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Exelon’s Dividend Disappointing, But Valuation Tempting

Summary Exelon has one of the largest retail customer bases among energy providers in the US. Though Exelon boasts a nice dividend yield, dividend growth investors have been disappointed and rightfully so. The firm is in the process of acquiring energy provider Pepco, a potentially lucrative move. Let’s take a look at Exelon’s recent performance and derive our fair value estimate for shares. By Paul Tait (click to enlarge) Exelon (NYSE: EXC ) is one of the US’ largest competitive energy providers and perhaps is best known for operating the largest nuclear fleet with over 19,000 megawatts (nearly enough energy to power 19 million homes). That’s incredible! No matter how much we like the company, however, its dividend payouts haven’t been electric in recent years, to say the least. We said Exelon’s dividend wasn’t on steady ground in the past, and we strongly encourage investors to not simply write off utilities’ dividends as safe . First Energy (NYSE: FE ) was another utility that cut its dividend, and Exelon’s Dividend Cushion ratio remains a lackluster 0.7 (anything less than 1 is unexciting). In recent news, Exelon is in the process of acquiring Washington, DC-based utility-holder Pepco. The deal would strengthen the firm’s hold on the mid-Atlantic utility market, and should the acquisition go through, Exelon would control nearly 80% of Maryland’s electric consumers. Critics are worried about price hikes, but that’s why investors like utilities in the first place: they’re legal monopolies. In this piece, let’s dig deeper into Exelon’s investment considerations and derive our fair value estimate of the firm’s stock price. Exelon’s Investment Considerations Investment Highlights • Exelon is a large competitive energy provider, with one of the largest retail customer bases in the US. It owns approximately 35,000 megawatts of power generation, including the nation’s largest nuclear fleet of more than 19,000 megawatts. It is also the US’ second-largest regulated distributor of electricity and gas. • Exelon is an important reminder as to why utility dividends aren’t always safe. Though many utilities boast regulated returns, their operations do not lend themselves to substantial financial flexibility. Credit quality will always take priority over dividend payments at key credit thresholds. The Dividend Cushion ratio considers both future free cash flows, the capital intensity of the business, as well as future cash dividend payments in coming to a comprehensive assessment. • The merger of Exelon and Constellation Energy has created one of the lowest-cost power generation fleets in the US. The tie-up offers opportunities for O&M synergies, portfolio optimization, and overhead savings. More than half of the combined company’s portfolio will be low-cost nuclear. Its acquisition of Pepco will further augment its presence. • Exelon recently slashed its dividend to a payout of $1.24 per year. Even after the cut, we don’t think the firm has strong dividend growth prospects. We’re not expecting increases anytime soon. Dividend growth investors are quite unforgiving. They may never come back to Exelon… ever again. Business Quality Economic Profit Analysis In our opinion, the best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Exelon’s 3-year historical return on invested capital (without goodwill) is 5.8%, which is below the estimate of its cost of capital of 7.9%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. Valuation Analysis This is the portion of our analysis that powers our opinion on a company’s shares. Below we outline our valuation assumptions and derive a fair value estimate. Our discounted cash flow model indicates that Exelon’s shares are worth between $30-$44 each. Shares are currently trading at ~$32, near the bottom of our fair value range. We feel there is more upside potential than downside risk associated with shares at this time. The margin of safety around our fair value estimate is driven by the firm’s LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $37 per share represents a price-to-earnings (P/E) ratio of about 19.7 times last year’s earnings and an implied EV/EBITDA multiple of about 9 times last year’s EBITDA. Our model reflects a compound annual revenue growth rate of -1% during the next five years, a pace that is lower than the firm’s 3-year historical compound annual growth rate of 13.2%. Our model reflects a 5-year projected average operating margin of 17.4%, which is above Exelon’s trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.8% for the next 15 years and 3% in perpetuity. For Exelon, we use a 7.9% weighted average cost of capital to discount future free cash flows. (click to enlarge) (click to enlarge) Margin of Safety Analysis Each fair value estimate we provide is flanked by a margin of safety, within which we feel a company is fairly valued. Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $37 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Exelon. We think the firm is attractive below $30 per share (the green line), but quite expensive above $44 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. Future Path of Fair Value We estimate Exelon’s fair value at this point in time to be about $37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm’s current share price with the path of Exelon’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change. The expected fair value of $44 per share in Year 3 represents our existing fair value per share of $37 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range. Wrapping Things Up We like what mergers have done for Exelon in the past — its merger with Constellation has helped create one of the lowest-cost power generation fleets in the US — and we like the potential acquisition of Pepco. If it passes the Washington, DC regulators, it would provide the firm with undeniable market presence and pricing power in the mid-Atlantic region. The company’s dividend prospects stand to benefit from the merger as well. Its dividend has been through a rough stretch in recent years, and cash flows will need to improve dramatically to help the situation. After disappointing dividend growth investors, the company will be working hard to regain their trust. All things considered, however, the company is worth keeping on the watch list in light of its valuation. It registers a 3 on the Valuentum Buying Index . (click to enlarge) Performance In the spirit of transparency, we show how the performance of the Valuentum Buying Index, our stock selection methodology, has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. To understand how we derive the VBI for each company, please download the pdf here . Past results are not a guarantee of future performance. Thank you for reading! (click to enlarge) 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.

