FirstEnergy's Reward/Risk Brightens

Regulated utilities continue to generate consistent profits and dividends, as seen in recent years by the likes of Duke Energy (DUK), Consolidated Edison (ED), Southern Company (SO) and American Electric Power (AEP). These shares have been Steady Eddies throughout the ups and downs of the economy and stock market. On the other hand, the merchant utility operators have been on a wild ride throughout this period. An unusually weak economy has led to declining profitability of power contracts as volumes and prices have declined. Earnings subsequently pulled back in the face of these deteriorating fundamentals. A good example of this disappointment has been Exelon (EXC). The merchant power business is finally beginning to hit bottom for a number of operators. The numbers should get even better as they cycle into 2015 and 2016. As a result, it is starting to become worthwhile to explore this space for potential opportunities. One hybrid regulated/merchant utility operator that may be interesting to investors is FirstEnergy (FE). Investors will get the benefits of owning a stable, regulated utility operation with the upside potential of participating in the rebound cycle of the merchant power business. As we believe the business traction for the merchant power business is finally improving, this should be a good time to get acquainted with this name. FirstEnergy is a large Midwestern/mid-Atlantic utility operator that serves more than 6 million customers throughout Ohio, Pennsylvania, New Jersey, Virginia, West Virginia and Maryland. The firm has more than $50 billion in assets, $15.5 billion in annual revenue, more than $1 billion in annual net income and a $15 billion market capitalization. The core regulated business accounts for $8.7 billion in annual revenue and virtually all of the firm's net income. The regulated business is highly stable and is expected to grow by a few percentage points per year. FirstEnergy does not have the best geographic markets or energy generation mix, but its core business is still very profitable and will grow over time. The current earnings contribution from its regulated business is $2.52 per share. The $1.44 annual dividend is covered by the regulated portion of the company. Where FirstEnergy has struggled has been in its merchant operations. In 2011, the company's merchant business earned $377 million, or $0.89 per share. After operating losses and charges, the business lost money in 2013. The merchant business is still losing money, but it will return to profitability by the end of 2014. FirstEnergy, along with the rest of the industry, has been taking action by reducing costs and excess capacity. Power volumes and prices are finally finding a bottom. As a result of the poor merchant operations, FirstEnergy's earnings have declined from a high of $4.38 a share in 2008 to a recent low of $2.50 for 2014. The company was forced to cut its dividend as a result of this earnings decline. The dividend went from $2.20 per share in 2012 to $1.65 in 2013, to a low of $1.44 in 2014. Although we are wary of utilities that cut their dividends, the dividend looks safe from here at $1.44 and should be fully covered by the regulated portion of the company. We believe that as long as the merchant utility business doesn't take another leg down from here, the current dividend should be safe. Where investors should find a cause for optimism is that the merchant portion of the company should return to profitability in the coming year. The business should get better from here, and just a marginal improvement in the merchant business could add $0.30 or $0.40 in extra earnings per share. This would be a catalyst for a turnaround in the stock. The shares are reasonably priced at 13.9x the 2014 EPS estimate of $2.50 and 11.7x the 2015 EPS estimate of $2.98. The merchant business is bottoming, and we believe that FirstEnergy will eventually experience a more complete turnaround once the economy fully improves. In the meantime, the core regulated utility operations are still very healthy, and the dividend should be safe at $1.44 per share. Consequently, investors are receiving a 4.14% yield while they wait. While FirstEnergy is riskier than most of the other utilities we have recommended in the past year, for those willing to take on a higher level of risk and uncertainty, it does give far more upside than the regulated utility group at this point.

FirstEnergy's Reward/Risk Brightens

Its regulated operations are stable, and its merchant utility business is bottoming out.

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