Why Exelon and FirstEnergy Are Sliding

What's driving down shares of utilities such as Exelon and FirstEnergy?

Jul 19, 2014 at 1:50PM

Shares of FirstEnergy (NYSE:FE) and Exelon (NYSE:EXC) have declined in the past month by more than 6% and 9%, respectively. If you're chalking it up to the U.S.'s plan to reduce carbon emissions by using less coal, which could lead to higher operating costs for utilities, then this reasoning doesn't hold up for Exelon. This company mostly uses nuclear power to generate electricity. So, let's consider the following factors that could be behind these companies' recent falls. 

Bullish market
As stated by a Foolish colleague, the recovery of the financial markets, including the S&P 500, is driving investors toward higher-risk assets and away from less risky assets such as utilities. If the bullish trend continues, investors are likely to look for growth companies and less for stocks offering high dividend yields and little to no growth in value. This also brings up another point: Will utilities' dividend yields remain high? 

Rise in debt and borrowing costs
The main draw of utilities is the high dividend yields they pay to their investors. But these companies aren't making enough to sustain the high dividend paychecks. In the first quarter, FirstEnergy's earnings per share reached $0.29, while its dividend per share was $0.36. Exelon's EPS reached only $0.1, while its dividend was $0.31 per share. 

Even these companies' operating cash flows don't cover the dividend payments. As a result, Exelon and FirstEnergy's debt levels increased in the past year by $0.5 billion and $1 billion, respectively. 

If their earnings don't pick up in the coming quarters, they are likely to slash their dividend payments again. Late last year, FirstEnergy reduced its dividend by 35%. Exelon also slashed its dividend payment by nearly 41% in early 2013. In such a case, these stocks will lose their appeal even further. 

The current market expectations are that the Federal Reserve may raise its interest rates by mid-2105. Such a change in policy is likely to lead to a slow rise in borrowing cost for companies, which will make borrowing cash less desirable for Exelon and FirstEnergy. 

Lower profit margins
Both companies use natural gas as one of their energy sources to generate electricity. For Exelon, natural gas accounts for 22% of its input; for FirstEnergy, natural gas is roughly 8% of its total fuel mix. During the first half of this year, the price of natural gas spiked to hover over the $4.5 mark. Further, during the second quarter of 2014, coal prices also rose by almost 5%, year over year. Coal accounts for 57% of FirstEnergy's fuel mix.  

The rise in energy prices could partly explain the drop in profitability of these companies, as indicated in the chart below.  

First Energy Profit Margin July

Source: Google Finance.

If natural gas and coal prices remain high, they could further cut the profit margins of these companies and make them less attractive as investments. 

The bottom line
FirstEnergy and Exelon haven't done well in the past several weeks, and as long as they don't show any significant improvement in their profit margins, and the bullish run in the equities market continues, these companies' stocks will keep losing their appeal, and investors will likely steer away. 

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Lior Cohen has no position in any stocks mentioned. The Motley Fool recommends Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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