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Over the past month the Utility Sector (XLU) has been selling off. As the utility sector has "fallen out of favor" this has presented an excellent opportunity to investigate utilities for investment purposes. ALLETE Incorporation (ALE) is one utility company worth considering.

There are a couple of reasons why the utility sector has fallen out of favor. These factors include: an expected slow economic recovery, and a fear of rising interest rates. Having stated that there are many advantages to adding utilities to your portfolio at this point, two main advantages include lower volatility and higher dividends. So, as 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 13, 2013, ALLETE Incorporation has a beta of 0.64 and a yield of 3.98%.

As future growth will rely on a utilities' ability to produce clean and renewable energy at a low cost to the customer, ALLETE's unique business structure encompasses growth through low cost fuels, clean energy innovations within the company and its subsidiaries.

ALLETE Incorporated is well positioned as a reliable provider of competitively-priced energy in the upper Midwest. ALLETE is comprised of six subsidiaries, which are; Minnesota power, ALLETE properties, SWL&P (Superior Water, Light & Power), BNI coal, ALLETE clean energy and ALLETE values.

Minnesota power - Minnesota Power is a company that serves electricity to 144,000 residents across northern Minnesota, 16 municipal systems, and some of the nation's largest industrial customers. Around 55% of Minnesota Power's generation is created by coal-fired steam plants. Close to 40% is being purchased from a North Dakota generator operated by the Square Butte Cooperative while the other 5% is powered from ten hydro-power stations.

What makes Minnesota power unique is that in 2012, 57% of the company's sales were to industrial companies. As the majority of the sales were to industrial companies this negated some of the seasonal effects that other utility companies have.

As Minnesota power is focused on expanding its renewable energy sources, on May 30th the company announced the dedication of its 101- turbine Bison Wind Energy Center. This is in part due to the response that the state of Minnesota mandates utilities companies produce 25% of their power from wind and other renewable sources by 2025. As part of the company's "Energy Forward" program designed to create less emissions while maintaining reliable and affordable power, Minnesota Power's long-term goal is a generation mix that is one-third renewable, one-third natural gas and one-third coal-based.

Another subsidiary of ALLETE is BNI Coal - BNI Coal delivers the lowest-priced lignite in North Dakota. A couple of advantages of using lignite coal is that it is cheaper than other forms of coal and it is low in sulfur content which can reduce the need for post-combustion sulfur emission control devices.

Image sourced from (www.lignite.com)

As there are a couple of advantages to using lignite there are some disadvantages. The disadvantages include; increased handling costs and decreasing boiler efficiency. As the coal has a lower heating value, more fuel must be handled thus increasing handling and maintenance costs. As well lignite has a higher moisture content thus decreasing boiler efficiency and increasing boiler issues and costs.

From an environmental point of view, the law requires that the reclaimed land from lignite coal be at least as productive as it was prior to mining. As the cost to reclaim land can run from $15,000 to $30,000 an acre it is important for a company to have the necessary equipment to keep the costs down. Currently, BNI Coal has the necessary equipment to reclaim the land within environmental laws.

On July 28, 2011 ALLETE announced a new wing of the business. ALLETE Clean Energy is an independent power producer and supplier that develops or acquires capital projects aimed at creating clean energy solutions via wind, solar, biomass hydro, shale, natural gas or liquids, mid-stream pipelines and processes, and other energy innovations. This should prove to be a very thoughtful move as environmental initiatives will increase and having a company on the leading edge of clean energy will prove to be of value for ALLETE.

Superior Water, Light & Power has served the area since 1889 and currently provides electric, natural gas and water service to 14,000 electric customers, 12,000 natural gas customers and 10,000 water customers.

By purchasing electricity at wholesale from Minnesota Power, SWL&P is able to combine reliable service with rates that are among the lowest in the state and are competitive nationally. Having connections to two interstate pipelines for their natural gas system provides for competitive rates and enhanced system reliability. As the company utilizes Lake Superior as its source, SWL&P water treatment system is able to provide high quality water with capacity to serve large industrial customers.

