I should confess that the longer I invest in stocks, the more risk adverse I am becoming. However, I don’t feel like this is necessarily a bad thing – as the portfolio size and value grows, naturally there will be a greater incentive to preserve capital. In this case, I need to insure that the passive income stream is sustainable long-term.
Recently, a holding of mine has been under siege, seeing its shares plummet substantially in the last few weeks (down over 13% since October 31). I first started investing in Exelon (EXC), one of the largest utility companies in the USA, in February of 2012. At the time, I was looking for entry into a utility and felt that most of the other options (DUK, SO, ED, PCG, etc.) were overpriced.
First off, why invest in a utility? There are many good reasons, but in general:
- Utilities are sort of like monopolies. They are usually the only game in town, so their client base really has no other alternative. In a way, they are able to geographically tie down their customers, locking in a secure revenue stream. There is a huge barrier to entry, as an enormous amount of capital and infrastructure is required. Thus, it would be extremely difficult/unlikely for a new competitor to emerge from out of the blue.
- Hot water, electricity and a working stove are basic human necessities. Everyone needs these services, plain and simple.
- Traditionally, utilities have been viewed as “widow and orphan” stocks. These holdings should be so safe and secure that you could count on being able to leave the shares behind for future generations, such as for your children, and grand-children. The dividends/income stream, traditionally, have also been secure.
- EXC is a huge company. It has operations in 47 states, D.C. and Canada. EXC has a generating capacity of 34,650 megawatts, and service territory stretching over 15,000 miles. In other words, EXC should be too big to fail!
- EXC is focused on clean energy. Whereas other utility companies like Southern Company (SO) generate upwards of 52% of their energy from coal, EXC relies more on nuclear (55%) and natural gas (28%). The Clean Air Act requires energy companies to reduce harmful environmental pollutants such as CO2, so EXC is ahead of its peers in this regard, and well positioned for the future.
- The stock was cheap. Trailing P/E and forward P/E were both low. Natural gas prices were falling to historic lows, but obviously, things wouldn’t always be this bad. Prices would eventually rise and recover. This led me to believe that EXC was a good value play. I thought that it was at/close to the bottom.
- The 6% yield was too enticing to pass up. Most utility companies pay around 4% to 5%. However, with eroding earnings, a weak balance sheet, and minimal free cash flow, I should have done more research to see if the dividend payouts would be sustainable long-term.
- Utility companies had a nice run-up in 2011, and some even continued their ascent well into 2012, routinely setting new marks for 52 week highs. EXC appeared to be the best bargain out of the lot.
EXC had a tremendous run-up from 2003-2008, seeing its shares peak at around $90/share. It was probably the darling of utility companies during that 5 year span. However, it has been trending downhill ever since, which is what made it immediately stand out in my eyes as a potential “value play”. It turned out to be a “value trap” for the following reasons:
- The dividend has been held static since 2008. The payout each quarter has been fixed at $0.525/share. And although the yield remains high, there’s usually a “good” reason why a company chooses to freeze its dividend. It’s usually because things are not good!
- With decreasing earnings and net income, the dividend payout ratio had no choice but to balloon upwards. 60% to 70% payout is about typical for a utility. EXC was slowly but surely encroaching into danger zone. A dividend cut was all but confirmed in the latest Q3 conference call, when CEO Christopher Crane hinted that the payout ratio/dividend yield was currently too high, “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”. EXC could potentially be forced to cut their dividend in order to maintain an investment grade credit rating.
- Just a quick glance at the EPS over the last 4 years would reveal an obvious, negative trend:
Where do we stand?
What are my options? EXC appears to be a sinking ship at the moment, but is it time to sell? Have the fundamentals changed? Or is the market simply over-reacting? Well, for starters…
- EXC isn’t going bankrupt. It’s the largest competitive power generator in the U.S. It’s customers aren’t exactly fleeing in droves to a competitor either. Were this a tech stock, I would probably be more inclined to hit the panic button and sell. But going back to one of the original reasons why I wanted a utility in the first place – EXC is a monopoly! It provides a basic human need, it has a huge customer base, and it is still basically too big to fail!
- Mergers typically take some time to digest before the new entity can fully reap the benefits. The Constellation deal should pay off in the long run.
- Energy prices will not be depressed forever. Natural gas prices will rise. These unusual, warm winters are more like flukes that won’t come around every year.
- The CEO said they need about six months to determine if the dividend will be sustainable. Until then, it’s just noise and speculation.
I’m a long term investor, so short term news doesn’t trouble me so much. I chose to invest in EXC because I wanted a large utility company that would be around for a long time. I still believe EXC will fulfill these requirements. I also knew going in that the short term growth would be slow, since earnings were falling and the dividend growth was zero.
In hindsight, I should have picked a higher quality utility company that featured a best-in-class management team. By choosing to invest in EXC, I am siding with a company that needs a lot of time to recover. As a result, my capital is tied to a non-dividend growth stock. I’ve learned from this experience how important dividend growth is to my fundamental strategy for investing!
What to do now?
In terms of immediate strategy, I don’t think it would be a wise decision to add more shares, since I feel like a dividend cut will be imminent in the next few quarters (the dividend yield is quickly -> 7%). Since the dividend hasn’t been officially cut, the shares cannot have bottomed out yet. The bad news isn’t baked into the price, and EXC shares will plummet further if/when the official announcement is made. There’s also the fear of “catching a falling knife” by buying more too soon.
Further, I don’t have that much confidence in EXC’s current management team. To keep investing in this company would suggest that I know of of no better companies to put my faith and hard earned capital into. This is simply not true.
I also don’t feel like now would be the best time to sell either. The market has overreacted to the short-term bad news and EXC has been oversold as result. The price should rebound a bit once the trading volatility normalizes to a more typical volume. Baring any more bad news, a better selling point should be attainable in the near future.
Moreover, the next dividend payout in December has already been announced, which is unchanged, so, I’ll just sit back and collect my 6% YOC dividend for the time being. The stock price is dropping, but I don’t really care. My dividends have yet to be affected, and ultimately that’s what I care most about.
The best play may be to hedge the investment by selling some shares of EXC and redeploying the capital elsewhere. At this time of writing, the utilities sector as a whole has been hit hard post-election. Some quality companies like DUK and SO are reaching 52 week lows. I will continue to HOLD and MONITOR, but may very well swap out some shares of EXC for a higher quality alternative.
Lastly, EXC shares could rise from its bottom if the next few quarters roll by and a dividend cut is not announced. This could very well happen if power prices do pick up, which seems likely. Power prices are expected to rise between $3-$6 in 2015/2016. The expected rise is not yet priced into the futures market, which EXC needs to hedge its prices.
With President Obama back at the helm, the shift away from coal-fired generation should be back in full swing (a record 57 generators are scheduled to be retired in 2012). If EXC can just get through this rough period, it should be ok in the long run.
Next time, I’ll try and do better than just ok.