Seeing The Forest Through The Trees; Timber ETFs

In the never ending search for new and interesting betas, perhaps few betas are as unique as that related to wood products. Perhaps apart from the occasional reality TV show, wood and industries related to it, aren’t the trendiest of products these days, but from snazzy car and home interiors, to humble old fashioned writing tablets and pizza boxes, wood, and its derivatives, everywhere one may look. Though the betas of wood ETFs may not be too far away from 1.0 on average ( WOOD ; 1.09, CUT ; 1.22), they may still perhaps supply a portfolio with an interesting route towards further diversification, and hence perhaps deserve a look. ________ Two of the most notable timber ETFs seem to be the surprisingly named WOOD and CUT. Though they are largely similar there seem to be certain qualities of each which make them slightly different from one another, but none the less interesting perhaps. _________ Apart from the year to date returns(price based); 1.86% for CUT, and 2.39% for WOOD, they also have different dividend based yield profiles per se, with W having a ~1.6% div. yield (according to Google finance), and C having a ~2.6 div yield. Apart from these sorts foreground, if one will, differences, the two ETFs also have different geographical allocations as far as their holdings’ are concerned. While Both have a US centric skew to their holdings, CUT seems to ultimately have a lesser percentage of its holdings invested in US based investments. One might argue that from largest to smallest position, WOOD also seems to be more concentrated(albeit slightly) in top holdings more so than CUT as well. These two ETFs share different subsector concentrations as one might expect, but before we get to that lets spice things up with an exciting picture of paper products. _______ For, though WOOD has so far held the crown in so far as skewness is concerned, CUT does show some more skewness in some regards, most specifically in so far as its subsector concentrations are concerned. For, though one may most often associate timber and wood products ETFs with a gentleman “leaping from tree to tree” in the forests of “British Columbia”, this death of the tree per se, is seemingly just the beginning of the flume ride if one will, that wood and its derivatives take through the world of industry. Image Source , Log Flume rides, soaking innocent bystanders at amusement parks since 1963 For when looking at these two wood ETFs one may notice that while WOOD is more concentrated in the paper products sector and “Reits”, presumably timber bearing land, with ~26% of said assets being held in said Reits, CUT seems to just sort of ” cut to the chase”; with a full 80 percent of its holdings specifically being in the “basic materials” subsector, presumably being wood or timberlands in general. Hence if one will it might be said that WOOD seems to be the more paper or wood derivatives centric of the 2 ETFs, with CUT being the more ” wood” centric of the two. Hence for the more specifically timber heavy play if one will, CUT might be the better ultimate choice, with WOOD being the favorite for paper products, etc. Hence perhaps the choice in between which of these two ETFs to allocate some cap., may come down to that age old discussion of wood vs. paper, and hence perhaps in a way perhaps they are, despite some broad overlap, somewhat complimentary. ______ Hence perhaps discussions of timber ETFs are also very much discussion of paper ETFs if one will. Ultimately whether one is looking for the felling of trees, or for some action regarding that semi-ancient medium of human writing etc., hopefully everyone’s investments are doing great, and everyone is having a good summer, and perhaps enjoying a log-flume ride or two, or whatever one chooses as a method to “beat the heat”. Thanks again for reading. ______ Prose of the post; an excerpt of lumberjack poetry; “spilling the fruit and chipping the bark, measuring, cutting into four by fours, and two by sixes,– numbering now instead of naming, until, even the complicitous apple was felled”

