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Summary EXC has a low beta which will help during potential market downturns. EXC underfunded pension liability offers a “negative earnings duration” which will benefit from rising rate environment. Forward dividend yield of 4.48% is supported by large dividend coverage ratio. Common shares are selling at a discount compared to historical valuations and peer group. Exelon Corp. (NYSE: EXC ) is a utility services holding company engaged in the energy generation and delivery business through its segments, Generation ComEd, PECO and BGE. According to the company’s website : Exelon’s family of companies represents every stage of the energy value chain. Exelon Generation is one of the largest competitive United States power generators, with approximately 32,000 megawatts of owned capacity comprising one of the nation’s cleanest, lowest-cost power generation fleets. Constellation provides energy products and services to more than 2 million residential, public sector and business customers, including more than two-thirds of the Fortune 100. And Exelon’s three utilities deliver electricity and natural gas to more than 7.8 million customers in central Maryland (BGE), northern Illinois (ComEd) and southeastern Pennsylvania (PECO).” Every day, we hear news about an impending stock market decline and an increase in interest rates. It was under this pretense that I went searching for companies that provide protection in both a rising interest rate environment and low beta stocks which could spare my portfolio in the event of a downturn. Low Beta The beta of a stock represents the systematic (market) risk of a company. When the beta is positive, the stock prices tend to move in the same direction as the market, and the magnitude of the Beta tells by how much. A stock beta greater than 1 implies that when the market goes up by 1%, we expect the stock to go up by more than 1% – the opposite is true if the market goes down by 1%. Utility companies are considered “Defensive” stocks because they typically have steady cash flows, attractive dividend yields and lower-than-average betas. Exelon is considered a “Diversified Utilities” company and has a lower-than-average beta of .24, compared to an average beta of .48 for all the “Diversified Utility” companies in the Russell 3000. All else being equal, we would expect to outperform its peer group in the event of a market downturn. Negative Earnings Duration What makes this sector especially enticing is that most of the firms have underfunded pensions, which represents a liability on the balance sheet. While that sounds ominous, it is quite common for older companies with pensions given the large amount of baby-boomers retiring today. In order to calculate the magnitude of the underfunded pension, you need to project out the future pension payments and discount them back at a specified rate of return, typically tied to the current interest rates. The difference in the pension liabilities is added or subtracted from earnings, depending on whether the liability is becoming smaller or larger. I like to call this “negative earnings duration” because the liability becomes smaller when you increase the discount rate (denominator). Duration measures the fall in price of a security given a 1% (parallel) rise in interest rates. In fixed income terms, we can say EXC has a negative earnings duration because earnings rise in a rising rate due the reduction in pension liability. Increasing interest rates reduce pension liabilities and increase earnings, all else equal. A quick glance at the magnitude of underfunded pensions in this sector makes EXC standout as an EPS beneficiary in a rising rate environment, given the size of its pension liability. On the Q3 conference call, Exelon management mentioned that every .25% rise in interest rates will lead to a .02 EPS increase. (click to enlarge) EXC selling at a discount compared to historical valuations and peer group Currently, EXC is selling below its 3 and 5 year price/earnings multiples, which could imply future mean reversion. Diversified utility companies typically have predictable cash flows and earnings due to the nature of the business and their hedging strategies. The charts below highlight the current PE multiple compared to its 3- and 5-year median as well as EXC quarterly earnings compared to analyst estimates. As expected, the actual earnings tend to oscillate around the estimates. (click to enlarge) (click to enlarge) Compared to its peer group, Exelon is selling at a discount by a nice margin based on PE multiples which implied that it is cheaper to own per share of earnings compared to its peer group: (click to enlarge) Dividend Coverage and Valuation Investors look to the utilities sector for dividends and EXC has not disappointed. The company has paid dividends consistently over the last 10 years and sports a healthy dividend coverage ratio. Dividend Cover is calculated by EPS/Common Dividends. For companies such as Exelon that are known to consistently pay dividends, taking a look at the dividend coverage ratio can be an effective way to see if dividend payments are being harder to make over time. Currently, dividend coverage is 1.816, which is healthy from historical perspective and makes the current dividend yield of 4.49% all the more attractive: (click to enlarge) When valuing EXC, we can look at the historical price earnings and price sales ratios for Exelon and its peer group over the last 20 years. From there, we can use the 2015 estimates for earnings and sales to derive a price for each and average the two together: Historical PE Multiple for EXC and Peer Group Average Median Blend 2015 EXC EPS estimate Price 1995-Present 22.9 16.2 19.55 2.5 48.875 Historical PS Multiple for EXC and Peer Group Average Median Blend 2015 EXC sales per share Price 1995-Present 1.5 1.23 1.365 28.11 38.37015 Source: Ycharts Blended price based on PS and PE 43.6258 Based on historical analysis, an intrinsic value of $43.62 represents a 58% upside from the current price ~$27.5 per share. Given EXC’s dividend coverage, low beta, (-) earnings duration and discount valuation, I believe it is a buy at these levels. Scalper1 News
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