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How to Trade Exelon During Its $6.8 Billion Purchase of Pepco Holdings

NEW YORK (TheStreet) -- Exelon  (EXC - Get Report) , a U.S.-based energy provider, and Pepco Holdings  (POM) , a holding company of utility subsidiaries, have recently filed for merger approval. This news comes after Exelon announced its intention to purchase Pepco Holdings back on April 30. The $6.8 billion deal has lead to a 20% spike in shares of Pepco Holdings since the end of April -- all the way to $27.41 as of Friday at 1 p.m.

When the buyout was announced, Pepco's market cap was around $5.7 billion. That means that Exelon paid a $1.1 billion markup on Pepco Holdings' stock to control the company. And Exelon's stock fell by more than 10% to $32.52 as of Friday at 1 p.m.

But will Exelon's shareholders benefit from this recent acquisition? Thus far investors in Exelon haven't made money on the deal, and they may not start now.

The merger will offer Exelon higher sales volume, provide advantages such as economies of scale and expand its reach to additional regions in the U.S. -- mainly in the east. Pepco Holdings and Exelon have similar operational profit margin of around 14%. Due to this merger, both companies' combined operations will provide services for 10 million customers.

The higher volume may bring down operational costs such general and administrative expenses. Currently these two companies aren't much different.

But the merger may not improve the value of Exelon by much and thus it may not benefit its investors. Let's see why.

Pepco Holdings has a much lower operating cash-flow-to-revenue ratio of 10% in the past year, compared to Exelon's ratio of 25%. This means that Pepco Holdings is able to turn a smaller portion of its revenue into cash, which could pose a cash-flow problem. Pepco Holdings also has a slightly higher debt burden than Exelon, as Pepco has a debt-to-equity ratio of 1.28 compared to 0.93 for Exelon.

Despite these recent developments, Exelon's trailing price-to-earnings ratio is 15.19. As a benchmark, the trailing P/E of the utility sector is 22.19. Duke Energy  (DUK)   has a trailing P/E of 26.61; FirstEnergy's  (FE)   ratio is 34.51.

Exelon plans to sell its fossil fuel power plants for $1 billion, which will partly finance this deal. It's still unclear how the company will finance the rest of the deal, but it could lead it to issue additional stock. That in turn could dilute the value of its shares and bring down the dividend yield.

The current annual yield is around 3.9%, but investors should also consider the buyback yield. This yield is a company's stock repurchase program divided by its market cap. If Exelon were to issue more stock, the buyback yield will be negative and thus bring down the total yield investors receive for their holdings in Exelon, since total yield is dividend yield and buyback yield combined.

These issues should be taken into account when shareholders consider Exelon's recent move. Investors should keep a close eye on how Exelon's management will eventually finance this deal. And most importantly they should consider whether it will it actually improve Exelon's profit margins.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

TheStreet Ratings team rates EXELON CORP as a Buy with a ratings score of B. TheStreet Ratings Team has this to say about their recommendation:

"We rate EXELON CORP (EXC) a BUY. This is driven by multiple strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its growth in earnings per share, reasonable valuation levels, good cash flow from operations, largely solid financial position with reasonable debt levels by most measures and increase in stock price during the past year. We feel these strengths outweigh the fact that the company shows low profit margins."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • EXELON CORP has improved earnings per share by 5.3% in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past year. We feel that this trend should continue. During the past fiscal year, EXELON CORP increased its bottom line by earning $2.00 versus $1.40 in the prior year. This year, the market expects an improvement in earnings ($2.38 versus $2.00).
  • Net operating cash flow has slightly increased to $1,586.00 million or 7.23% when compared to the same quarter last year. In addition, EXELON CORP has also modestly surpassed the industry average cash flow growth rate of -2.15%.
  • The debt-to-equity ratio is somewhat low, currently at 0.93, and is less than that of the industry average, implying that there has been a relatively successful effort in the management of debt levels. Despite the fact that EXC's debt-to-equity ratio is low, the quick ratio, which is currently 0.65, displays a potential problem in covering short-term cash needs.
  • EXC, with its decline in revenue, slightly underperformed the industry average of 5.4%. Since the same quarter one year prior, revenues slightly dropped by 1.9%. The declining revenue has not hurt the company's bottom line, with increasing earnings per share.

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