IWM’s 2015 2nd-Quarter Performance And Seasonality

Summary The iShares Russell 2000 ETF behaved better than the iShares Core S&P Small-Cap ETF did in the first half of the year. The former fund also performed better than the latter fund did in the second quarter. However, the converse was the case in June. The iShares Russell 2000 ETF (NYSEARCA: IWM ) and the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ) both recorded positive returns in the first half, Q2 and June based on their respective adjusted closing daily share prices, which is saying something in the current equity-market environment. IWM led IJR by 66 basis points in the first half as it ascended to $124.84 from $119.26, a climb of $5.58, or 4.68 percent. And IWM outdistanced IJR by 21 basis points in Q2 as it expanded to $124.84 from $124.37, a gain of 47 cents, or 0.38 percent. But the two ETFs switched roles in June, with IWM lagging IJR by -29 basis points as it grew to $124.84 from $123.89, an increase of 95 cents, or 0.77 percent. Comparisons of changes by percentages in IWM, IJR, the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ), the SPDR S&P 500 ETF (NYSEARCA: SPY ) and PowerShares QQQ (NASDAQ: QQQ ) during the first half, over Q2 and in June can be found in charts published in “SPY’s 2015 2nd-Quarter Performance And Seasonality.” Figure 1: History Of IJR And IWM Daily Share Prices (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing daily share prices at Yahoo Finance . Since IWM and IJR were launched May 26, 2000, there has been a perfect positive correlation coefficient between the adjusted closing daily share prices of the two ETFs, which is one reason I believe each is an excellent proxy for the small-capitalization segment of the U.S. equity market (Figure 1). Accordingly, I analyze data associated with both funds in the context of my Risky Business Daily Market Seismometer , as mentioned in “Assessing IWM With The Aid Of The U.S. Economic Index.” Of course, the ETFs are not identical but similar, as evidenced by their behaviors between their shared launch date and June 30, when IJR handily outpaced IWM by 102.54 percentage points. In this period, the fund based on the S&P 600 index rose 333.86 percent and the fund based on the Russell 2000 index rose 231.32 percent. As result, I think the ETFs’ differences are relatively trivial in terms of analysis and absolutely nontrivial in terms of their employment in an investing or trading portfolio. Overvaluation appears to be one characteristic currently shared by both funds’ underlying indexes. I note the Russell 2000’s price-to-earnings ratio on a trailing 12-month basis was calculated as 78.00 July 2, according to Birinyi Associates data published by The Wall Street Journal , and I point out the S&P 600’s valuation was discussed in “IJR’s 2015 2nd-Quarter Performance And Seasonality” here at Seeking Alpha. Figure 2: IWM Monthly Change, 2015 Vs. 2001-2014 Mean (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance . IWM behaved a little worse in the first half of this year than it did during the comparable periods in its initial 14 full years of existence based on the monthly means calculated by employing data associated with that historical time frame (Figure 2). The same data set shows the average year’s weakest quarter was the third, with an absolutely large negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Figure 3: IWM Monthly Change, 2015 Vs. 2001-2014 Median (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance. IWM performed a lot worse in the first half of this year than it did during the comparable periods in its initial 14 full years of existence based on the monthly means calculated by using data associated with that historical time frame (Figure 3). The same data set shows the average year’s weakest quarter was the third, with an absolutely large negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice. 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.