Operating in a regulated power market is a great business. Selling power on the open market was a great business. Now it isn’t. That’s led to a few utility dividend cuts and some turnaround opportunities for investors.
Two Markets
There are basically two types of power companies, those that operate in regulated markets and those that sell electricity on the open market. Many utilities have operations in both spaces.
Regulated markets offer generally predictable revenue streams. The wild card is having to ask regulators for price increases, called rate cases. Such cases can be contentious and may actually go against the utility. Still, this type of business tends to be very reliable.
Merchant power companies that sell electricity on the open market don’t have the benefit of preset rate structures. So, they are subject to supply and demand. That can mean a windfall when electricity prices are high, but can be devastating when prices are low—like right now.
Cuts
Utilities hate to cut their dividends, since that is often the most enticing aspect of their stocks. However, the current down cycle in merchant power has forced some to do just that. That has set investors up to buy utilities with turnaround potential. Here are a few to consider:
Exelon Corporation (NYSE:EXC)
Exelon Corporation (NYSE:EXC) has two sides to its business. Its three regulate utilities are Baltimore Gas and Electric, ComEd, and PECO. These are stable businesses, serving more than 6.6 million electric and gas customers. Although these utilities provide a nice base, Exelon Corporation (NYSE:EXC) is also among the largest merchant power companies in the country. That exposure in a weak power market led to a recent dividend cut.
Although no one likes to see a dividend cut, management chose to preserve the company’s credit rating and financial flexibility instead of continuing to pay its previous dividend. That move has set the company up to weather the current environment and benefit when the merchant power market improves.
What makes the company stand out, besides an over 5% dividend yield, is its nuclear power fleet. Exelon Corporation (NYSE:EXC) is the largest nuclear power company in the U.S. market. So, it has the ability to produce relatively low cost electricity. It also has a major head start on the emissions front, since nuclear is among the cleanest power sources.
With a strong core business, a collection of enviable nuclear plants, and a right-sized dividend, Exelon Corporation (NYSE:EXC) would be a good choice for all but the most conservative investor.
Atlantic Power Corp (NYSE:AT)
Atlantic Power is another merchant power company. However, the crossroad this Canadian company faced was more severe than Exelon Corporation (NYSE:EXC) because Atlantic Power is far more reliant on open market electric prices. With long-term contracts set to end, Atlantic Power Corp (NYSE:AT) was forced to cut its dividend.
Essentially, new contracts would have been much less generous than the old ones, leaving it unable to pay its distribution. The cut hit the shares hard, which is where the opportunity resides. A share price in the low single digits and a dividend yield hovering around 8%, however, is an opportunity, but it is also a statement to the risks here.
The company’s new direction is to sell assets in an attempt to move more aggressively into renewable power sources. It has been actively buying and building wind farms, for example. Government mandates about cutting dangerous emissions will help create demand for electricity from such generation.
The cut should bring the company’s payout in line with its ability to grow its business and continue to pay a dividend. There is, however, no guarantee of that. So, for more aggressive investors willing to bet that the new direction works out, Atlantic Power might be a good option. And you’ll be paid well to wait for the turnaround.
NRG Energy Inc (NYSE:NRG)’s dividend is actually going the opposite direction. After exiting bankruptcy about a decade ago, the company started paying a dividend in late 2012. This despite the downturn in power prices. Although the dividend yield at around 1.4% is relatively low, newly initiated dividends tend show the greatest growth. So, this is an opportunity to get in “on the ground floor” of a well-financed utility that is just beginning to return value to shareholders.
The thing to watch at NRG Energy Inc (NYSE:NRG) is the progress of recently purchased GenOn. Estimated cost saving need to be met if the deal is to be a success. Still, middle of the road investors willing to wait for dividend growth might find this solid merchant power company worth a look.
Down and Out
Down and out sectors can be filled with good investment ideas. Every stock won’t be a buy for every investor, but taking a look around can reveal some real gems. The three utilities above are all interesting in their own way.
The article Merchant Power Bargains originally appeared on Fool.com is written by Reuben Brewer.
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