4 Reasons to Avoid This Company

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

I'm always looking for undervalued companies, and if they pay a good dividend that's even better. I used to own Exelon (NYSE: EXC) until it became clear to me that the company's main attraction, their dividend, might be in jeopardy.

When you buy a stock for their dividend, and management hints the dividend could be cut, you have two choices. You can either accept the risk and hold on, or you can sell your shares and move on. I chose the latter strategy and sold.

Not everyone has the same opinion though, and I recently watched a video on Fool.com by Taylor Muckerman where he gave, “3 Reasons To Buy Exelon Today.” With due respect to Taylor, I'm going to go one better and give you four reasons to stay away.

The Bubble Is Real, But Exelon Is More Dangerous
I've made no secret about the fact that I think if there is a dividend bubble it exists in the utilities sector. There are a number of companies that have negative free cash flow, relatively high valuations, and yields that are not what they once were. What Exelon offers investors on paper is seemingly a much better dividend yield and a lower relative valuation. However, like in sports just because it looks good on paper doesn't mean it is. 

The Best Reason To Buy Is The Biggest Reason To Stay Away
One of the primary reasons investors are buying Exelon today has to be the dividend yield. The stock currently yields just under 7%, and for utility investors looking at yields of between 4% and 5% elsewhere this has to look awful tempting. There is just one big problem: this yield is anything but safe.

In the company's last earnings call, their CEO Chris Crane said that their investment grade credit rating was “fundamental” to Exelon. He further said, “this is a stressed period, we don't want to live on the edge.” In plain English, the company said if it was a choice between maintaining an investment grade credit rating and the dividend, that the dividend policy would be reviewed (otherwise known as cut). If Exelon sells for just under 12 times earnings with a near 7% yield, imagine what would happen if the yield were lower.

I'll give you a clue; the market doesn't like dividend cuts, and the stock would likely fall further. 

If Only There Were Something Other Than The Dividend
In Taylor's video he suggested that Exelon's strong nuclear operations gives the company an edge, as this is clean energy in a field that no one seems to be entering.

I would argue the reason no one wants to get into nuclear is that it's not as profitable as other resources. Exelon's nuclear costs have been higher than coal or natural gas, and this has hurt profitability. Due in part to this competitive disadvantage, Exelon is expected to see EPS contraction over the next few years.

By comparison, competitors like Southern Company (NYSE: SO), Consolidated Edison (NYSE: ED), and Integrys (NYSE: TEG) are all expected to show positive earnings growth. If Exelon were to cut its dividend, the lack of EPS growth would make the stock a difficult choice over other utilities. 

Widely Diversified With Worse Margins
While it's true that Exelon is diversified in the types of power generation it offers, this has not helped the company's margins.

Specifically, Exelon's gross margin of 21.05% is the lowest of the competitors we have named. Integrys has the closest gross margin at 21.32%, but Southern Co. and Consolidated Edison crush the field with their 38.79% and 45.55% gross margins respectively. 

A Weaker Balance Sheet Than Their Competition, Too
Exelon's main concern is keeping their investment-grade credit rating. One simple way to tell if their balance sheet is in any type of trouble is by comparing total assets to total liabilities. Unfortunately for Exelon investors, their company comes in last in this all-important comparison.

Exelon's assets-to-liabilities ratio is 1.39. By comparison, Consolidated Edison has a ratio of 1.43, Integrys scores a 1.45, and Southern Co. has a ratio of 1.47. It may not sound like much, but a small difference in ratio means millions of dollars in difference between the four companies. 

Why Take The Chance?
It really comes down to risk versus reward with Exelon. At this point, shares sell for about 11.8 times projected earnings, but those earnings are expected to contract over the next few years. This will cause the P/E ratio to rise. Though the yield is currently at near 7%, if the dividend is cut as I expect it will be, the lone reason to own the shares will virtually disappear.

The company won't have to eliminate the dividend to make this a bad investment. Investors can buy Consolidated Edison with a 4.3% yield, Southern Co. with a 4.44% yield, or Integrys with a near 5% yield. Since each of these companies offers EPS growth whereas Exelon is expected to see contraction, there would be no reason left to choose Exelon. If you want exposure to the utility industry, any of these other three seem like better choices. Exelon has become a situation where the risk just isn't worth the reward.

MHenage owns shares of Integrys Energy Group. The Motley Fool recommends 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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