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Invest In Utilities Since The Fed Remains Dovish

Summary Utility stocks are often discarded as boring but provide stable income through dividends. The Fed decided not to raise interest rates in their September meeting but indicate by the end of the year would be appropriate. Utilities should be held in a diversified portfolio as an alternative to long duration bonds. This was supposed to be the month. The first time since 2006 the Fed raised interest rates. It turned out to be another case of the Fed getting cold feet. After all, the rest of the world’s central banks continue with their easy monetary policy. The case has been made that 25 basis points won’t make a difference so why not raise rates? On the other side of the argument, if 25 basis points doesn’t make a difference, why risk blowing up the stock market over it? The Fed’s statement was dovish indicating that we could continue to see interest rates held near zero into next year. The market believes the Fed will not move this year as indicated by Bloomberg’s world interest rate probability monitor. Bloomberg currently shows the market indicating an 18% probability of a rate increase in October and 43% of an increase in December. These figures were at 44% and 64% respectively prior to the Fed meeting earlier this month. Yellen gave a speech last week stating she still believes it would be appropriate to raise rates by the end of the year. If the Fed is in fact data dependent, what will change in the next two and a half months in the data that will significantly change the Fed’s view that it’s time for liftoff? The answer is nothing. So investors continue on with no clarity from the Fed. The Fed presidents meet and decide not to raise rates and then the next week give speeches indicating that a rate increase would be appropriate. It makes no sense. Why utilities make sense now This confusion over the Fed lead me to the utility sector. The dividend yield of the S&P 500 Utilities index is currently 3.66% versus the 30 year treasury yield at 2.96%. That’s an extra 70 basis points in yield for holding utilities for just one year as compared to holding the treasury for 30 years. This is not a new trade as utility yields have been relatively attractive for some time. Utilities provide stable income for portfolios as they tend to trade more like bonds but I see less downside risk for utility stocks if the Fed were to raise rates. My thought is as rates increase, the cost of capital used for stock valuation will also increase which will lower stock prices. The safety of utilities will be a safe bet for stock investors as volatility increases around the rate increase. Stock investors will seek the stability of utilities which would increase the value of the sector and it should outperform. On the other side, if the Fed continues to keep rates low into next year, utilities provide a relatively decent yield as compared to bonds and much better than leaving money in the bank to lose value in real terms after factoring in inflation. Even if the Fed does raise rates, they have indicated the pace will be slow. Utility Index ETF’s provide better diversification An easy way to add utility exposure is to buy a utility index ETF such as (NYSEARCA: VPU ), (NYSEARCA: IDU ), or (NYSEARCA: XLU ). These funds provide exposure to the respective index the ETF tracks which pay around a 3.6% dividend yield (each fund yield is slightly different depending on holdings). Using an ETF is also an easy way to diversify your utility holdings so you don’t have concentrated exposure to one utility in case there are problems. There are many regulatory factors to consider with individual utility companies and the states they operate in. The capital structure of these companies and their subsidiaries can be pretty complicated as well. If you don’t have the time and patience to take a deep dive into an individual stock, then an ETF would be the way to go. PEG looks relatively attractive Looking at the relative value metrics of the utility sector and the stock that stands out to me is Public Service Enterprise Group (NYSE: PEG ). While PEG does not pay the highest dividend yield, the P/E and EV/EBITDA ratios are below the sector average. An important consideration for a utility is the dividend coverage ratio. PEG has a coverage ratio of 1.75x which is above the average of 1.42x. This is a direct result of the lower debt profile of PEG. With less income going towards interest payments and debt, this leaves more cash flow available for equity. The utility industry is characterized by high debt loads due to the considerable size of the capital expenditures required to maintain their plant assets. PEG has one of the most attractive debt profiles with just 26% total debt to assets and 69% debt to equity. Name Mkt Cap – USD EV/TTM EBITDA EV/EBITDA FY1 P/E Dividend Yield Average 26.02B 8.78 9.01 15.59 3.98% DUKE ENERGY CORP (NYSE: DUK ) 48.67 8.62 9.54 17.35 4.54% NEXTERA ENERGY INC (NYSE: NEE ) 45.41 9.27 10.13 17.96 3.08% DOMINION RESOURCES INC (NYSE: D ) 41.64 13.85 12.4 20.14 3.63% SOUTHERN CO/THE (NYSE: SO ) 40.09 10.97 9.88 16.22 4.84% AMERICAN ELECTRIC POWER (NYSE: AEP ) 27.47 8.67 8.68 15.37 3.79% P G & E CORP (NYSE: PCG ) 25.89 8.74 8.25 13.46 3.44% EXELON CORP (NYSE: EXC ) 25.42 5.81 7.37 10.93 4.20% PUBLIC SERVICE ENTERPRI 20.69 6.33 7.23 14.19 3.77% Source: Data from Bloomberg Conclusion While the Fed keeps investors confused about the timing of the first interest rate increase, it makes sense to remain defensive with portfolios. Lower inflation due to cheap oil means the Fed will be slow with the interest rate hike. Dividend paying utilities seem to be a better play versus other stock sectors as the stable income provides some downside protection while being a more attractive option to long duration bonds.