As ALLETE's business model encompasses the customer base, energy sources, clean energy initiatives and infrastructure to supply the needs to the customers, this has set up one of the most efficient utilities in the market.

In the section below we will analyze aspects of ALLETE's past performance. From this evaluation we will be able to see ALLETE'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's 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 = $75 million
  • Net income 2011 = $94 million
  • Net income 2012 = $97 million.
  • Net income 2013 TTM = $105 million.

Over the past couple of years ALLETE Inc.'s net profits have increased from $75 million in 2010, to $105 million in 2013 TTM. This represents a 40.00% increase.

  • Operating income 2010 = $136 million.
  • Operating income 2011 = $150 million.
  • Operating income 2012 = $155 million.
  • Operating income 2013 TTM = $161 million

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 $136 million to $161 million. This represents an increase of 15.83%.

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 = $75 million
    • Net income 2011 = $94 million
    • Net income 2012 = $97 million.
    • Net income 2013 TTM = $105 million.
  • Total asset growth

    • Total assets 2010 = $2.609 billion.
    • Total assets 2011 = $2.876 billion.
    • Total assets 2012 = $3.253 billion.
    • Total assets 2013 TTM = $3.251 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 2.87%.
    • Return on assets 2011 = 3.27%
    • Return on assets 2012 = 2.98%.
    • Return on assets 2013 TTM = 3.23%.

Over the past four years, ALLETE Inc.'s ROA has increased from 2.87% in 2010 to 3.23% in 2013 TTM. This indicates that the company is generating more income 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 = $136 million
  • Net income 2010 = $75 million

2011

  • Operating income 2011 = $150 million
  • Net income 2011 = $94 million

2012

  • Operating income 2012 = $155 million.
  • Net income 2012 = $97 million

2013 TTM

  • Operating income 2013 TTM = $161 million
  • Net income 2013 TTM = $105 million

Over the past four years, the operating income has been higher than the net income in all years. This indicates that ALLETE Inc. 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 = $2.609 billion.
    • Total assets 2011 = $2.876 billion.
    • Total assets 2012 = $3.253 billion.
    • Total assets 2013 TTM = $3.251 billion.
    • Equals an increase of $642 million
  • Total liabilities

    • Total liabilities 2010 = $1.633 billion.
    • Total liabilities 2011 = $1.797 billion.
    • Total liabilities 2012 = $2.052 billion.
    • Total liabilities 2013 TTM = $2.011 billion.
    • Equals an increase of $378 million

Over the past four years, ALLETE Inc.'s total assets increased by $642 million, while the total liabilities have increased by $378 million. This indicates that the company's assets have increased 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 = $240 million.
    • Current assets 2011 = $277 million.
    • Current assets 2012 = $273 million.
    • Current assets 2013 TTM = $256 million.
  • Current liabilities

    • Current liabilities 2010 = $159 million.
    • Current liabilities 2011 = $163 million
    • Current liabilities 2012 = $283 million
    • Current liabilities 2013 TTM = $203 million
  • Current ratio 2009 = 1.51
  • Current ratio 2010 = 1.70
  • Current ratio 2011 = 0.96
  • Current ratio 2012 = 1.26

Over the past four years, ALLETE Inc.'s current ratio has been declining. Even though the ratio has been declining the ratio is still over 1. This indicates that ALLETE Inc. would 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 = $582 million / $907 million = 64.17%.
  • Gross margin 2011 = $622 million / $928 million = 67.03%.
  • Gross margin 2012 = $653 million / $961 million = 67.95%.
  • Gross margin 2013 TTM = $667 million / $985 million = 67.12%.

