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

Tickers in this article: DUK EXC FE POM

NEW YORK ( TheStreet) -- Exelon , a U.S.-based energy provider, and Pepco Holdings , 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.

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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 has a trailing P/E of 26.61; FirstEnergy's 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.