Why the Utility Sell-Off Was Warranted

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

The sell off in utilities has caused many investors to rethink their stability. While they offer attractive dividends and predictable earnings, their growth curves are flat at best and negative at worst. Below, I review three utility companies and explain why I believe they will underperform not only from a challenging business environment but weak fundamentals. From poor integrations to weakening financial profiles, the downside outweighs any predictable upside.

A Dividend Cut In The Works For Exelon Corporation (NYSE: EXC)

Over the past 5 quarters, Exelon's performance has been spotty, with 2 misses in 4Q11 and 2Q12. This has been reflected in the stock price, which has declined 33.2% over the last 12 months. While much of the loss is due to fears of a dividend cut, the situation has been made worse by higher likelihood that dividend taxes will be hiked--an 8.6% loss was experienced since President Obama, an advocate of this revenue strategy to the fiscal cliff, was re-elected. Exelon's dividend now stands at 7.2%.

Going forward, I see the company as a mixed bag. P3, one of the biggest Texas electricity aggregators, recently selected Exelon to supply customers 2.7 million megawatt hours of electricity. But free cash flow has been on the decline, and the company is likely to cut the dividend (the CEO has already floated the idea). The volatility of ExGen's wholesale business strains the utility's ability to maintain an investment grade rating while pursuing a shareholder-friendly capital allocation policy like regulated utilities can. By cutting the dividend distribution, management could use of the newly-available cash to pay off debt and improve its credit profile. Net income has been on the decline--falling from $2.7 billion 2Q11 (ttm) to $1.4 billion in 3Q12 (ttm)--and could unfortunately overshadow such an effort.

Exelon has hedged against power prices to control costs; but, with a forecast for low future power prices, this financial strategy has adversely impacted the bottom-line. With the stock trading at 11.4x and forecasted for annual EPS declines of 4.7%, the downside story will deter investor entry. Should earnings continue to be worse-than-expected, the sell off will continue. On this note, I recommend avoiding the stock.

NextEra Energy (NYSE: NEE), Duke Energy (NYSE: DUK) Preferable Over Exelon But Still Uncompelling

NextEra and Duke are, in my view, slightly better investments than Exelon. Nextera trades at 13.2x past earnings, while Duke trades at 19.4x past earnings. Duke's dividend yield of 5%, however, exceeds NextEra's by around 150 bps. Both of these firms are forecasted for low but positive earnings growth. I do not believe that they will be enough to cause either  stock to outperform the broader indices.

Assuming NextEra successfully grows EPS by a rate of 5.8% over the next half decade as expected, 2016 EPS will come out to $5.85, which, at a multiple of 15x translates to a future stock value of $87.65. Discounting backwards by 7% yields a present value of $54.42. This is at a ~20% discount to the current stock price.

Fundamentally, both companies have struggled. NextEra missed third quarter earnings by 13 cents on EPS of $1.26 as revenue decline a staggering 12.3% y-o-y. And Duke, after acquiring Progress in a deal that granted regulated $875 million worth of concessions, has had little to show for the integration. With only a slight margin advantage over competitors, the acquisition will cause near-term pressure over execution risks.

Adverse market conditions have made business very hard for NextEra in energy resources. While management has guided for a return to growth in 2013, headwinds from lower power prices will overcloud the story with weak profitability. NextEra's free cash flow has plummeted to a loss of $3.9 billion. This weakness, coupled with poor growth prospects, makes it a stock to avoid. At least Duke has improved free cash flow so that it is closer to the positive territory (-$615 million).


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