Risk-Reward Balanced at Pepco Holdings - Analyst Blog

On May 23, we issued an updated research report on energy company Pepco Holdings Inc. POM. This pure play regulated utility benefited from recoverable investments and a severe winter in its service territories that spurred demand.

Pepco Holdings, a Zacks Rank #4 (Sell) stock, reported adjusted earnings of 30 cents per share in the first quarter of 2014, outpacing the Zacks Consensus Estimate by 6 cents. Earnings also improved 25% year over year. The upside stemmed from increased electric distribution revenues resulting from robust infrastructure investment that drove rates. A decline in operation and maintenance expenses also helped results.

Pepco has planned investments worth $5.8 billion in its electric system over the next 5 years. Pepco depends on timely constructive regulatory decisions to earn an adequate return on its capital investments. Any failure to recover the investments might jeopardize the utility's growth plans.

Like all regulated utilities, Pepco Holdings also depends on favorable rate outcomes. However, recent rate case decisions have not entirely gone in favor of the company. If the same trend continues this year Pepco will find it difficult to recover the costs and sustain systematic development work.

Pepco's regulated utility business is thus subject to regulations by various federal, state and local agencies, which have varying jurisdictions and applicable rates. Compliance with new or stricter regulatory policies in its service territories might lead to higher operating costs and eat into margins.

Merger talks with Exelon Corp. EXC have seen an upward revision in Pepco Holdings' share price. In fact, the current traded price of Pepco Holdings is higher than the price of $27.25 per share offered by Exelon. If the prices continue to go north, Exelon will most likely have to make a fresh bid to acquire Pepco. This upward movement in prices will benefit the legacy shareholders of Pepco and other opportunist investors who are hoping to gain from this transaction.

Investors interested in the utility space may consider stocks like Black Hills Corp. BKH and Calpine Corp. CPN. Both these stocks carry a Zacks Rank #1 (Strong Buy).

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