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Over the past month the Utility Sector (NYSEARCA:XLU) has been selling off. This has provided an excellent opportunity to investigate utilities for investment purposes. FirstEnergy Corporation (NYSE:FE) is one company utility worth considering.

There are many advantages to adding utilities to your portfolio. Two main advantages include Lower volatility and high dividends. So, if the market is getting unpredictable or "frothy," a well picked utility can add some stability to your portfolio while paying a solid dividend. As of June 5, 2013, FirstEnergy has a beta of 0.37 and a yield of 5.64%.

FirstEnergy is a diversified energy company dedicated to safety, reliability and operational excellence. With its headquarters in Akron, Ohio, FirstEnergy includes one of the nation's largest investor-owned electric systems and a diverse generating fleet with a total capacity of more than 20,000 megawatts.

FirstEnergy's diverse generating fleet produces approximately 100 million megawatt-hours of electricity annually from a fleet of non-emitting nuclear, scrubbed coal, natural gas, and pumped-storage hydro plants. With nearly 500 megawatts of wind power under long-term contracts, the company is one of the largest providers of renewable energy in the region.

In the section below we will analyze some aspects of FirstEnergy's performance. From this evaluation we will be able to see FirstEnergy's profitability, debt and capital, and operating efficiency and free cash. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets, and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $784 million
  • Net income 2011 = $885 million
  • Net income 2012 = $770 million.
  • Net income 2013 TTM = $660 million.

Over the past couple of years FirstEnergy's net profits have decreased from $784 million in 2010, to $660 million in 2013 TTM. This represents a 15.38% decrease.

  • Operating income 2010 = $1.805 billion.
  • Operating income 2011 = $1.698 billion.
  • Operating income 2012 = $2.176 billion.
  • Operating income 2013 TTM = $2.084 billion

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past four years, the company's operating income has increased from $1.805 billion to $2.084 billion. This represents an increase of 15.45%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2010 = $784 million
    • Net income 2011 = $885 million
    • Net income 2012 = $770 million.
    • Net income 2013 TTM = $660 million.
  • Total asset growth

    • Total assets 2010 = $34.805 billion.
    • Total assets 2011 = $47.326 billion.
    • Total assets 2012 = $50.406 billion.
    • Total assets 2013 TTM = $50.424 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 2.25%.
    • Return on assets 2011 = 1.87%
    • Return on assets 2012 = 1.53%.
    • Return on assets 2013 TTM = 1.31%.

Over the past four years, FirstEnergy's ROA has decreased from 2.25% in 2010 to 1.31% in 2013 TTM. This indicates that the company is making slightly less on its assets than it did in 2010.

Quality Of Earnings

Quality of Earnings is the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2010

  • Operating income 2010 = $1.805 billion
  • Net income 2010 = $784 million

2011

  • Operating income 2011 = $1.698 billion
  • Net income 2011 = $885 million

2012

  • Operating income 2012 = $2.176 billion
  • Net income 2012 = $770 million

2013 TTM

  • Operating income 2013 TTM = $2.084 billion
  • Net income 2013 TTM = $660 million

Over the past four years, the operating income has been higher than the net income in all years. This indicates that FirstEnergy is not artificially creating profits by accounting anomalies such as inflation of inventory

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $34.805 billion.
    • Total assets 2011 = $47.326 billion.
    • Total assets 2012 = $50.406 billion.
    • Total assets 2013 TTM = $50.424 billion.
    • Equals and increase of $15.619 billion
  • Total liabilities

    • Total liabilities 2010 = $26.260 billion.
    • Total liabilities 2011 = $34.046 billion.
    • Total liabilities 2012 = $37.322 billion.
    • Total liabilities 2013 TTM = $37.428 billion.
    • Equals and increase of $11.168 billion

Over the past four years, the company's total assets increased by $15.619 billion, while the total liabilities have increased by $11.168 billion. This indicates that the company's assets are increasing more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $3.698 billion.
    • Current assets 2011 = $3.355 billion.
    • Current assets 2012 = $3.768 billion.
    • Current assets 2013 TTM = $3.499 billion.
  • Current liabilities

    • Current liabilities 2010 = $4.698 billion.
    • Current liabilities 2011 = $4.855 billion
    • Current liabilities 2012 = $7.605 billion.
    • Current liabilities 2013 TTM = $7.132 billion.
  • Current ratio 2009 = 0.79
  • Current ratio 2010 = 0.69
  • Current ratio 2011 = 0.50
  • Current ratio 2012 = 0.49

Over the past four years, FirstEnergy's current ratio has been declining. As the ratio is currently under 1, this indicates that the company would not be able to pay off its obligations if they came due at this point.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $7.283 billion / $13.339 billion = 54.60%.
  • Gross margin 2011 = $8.955 billion / $16.258 billion = 55.08%.
  • Gross margin 2012 = $8.595 billion / $15.303 billion = 56.17%.
  • Gross margin 2013 TTM = $8.561 billion / $15.042 billion = 56.91%.

