An Opportunity To Make 18% a Year On a Utility Stock

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

Exelon Corporation (NYSE: EXC), a utility services holding company, engages in the energy generation and distribution business in the United States. Exelon is one of the "cleanest" power producers in the country. About half its fleet is nuclear, a quarter is natural gas, and nearly 10% is hydro, wind, and solar. 

The Opportunity

Shares of this energy giant have been declining recently. This decline is partly attributed to an overall downtrend in energy stocks, and partly attributed to certain concerns regarding the ability of the company to pursue its strategic goals, specifically in the uranium segment.

Obviously, Exelon isn't alone in the utility energy business. Its two main competitors are Duke Energy (NYSE: DUK) and Consolidated Edison (NYSE: ED). But following Excelon's sharp decline, I believe that at a current price of $30, Exelon is much more favorable than its peers for the following reasons: 

  1. What separates Exelon from the field is that it produces electricity from both natural gas and nuclear power. In fact, Exelon is the largest nuclear power generator in the United States. This gives Exelon a competitive edge because it's a low cost power producer. Duke and "steady Eddi," on the other hand, don't enjoy the benefit of producing electricity from nuclear energy.
  2. In early 2012, Exelon attained an electricity trading operation. That means, in addition to producing power, Exelon also operates a "trading desk" through which it buys and sells electricity to other providers. That's important, because it allows Exelon to more fully exploit the price difference between gas and nuclear power. Again, Duke and Edison don't have their own electricity trading desks. They pay for its services via a third party. 
  3. Exelon is very cheap compared to its rivals. It currently trades at a forward price-to-earnings of only 13.5x. That's cheaper than the P/E of 15x for both Duke and Edison. In addition, Exelon trades at a price-to-sales of only 1.1x. That's dirt cheap, especially when you compare it to Duke's 2.2x and Edison's 1.5x. 

Why not just buy shares for $30?

When this much skepticism enters the market, the premium on options in general -- and put options in particular -- rises exponentially. This means that investors are now able to take advantage of this scenario by selling put options and pocketing fat cash premiums on this trade. As of this writing, shares of Exelon are trading at $30.3 and the October $31 puts are selling for $1.85. This translates into an immediate 6% gain on your investment by waiting four months until the October expiration.

To put it differently, investors can act as an insurance company and collect a premium of $185 for each option contract they sell. This contract, in turn, obligates them to buy shares of Exelon on the expiration day of October if shares of Exelon are trading under $31. Repeat this trade 3 times a year, and you will have an 18% return annually.

How this plays out

There are three different scenarios that can happen on expiration day on October:

  1. Share price of Exelon > $31: You get to pocket the premium and have no obligations.
  2. Share price of Exelon = $31: You get to pocket the premium and have no obligations.
  3. Share price of Exelon < $31: You get to pocket the premium, but you will also be obligated to buy the shares at the predetermined price of $31. Since this is an excellent price to pay for the shares, we are fine with that obligation. Of course, you need to adjust the number of shares you are obligated to purchase to the trading position size that is right for you. This rule applies to any trade you make, regardless of the use of options .

The Foolish takeaway

I recommend that you sell to open the Exelon October 2013 puts, at the $31 strike price, for no less than $165 an option.

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Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Exelon. 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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