Utility stocks have remained popular among dividend-hunting investors as they offer attractive yields. Exelon (NYSE:EXC) is among the leading utility companies in the U.S., with exposure to both regulated and unregulated operations, and offers a yield of 3.5%. The company has announced plans to acquire Pepco (UNKNOWN:POM.DL) to increase the exposure to regulated operations and to lower earnings uncertainty.
Utilities, including Exelon and Duke Energy (NYSE:DUK), have been taking measures to increase their regulated business exposure, as the earnings and cash flows of unregulated operations remain weak and volatile because of uncertain forward-power prices, which are determined through auctions. Mergers and acquisitions, long-term price contracts and the sale of unregulated generation assets are the various options being considered by companies to reduce unregulated operations exposure.
Exelon's performance in recent years has remained challenged because of weakness in commodity and forward power prices, which put pressure on margins and cash flows and resulted in volatile earnings. As a result of the weakness in the unregulated power market, Exelon slashed its dividends by more than 40% in the first quarter of 2013.
Exelon has announced its plans to acquire Pepco for $6.8 billion at a share price of $27.25 in an all-cash transaction. The transaction is to be financed with 50% debt, with the remainder to be financed through the sale of noncore assets and equity. The proposed transaction is subject to shareholder and regulatory approval. Exelon and Pepco expect the transaction to close in the second or third quarter of 2015.
The acquisition will help Exelon increase its regulated operations; earnings contribution of regulated operations will increase to 60%-65% from the current level of 55%-60%. The company's management disclosed that it does not have any specific target for the level of contribution to earnings from regulated operations. As Exelon's exposure to regulated operations will increase, it will provide more revenues, earnings, and cash flow stability. Also, the increase in regulated exposure will help the company lower its risk profile and will augur well for the stock valuation.
Benefits of synergy
The geographically close operations and Mid-Atlantic presence of both Pepco and Exelon will also result in cost savings. Exelon expects the transaction to be immediately accretive to earnings and is expecting $0.15-$0.20 accretive to earnings post-2016. Also, the company expects to realize net synergies of $250 million over the first five years, with 40% to be retained by the company. As Exelon has extracted a lot of synergies from its operations post the Exelon-Constellation merger in 2012, now most of the savings will be derived through a reduction in Pepco's operational and maintenance (O&M) expenses.
Also, Exelon's regulated rate base growth will improve in the future as a result of Pepco's acquisition; Pepco has an attractive regulated rate base growth of almost 8% per annum through 2018. The acquisition will add Pepco's $8.3 million rate base to Exelon's regulated rate base; Exelon has already planned to spend $15 billion on its regulated operations over the next five years. The transaction will increase Exelon's regulated rate base, will provide earnings growth, and will ensure earnings and cash flow stability.
Duke Energy also has plans to exit from the unregulated power market in efforts to lower earnings volatility, and is considering the sale of its competitive power assets. In the first quarter of 2014, Duke took a $1.4 billion impairment charge in relation to the sale of competitive power assets in the Midwest. The sale of competitive assets is likely to result in proceeds of more than $2 billion. The sale proceeds will be used by Duke to either buy back common shares or repay debt, which will augur well for EPS growth in the future.
The sale of competitive assets will increase Duke's exposure to regulated operations, and lower earnings volatility. Also, as Duke is focused more on its regulated operations, it plans to accelerate regulated capital spending starting from 2015 through 2018. Duke anticipates regulated rate base growth to increase to 6% in the second half of the decade, up from the current rate base growth of 4%.
Exelon's planned acquisition of Pepco will allow the company to increase its revenue stability and reduce volatility in earnings and cash flows. The transaction will also improve Exelon's dividend stability, which in the past has remained questionable. Exelon will also benefit from net synergies, which will be accretive to EPS in the future. Moreover, the company's risk profile will improve as a result of increased regulated business operations.