Over the past four years, FirstEnergy's gross margin has increased. The ratio has increased from 54.60% in 2010 to 56.91% in 2013 TTM. As the margin has increased, this indicates that FirstEnergy overall has been more efficient.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $13.339 billion.
    • Revenue 2011 = $16.258 billion.
    • Revenue 2012 = $15.303 billion.
    • Revenue 2013 TTM = $15.042 billion.
    • Equals an increase of 12.79%.
  • Total Asset growth

    • Total assets 2010 = $34.805 billion.
    • Total assets 2011 = $47.326 billion.
    • Total assets 2012 = $50.406 billion.
    • Total assets 2013 TTM = $50.424 billion.
    • Equals an increase of 44.88%.

As the revenue growth has increased by 12.79% while the assets have increased by 44.88%, this indicates that the company from a percentage point of view has been generating less cash with more assets, effectively becoming less efficient at creating revenues.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

Over the past four years we can see that the company has posted positive free cash each year except 2009. In a business that is looking to spend a lot of cash in upgrades to increase efficiency and keep up with increasing environmental standards this is a positive. This indicates that the company is growing at a pace that it can support, without adding additional risk to the company and ultimately the shareholder.

  • 2010 - $3.076 billion - $(1.963) billion = $1.113 billion
  • 2011 - $3.063 billion - $(2.278) billion = $785 million
  • 2012 - $2.320 billion - $(2.678) billion = $(358) million
  • 2013 TTM - $2.783 billion - $(2.987) billion = $(204) million

Even though the company's fundamentals are strong the analysis above indicates a degradation in the bottom line for the company. The net income has dropped even though revenues are up. This degradation in earnings is something to watch moving forward as it will have an impact on the overall performance of the company.

Forward Looking

Currently, FirstEnergy has a couple of things working against it in the near-term. On May 24, Reuters released an article regarding the capacity auction. The article stated that U.S. power grid operator PJM said that on the previous Friday its capacity auction secured a record amount of new generation and record imports for the 2016/2017 delivery year at much lower prices.

"Prices were generally lower than last year's auction due to competition from new, gas-fired generation, low growth in demand because of the slow economy and increased imports from other regions, primarily to the west of PJM," Ott said in a release.

In FirstEnergy Corp's northern Ohio territory, PJM said the capacity price dropped 68 percent, to $114 from $357 per MW in the 2012 auction.

Lower capacity prices have been a contributing factor to declining profitability for the company but over the next few years as the economy improves many expect capacity costs to begin to rise.

Matt Brakey of Cleveland Business states "An exponential jump in capacity costs for the 2015-2016 delivery year will significantly increase electricity prices for FirstEnergy Corp.'s Ohio customers." As Capacity costs increase over the next few years so will the turnaround in FirstEnergy's profitability.

As Seeking Alpha Author Jonathan Wolfe pointed out in his excellent article: Facts Show It Time To Buy FirstEnergy, Even though the 2016/2017 capacity auction released low results compared to 2015 "it is a big price improvement from today."

Currently, at these levels an investor should not expect any dividend increases as the current dividend payout ratio is a very high at 139.41%. As well the next couple of years look to be quite stagnant as power prices are expected to remain low. Having stated that at these levels an investor would get a nice 5.68% yield to wait for an increase in capacity pricing.

In a recent article by Insider Monkey it was noted that Hedge Funds were adding FirstEnergy to their portfolios. Carlson Capital, managed by Clint Carlson, recently initiated a $48.3 million investment while Jim Simons' Renaissance Technologies also initiated a $12.9 million position during the quarter. The following funds were also among the new FE investors: Israel Englander's Millennium Management, Peter Rathjens, Bruce Clarke and John Campbell's Arrowstreet Capital, and John Overdeck and David Siegel's Two Sigma Advisors."

Analysts' Estimates

Analysts at MSN Money are estimating an EPS for FY 2013 at $2.99 while moderate growth is expected to continue into 2014 as EPS estimates increase to $3.05. Bloomberg Businessweek supports this idea as it expects the company's revenues to be around $15.6 billion for FY 2013 and increase to $15.4 billion for FY 2014.

Price Targets

  • Finviz has a price target for FirstEnergy at $43.70
  • Recently, Barclays gave the company an "Equal Weight" rating with a target of $44.
  • On April 17, Deutsche Bank gave the company a " Hold" rating with a target of $46.

Over the past month or so the utility sector has been showing weakness compared with the market. The above analysis reveals that FirstEnergy is a fundamentally sound utility but has declining profitability. Among the main factors in the declining profitability are the capacity prices. As capacity prices are expected to increase this will have a positive effect on the company's profitability. The next couple of years look to be stagnant for the company as this is reiterated by analysts at MSN Money and Bloomberg having earnings per share in the $3 dollar range with no growth in revenues. But, the future looks bright for FirstEnergy as capacity prices should increase and demand for energy should pick up over the next few years. As the demand for energy increases the company's profitability and subsequently the share price should increase as well. This statement is supported by many hedge fund managers who have recently picked up a solid utility at current depressed prices. As the stock price has declined over the past month this has proven to be an attractive point to look at the utility sector. If patience is used and price begins to form a bottom and ultimately break to the upside, it could prove to be an excellent opportunity to invest in FirstEnergy.

Source: FirstEnergy: 5.64% Yield With Growth On The Horizon