Why This Utility Company Continues to Struggle


In the past three months, FirstEnergy shed nearly 15% of its value (between November 2013 and January). This stock's decline is mostly attributed to the uncertainty around the company's dividend paycheck. But beyond the potential drop in dividend payment, is the company doing well for its industry?

After all, leading analysts at Wells Fargo and Goldman Sachs have recently upgraded the company. Looking forward, is the company still worth owning? Let's try to tackle these questions starting with the recent developments in the utility market.

The electricity market is powering down
According to latest Energy Information Administration update, between July and October, electricity prices remained higher than last year's by roughly 1% to 4%. The chart below shows the changes in the prices of electricity between 2010 and 2013.

Source: EIA

As you can see, the price of electricity peaked in July 2013 -- the highest level in recent years. Due to the elevated electricity prices, the profit margin of some utility companies such as Exelon and Duke Energy have risen during the third quarter.

The chart below shows the changes in the profit margins of the above-mentioned companies.

Source: Google Finance

Both Duke Energy and Exelon improved their profit margins during the third quarter (year over year), while FirstEnergy did not. For Duke Energy and Exelon, the rise in prices improved their profit margins. According to Exelon's third-quarter earnings report, the company's average margin rose by nearly 1% year over year.

FirstEnergy's decline in profitability is due to several factors, including lower demand for electricity in its regulated-distribution segment (this segment accounts for nearly 60% of its revenue), increases in purchase power from other companies, and changes in its amortization charges (non-cash provision).

Moreover, the company's revenue also fell 6.4% during the quarter. FirstEnergy wasn't the only one that recorded a decline in revenue: Exelon's revenue fell by 1% during the third quarter.

One of the reasons for the drop in revenue was lower consumption: Exelon's electric supply fell from 74,421 GWhs to 65,020 GWhs -- a 13% fall. Conversely, during the first nine months of 2013, the company's power-generation operations grew by more than 12.5%. In total, the company augmented its revenue by nearly 9% during the first three quarters of the year. Exelon's merger with Constellation Energy back in 2011, which was completed during the first quarter of 2012, has been the main driving force behind the company's growth in sales earlier last year.

During the third quarter, Duke Energy's revenue inched lower by 0.2%; this was mainly due to the company's decline in electric supply by 1.6%.

Based on the above, it seems that FirstEnergy hasn't done well compared to other utility companies.

The company also faces ongoing regulatory problems in its attempts to comply with the Environmental Protection Agency's Mercury and Air Toxics Standards. Because 60% of FirstEnergy's power is generated with coal, high environmental costs are likely to keep this company's capital expenditures and uncertainty high. After all, a few months back, FirstEnergy shut down two of its coal-based plants that were responsible for nearly $280 million of the fines it had to pay.

Duke Energy, much like FirstEnergy, also heavily uses fossil fuel, as it accounts for 70% of its power generation in the U.S. Therefore, Duke is also exposed to similar tax and fine burdens to FirstEnergy. On the other hand, Exelon relies on nuclear power -- more than 55% of the generated power is nuclear.

Looking forward, FirstEnergy's fourth quarter isn't likely to improve, as the company narrowed its 2013 guidance for basic earnings per share (excluding special items such as regulatory provisions, merger costs, etc.) to $2.90-$3.10, or an average of $3 EPS, which is roughly 10% lower than 2012.

Based on these numbers, they imply that for the fourth quarter, the expected EPS will be around $0.70, which is 12% lower than the same quarter last year. Besides lower earnings, the company's potential dividend reduction could cut down the demand for this stock. But this could have a short-term effect as well. Let's see why.

With an annual dividend yield of nearly 7%, its high yield remains the main attraction for holdingFirstEnergy or any other utility company. But will a sharp dividend cut have a long-term effect on the company's stock? Let's try to tackle this issue by comparing the market's reaction to another utility company that slashed its dividend: Exelon cut its dividend by 41% back in February 2013.

Despite this cut, Exelon's stock rallied in the following months after this announcement was made. So it seems that investors didn't react much to this news. Currently, the company provides a dividend yield of 4.6%; this is close to several other utility companies' yields, such as Duke Energy, which offers an annual pay of $3.12 -- nearly a 4.6% yield. So even if FirstEnergy reduces its dividend, this could have, at most, a short-term negative effect on the company's stock.

Final words...
FirstEnergy is facing problems in increasing its revenue and improving its profit margin. Even higher electricity prices aren't enough to pull this company's earnings up. Moreover, the company's reliance on coal will continue to be a "known unknown" that could adversely affect its bottom line. Therefore, even if the company doesn't cut its dividend payment in the near future, its fundamentals will continue to pull investors away from this stock.

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The article Why This Utility Company Continues to Struggle originally appeared on Fool.com.

Lior Cohen 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.

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