Four Numbers Say This Dividend Is in Trouble

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you believe there is a dividend bubble in the market, look no further than the utilities industry. With companies regularly selling for two, three, or more times their expected growth rates, investors are asking a lot of this stodgy business. I know that these stocks appear to offer a better income stream than CDs or safer investments, but I fear for investors when short-term rates eventually rise. I realize it might be a while before this happens, but do you think investors would be willing to pay 15 times earnings for a company like Southern Co (NYSE: SO) if they could get the same type of yield in a CD?

It wasn't that many years ago that a five year CD paid better than 5%, and when those rates come back, these stocks could see investors flee at an alarming rate. What is really a shame is when investors are caught unaware and a utility decides to cut its dividend. What is even worse is when investors buy more even after management has tipped its hat that the dividend is in trouble. That is the situation at Exelon (NYSE: EXC).

To be fair, I owned Exelon for a time. I saw a stock with a yield of about 5.75% and the company was making positive acquisitions as well. I probably was blinded by the fact that Exelon was acquiring Constellation, which owns BG&E. Since BG&E is my electric company, I figured what better buy than a company I would be paying for my electric bill. However, I missed some obvious signs of problems at the company. When management tanked the stock by suggesting the dividend could be in trouble I didn't hesitate, and I sold my shares. I did take a small loss, but those hanging on right now are staring an even bigger loss right in the face. Looking at the company's last earnings report showed me at least four reasons this dividend is potentially in trouble.

There is no way around the fact that a company with a low margin has to work harder to make money than competitors with higher margins. While Exelon could be considered a turnaround play based on this factor, I believe buying this stock as a turnaround candidate is premature. Even if you can get past the fact that Exelon saw net income drop by 11.44% in the current quarter, what's worse are the reasons behind why the company's earnings dropped. Exelon listed virtually everything they could to explain why they had problems; whether it was higher nuclear fuel costs or higher operating expenses and maintenance expenses, everything went wrong. What was even more disconcerting was that the number of unplanned outage days during the quarter came in at 40 days versus just three last year. What this did was effectively kill the company's operating margin.

With an operating margin of just 9.19%, the company lagged every competitor I thought of. From Southern Co's operating margin of 34.46% to Duke Energy (NYSE: DUK) at 16.04%, Exelon just doesn't measure up. Even smaller players like Integrys (NYSE: TEG) showed a better margin at 11.66%, and they have multiple advantage over Exelon. What investors need to remember is a lower margin affects cash flow, and this is clear looking at Exelon's cash flow in the last several months.

In fact, Exelon reported negative free cash flow over the last nine months. While it's true that Duke Energy and Southern Co have run into challenges with negative free cash flow in the past, each of these companies has seen an improvement in their free cash flow in the last quarter or so. Integrys has been a strong performer when it comes to free cash flow as well, except in the current quarter where they invested for future growth. Let's face it, negative free cash flow for an established company is never a good thing. What this does is causes the company to access the debt markets or use cash on the balance sheet to cover its costs.

To say that Exelon has accessed the debt markets is an understatement, as long-term debt is up $5.25 billion in the last nine months. While it's true that some of this was due to acquisitions, there is no getting around the fact that negative free cash flow has been a contributing factor to weakness in the balance sheet. In addition, we can assume Exelon is paying a higher rate for its debt than its competition. The reason I can draw this conclusion is that management has already said their main focus is maintaining their investment grade debt rating.

However, the company's long-term debt to total assets ratio is 0.23. When we compare this ratio to the 0.31 or 0.32 ratios at Southern Co. or Duke Energy, it seems like Exelon is in better shape. One of the best bets for balance sheet strength in the sector is Integrys with a 0.17 debt-to-total assets ratio. The only reason Exelon would be more worried about their investment rating than these higher leveraged competitors is the possibility of paying a higher rate. In addition, if investors believe things will improve at Exelon, they haven't looked at what analysts are calling for in the next several years.

A negative growth rate in earnings is one thing, but when analysts are expecting negative 14% EPS growth, investors need to sit up and take notice. This is exactly what analysts are calling for at Exelon in the next few years, double-digit EPS declines. When you realize that none of their competition is expected to see a decline, you can see why this is such a big concern. In fact, between Duke, Integrys, and Southern Co, each company is expected to grow earnings by 3% to 5.5% in the next few years.

When you think about it, Exelon investors are in for a lot of pain if the dividend is cut. Even with the current 7%+ yield, if the company's EPS decline by 14% or more, and the stock price follows suit, investors would lose money on the deal. Now think about those numbers and then cut the dividend; the picture gets even more scary. The bottom line is, Exelon seems to represent one of the worst values in the utility sector at the present time. If you are convinced of a turnaround, I would suggest waiting to invest until after the dividend is cut. Right now the stock is down because a rumor of a dividend cut is on the table; if or when that dividend cut happens, the stock could fall even further. No matter how you slice it, Exelon's dividend is anything but safe.


MHenage owns shares of Integrys Energy Group. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Exelon and Southern Company. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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