. The average diluted share count has crept up, according to the 2019 10K and second-quarter earnings report:

  • 2017: 949 million
  • 2018: 969 million
  • 2019: 974 million
  • 2020 (anticipated): 977 million.

Gurus

When the Exelon share price dropped with the rest of the market this spring, the investing gurus went on a buying spree; since then they've shown considerably less interest:

Exelon guru buys and sells

Twelve gurus have holdings in the stock; Barrow, Hanley, Mewhinney & Strauss held 14,764,742 shares at the end of the second quarter for a 1.52% stake in the company, representing 2.10% of its own assets. During the quarter it added 1.07%.

Pioneer Investments (Trades, Portfolio) owned 2,411,283 shares after adding 35.18% during the quarter. Sarah Ketterer (Trades, Portfolio) of Causeway Capital Management held 1,186,592 shares after reducing her holding by 11.96%.

Conclusion

There are several reasons to think of Exelon as a substitute for a corporate or government bond. Despite its low metrics for debt and revenue, they are comparable with the data for other players in the Utilities-Regulated industry. Its profitability is good and its valuation is reasonable.

The dividend, at more than 4%, is much better than that of any reasonable bond, and the company intends to keep growing it. There's no reason it can't; with robust margins and a payout ratio of 55%, there is cash and there is room.

Therefore, I think income investors may wish to put Exelon on their shortlists. Value investors will likely shy away because of the debt and a share price that is not compelling. Growth investors may see the current low price as an entry opportunity, but generally, slow-and-safe utilities are not the stocks for them.

Disclosure: I do not own shares in any of the companies named in this article.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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