From One Of The Best, To One Of The Worst

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

I don't like being wrong about a company, but what I hope to do is limit my losses when I realize my investment thesis is off the mark. Peter Lynch once said that in the market there was no way to be right 100% of the time. He said in stocks if just 60% of the time he was right he would be very happy. For those who have an open mind about Exelon (NYSE: EXC), it's time to re-evaluate why you own this stock.

I Lost Money, But I Still Sold
I'll readily admit that I owned Exelon and lost money on the shares. I owned the shares primarily for the yield, and when the company hinted that the dividend might have to be cut, I sold. When you buy a company primarily for their yield, and the yield is called into question, you leave. The problem many investors have is they can't stand the idea of losing money. 

When a company pays a dividend, the tendency is to wait for enough dividend payments to lower your cost basis and then get out. The problem is, utilities that have to cut their dividend don't always turn around in an immediate reversal of fortune. Based on the fact that Exelon's stock has actually increased a bit since the dividend cut, I'm not sure investors are really paying attention to the facts.

4 Big Problems
Exelon has four big problems, and none of them are easy to solve. Given the alternatives, there just isn't a great case to be made for the company's stock. 

The first issue facing Exelon is the most obvious; their yield isn't what it once was. With the dividend cut, the company's current yield is about 3.9%. If you look at several of their competitors, this yield just isn't good enough. Investors have the choice of Duke Energy (NYSE: DUK) paying a 4.4% yield, Southern Co. (NYSE: SO) paying a 4.49%, or Integrys (NYSE: TEG) paying a 4.84% yield. With these better options, why would anyone settle for 3.9%?

The second issue investors seem to be ignoring is, Exelon is the only utility in this group that analysts expect to show earnings compression over the next few years. While Duke, Southern Co., and Integrys are expected to grow earnings at 2.95%, 4.86%, and 5.5%, respectively; Exelon is expected to show a decrease in the double-digits.

Exelon also shows the lowest operating margin of the group. In the current quarter, Southern Co. was the leader in operating margin at 34.46%. Duke came in second with an operating margin of 16.04%, and Integrys reported a margin of 12.17%. By comparison, Exelon's margin was just 11.2%. For those who believe Exelon's large nuclear infrastructure will provide some sort of cost advantage, that just isn't happening at the current time.

While the company's lower dividend yield would seem to solve the company's dividend issue, I'm not sure this is the case. In the last four quarters, Exelon's free cash flow payout ratio was 78.6%. However, in the current quarter, Exelon actually reported over $500 million in negative free cash flow. It's true that Duke Energy reported negative free cash flow both this year and last. However, Duke's merger with Progress offers cost savings for future margin and cash flow improvement. While Southern Co. showed a 456% free cash flow payout in the current quarter, last year the company's free cash flow payout was a reasonable 61%. Competitor Integrys showed a seemingly high 251% payout ratio in their current quarter, but again last year they managed a payout ratio of just 51%. The bottom line is, with Exelon reporting negative free cash flow, even the lower dividend may not be safe.

What's The Next Move?
For investors in Exelon, they have to be hanging onto CEO Chris Crane's statement that this lower dividend provides the, “capacity to invest in growth.” However, the company's dividend cut forecasts something completely different. Exelon has one of the stronger balance sheets of the group with a debt-to-equity ratio of 0.80. By comparison, only Integrys has a better ratio at 0.56. Both Duke and Southern Co. have debt-to-equity ratios of 0.88 and 0.98 respectively. This would seem to argue that Exelon should have been fine. Most companies don't cut their dividend to grow faster; they cut the dividend to protect themselves from financial problems. 

Exelon's free cash flow reversal has been significant. To go from over $700 million in positive free cash flow to $500 million negative in one year is a problem that won't easily be reversed. Exelon carries the lowest yield of their peers, and their operating margin is the lowest of the group as well. When there are three other companies with better yields, better growth rates, and better margins, there isn't a reason to stick around and see what happens. The Exelon investment thesis has changed. Investors would be wise to open their eyes to this harsh reality and change their portfolio accordingly.

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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