The phrase "defense wins championships" is thrown around quite often in sports but what about the in investment universe? Slow, stable growth tends to be the hallmark of defensive stocks with their total return augmented by high dividend yields that are made possible by consistent cash flows from a commoditized product. When thinking about defensive sectors, utilities immediately come to mind, along with health care and consumer staples.
What makes utilities a commoditized product in the United States? The fact that developed nations cannot run without a reliable supply of electricity certainly helps, and the United States is no exception. And because a megawatt of electricity equals a megawatt of electricity regardless of where it is produced, the only differentiating factors are the cost to produce it and its distance from the end user. That is why the sharpest run, lowest cost domestic utilities have been considered beneficial long-term investments for quite some time.
Qualitatively, Exelon (NYSE:EXC) is one of the finest companies in the utility business. It offers a clean, diverse generation portfolio, including the largest nuclear fleet in the U.S. and a growing renewable generation segment (hydro, solar, and wind). After its merger with Constellation Energy, it became the second-largest utility by customer base in the country, trailing only Duke Energy (NYSE:DUK) after its merger with Progress Energy. This large customer base is also geographically diverse, ranging from Illinois and Ohio to Pennsylvania and Maryland. These generation and customer portfolios provide great stability due to the lack of heavy reliance on any one area.
So why are EXC shares trading near their 52-week low? Well, aside from the utility sector, as a whole, underperforming the broad market lately, dividend reduction rumors at Exelon that surfaced recently helped drive its price down to multiples well below those of its peers. This article will attempt to examine this issue more closely in an exercise to prove that Exelon is valuable quantitatively as well, and that it is indeed undervalued in its peer group, providing a potentially ripe buying opportunity.
Trading at Black Friday price discounts
When analyzing some of the largest utility companies in the U.S. market (minimum market capitalization of $14 billion), Exelon stands out as a cheaply traded, efficiently run company with myriad strategic advantages. Upon looking at Exelon's share price from both a price-to-earnings and price-to-book angle, shares of this utility can be had cheaper than many of its closest peers:
Generally, when a stock is trading at a discount to its peers, there tends to be an obvious reason why. One would be hard-pressed to find reason enough for EXC to be trading at such discounted price multiples in a continued comparison with this peer group. In the utility sector, several fundamentals are considered important when conducting a peer comparison: dividend yield and balance sheet strength in the form of financial leverage and interest coverage. Each of these issues are examined more closely below.
Making the dividend a priority
After releasing its third-quarter results for the 2012 calendar year, Exelon management hinted at the possibility that it might need to trim its dividend in order to maintain its current credit profile and ratings. Following this announcement, shares were quickly sold off as investors feared that the total return advantages of Exelon, made possible by its industry-leading dividend, would take a hit. After seeing a recent presentation from EXC at the Edison Electric Institute Financial Conference earlier this month, I believe those fears will soon be assuaged.
Protecting the dividend, while maintaining an investment grade rating, is now a top priority of the company. In order to achieve this, management plans to keenly focus on cost management, achieving greater financial flexibility and deferring certain growth projects to align with "expected market recovery." Combining these strategies with effectively achieving synergies from its merger with Constellation Energy in a timely fashion will go a long way toward keeping income-oriented investors in the game.
Balancing on the capital structure high wire
Maintaining a rock-solid, manageable balance sheet is a sign of effective leadership and provides comfort to shareholders about the competitive longevity of the organization. Overextending exposure to the debt markets can severely restrict management's ability to effectively utilize cash for growth initiatives and for shareholder wealth creation through dividend payments and share buybacks. Even in a low interest rate environment like we are in right now, interest payments can add up and can require additional debt offerings or shareholder dilution through subsequent equity issuances to pay for them. Analyzing some key balance sheet metrics of Exelon and its peers indicates that it is in an admirable position in terms of financial leverage and solvency.
Taylor Muckerman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend 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.