Why Exelon Remains A Buy

Summary EXC has increased its presence in the regulated segment, with a focus on acquisitions. The EPA’s decision works in favor of Exelon. The company has a low valuation and good performance with a regular dividend payout. I have long been bullish on Exelon Corp. (NYSE: EXC ) given its clean energy portfolio, major presence in the U.S. utility market, low valuation, and dividend growth. The company has a market capitalization value of $27 billion and delivered revenues of approximately $27.4 billion in 2014. The company is engaged in the production, sales, and transmission of energy. The stock declined in line with other large U.S. utilities like Southern Company (NYSE: SO ), Dominion Resources (NYSE: D ), and Duke Energy (NYSE: DUK ). However, what gives EXC an edge when compared to the other utilities is its large fleet of green assets. Exelon Nuclear operates the largest nuclear fleet in the nation and the third largest fleet in the world. With the utility industry coming under increasing EPA pressure to reduce carbon emissions, EXC is set to outperform as its nuclear plants emit zero greenhouse gases. Furthermore, the company’s focus on regulated markets, its increased infrastructure improvements, increasing renewable energy asset base, and low valuation make it a buy in my view. Why I Like Exelon 1. Large, Clean Asset Base — The company operates a large low-cost and low-carbon generation fleet across the U.S. Exelon owns more than 35 GW of power generating capacity with less than 10% of its capacity coming from thermal power plants. The other utility companies are predominantly dependent on coal for their power generation. What I like about Exelon is its large clean asset base, which in my view is one of the biggest strengths of the company. It has one of the largest portfolios of solar and wind energy farms. Other than its large nuclear energy fleet, the company also owns and operates the following: More than 1.2 GW of the wind energy portfolio Exelon City Solar, the largest urban solar installation in the United States Four hydroelectric power plants 2. EPA Decision Taxing on Dirty Coal — The U.S. has already finalized its clean power plan , which focuses on cutting carbon emission from power plants. By 2030, the clean power plan will reduce carbon emissions by 32% below 2005 levels. All 50 states have utilities working toward establishing a cleaner and efficient power system using renewable energy. This decision by the EPA will be problematic for utilities relying on coal for their power production. 3. Good Dividend Yield — The company declared a regular quarterly dividend of 31 cents per share. Utility stock owners are mostly interested in a high, stable and growing dividend yield. Utilities attract investors for their stable dividend. If utilities’ stock prices fall, the dividend yield goes up. EXC has a dividend yield of 4.18%. 4. Focus on Regulated Markets — In the wake to overcome current weakness in the energy market, the company is slowly shifting its focus toward the more regulated segment of the market. The company has plans to invest $15 billion in BGE, ComEd and PECO (Exelon’s utilities) between 2014 and 2018. This will ensure stable earnings. Exelon is also expanding its footprint in the natural gas business. The company acquired Integrys Energy Group , with regulated natural gas and electric utility operations. 5. Lower Valuation — EXC stock has a P/B of 1.2x and P/S of 0.9x , which is lower than the industry average of 1.7x and 1.3x, respectively. The lower valuations are due to its lower operating ratios, compared to the general utility industry. Its operating margin at 15.5% is lower than industry average at 21.6%, while its net margin at 7.9% is also lower than the average. The reason for the lower margins is the company’s dependence on wholesale markets where prices have been low over the past few years. Its nuclear power plants have suffered from the low prices. The valuation multiples are also lower than the bigger utility companies. Market Cap ($ billions) P/S P/B Exelon 27 0.9 1.2 Dominion Resources 41.3 3.4 3.3 Duke Energy 48 2.1 1.2 Southern Co. 39.5 2.2 2 Source: Figures from Morningstar. 6. Good Recent Quarter Performance — The company reported a quarterly EPS of 59 cents per share, exceeding its guidance for Q2 2015. The company expects Q3 2015 earnings of $0.65 to $0.75 per share and has narrowed its full-year guidance range from $2.25 to $2.55 per share to $2.35 to $2.55 per share. Exelon has shown considerable improvement across all segments in quarterly revenues and net income when compared to Q2 2014, as can be seen below. (click to enlarge) (Note: Figures in millions.) 7. Exelon & Pepco Merger — In April 2014, Exelon announced its merger with Pepco Holdings, Inc. (NYSE: POM ) in an all-cash transaction. This would have led to the emergence of a leading Mid-Atlantic electric and gas utility. This was a good move by Exelon, as it would expand its regulated holdings and thus strengthen its earnings stability. It was a win-win situation for both companies. This merger recently faced heat from D.C. regulators. However, the companies will appeal the decision and analysts believe there is a 50-50 chance of the merger taking place. I think the merger should go through given its financial benefits for customers . Risks — Nuclear Base Risk While nuclear energy has its advantages in the form of no carbon emissions and low costs, it is still facing a lot of criticism worldwide given its danger of radiation accidents. However, Japan has recently restarted its nuclear power four years after Fukushima. Exelon spends nearly $1 billion annually on its nuclear plants to keep them operating safely and reliably. — Increasing Bond Yields Utility stocks can lose their attraction to yield investors as long-term bond yields rise. With the Federal Reserve expected to raise interest rates this year, bond yields are likely to increase. This will pressurize utility stocks that have benefited from the zero rate interest environment in the past few years. Stock Performance The stock is currently trading at $31.5, which is higher than its 52- week low. The company has a market capitalization value of more than $27 billion. The stock has lost 17% of its value since 2015 . Conclusion Exelon will benefit from the increasing demand for clean electricity in the near future. Though the company is facing various economic challenges in the form of low natural gas and power prices, it is trying to cover up its weaknesses through investments and M&A opportunities. The new EPA rules will improve EXC’s competitive position as compared to other utilities. I remain bullish on the stock given its growing commitments in the regulated markets, its large, clean asset base, its low valuation, and its good dividend yield. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.