Over the past four years, ALLETE Inc.'s gross margin has increased. The ratio has increased from 64.17% in 2010 to 67.12% in 2013 TTM. As the margin has increased, this indicates that ALLETE Inc. 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 = $907 million.
    • Revenue 2011 = $928 million.
    • Revenue 2012 = $961 million.
    • Revenue 2013 TTM = $985 million.
    • Equals an increase of 8.60%.
  • Total Asset growth

    • Total assets 2010 = $2.609 billion.
    • Total assets 2011 = $2.876 billion.
    • Total assets 2012 = $3.253 billion.
    • Total assets 2013 TTM = $3.251 billion.
    • Equals an increase of 24.61%.

As the revenue growth has increased by 8.60% while the assets have increased by 24.61%, 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.

Based on the information above we can see that ALLETE Inc. has produced very positive results over the past four years. Revenues have increased by 8.60%, the gross margin is currently at 67.12%, assets have increased more than liabilities thus increasing shareholder value while the company's ROA has increased from 2.87% to 3.23%. These are all positive signals that management's business model is working and building a very efficient and cost effective utility.

Forward Looking

On January 30, 2013, Minnesota Power announced "Energy Forward," a strategic plan for assuring reliability, protecting affordability and further improving environmental performance. The plan includes completed and planned investments in wind and hydroelectric power, the addition of natural gas as a generation fuel source, and the installation of emissions control technology. Significant elements of the "EnergyForward" plan include:

  • Major wind investments in North Dakota
  • Planned installation of approximately $350 to $400 million in emissions control technology at our Boswell Unit 4 to further reduce emissions of SO2, particulates and mercury.
  • Planning for the proposed Great Northern Transmission Line to deliver hydroelectric power from northern Manitoba by 2020
  • The conversion of our Laskin Energy Center from coal to cleaner-burning natural gas in 2015.
  • Retiring Taconite Harbor Unit 3, one of three coal units at our Taconite Harbor Energy Center in 2015.

All of these elements are designed to improve environmental standards while focusing on growth for the company.

Overall, as these plans will be costly for the company, it is important to look at ALLETE's future capital spending. Below is the company's estimates for future capital spending taken from the company's 10-K.


(Click to enlarge)

Even though there is growth expected in ALLETE's earnings, the company will continue to post negative free cash as ALLETE expects capital expenditures will continue to be in the 300 million dollar range over the next five years. This is not necessarily a bad thing as the company has used its free cash to purchase assets, upgrade its facilities and should continue to do so.

Analysts' Estimates

Analysts at MSN Money are estimating an EPS for FY 2013 at $2.75 while growth is expected to continue into 2014 as EPS estimates increase to $3.07.

If ALLETE maintains the same amount of shares over the next couple of years (39.92 million) this would give ALLETE a net income of $109.78 million in 2013 and a net income of $122.55 million in 2014. This would represent an increase of 13.06% in 2013 compared to 2012 and an increase of 26.22% compared to 2012 in 2014.

Dividend

In looking at the dividend over the past three years, the payout ratio has averaged 73.06%. In 2012, ALLETE earned $2.58 per share and paid $1.84 per share. In 2013, ALLETE has a full year estimated payout of $1.92. If the company earns $2.75 a share that would be a payout ratio of 69.82%. If earnings continue as projected and ALLETE earns $3.07 per share in 2014 and paid even a 67% payout ratio that would equate to a payout of $2.06 a share or an increase of 7.29% over 2013.

Price Targets

  • Finviz has a price target for ALLETE Inc. at $55.08
  • On April 16, Williams Capital Group gave the company an "Outperform" rating with a target of $55.
  • The Nasdaq currently has a price target of $55.25

Over the past month or so the utility sector has been showing weakness compared with the market. The above analysis reveals that ALLETE Inc. is a strong company that is getting stronger. The company's focus on environmental standards while maintaining growth leads an innovative company with a bright future. Earnings projections have ALLETE Inc.'s net income at $109.78 million in 2013 and at $122.55 million in 2014. As this is the case analysts are estimating that ALLETE earns $2.75 a share in 2013 and $3.07 in 2014. Based on this information the company should be able to support a strong increase in the dividend in 2014. Currently, it looks like the sector is forming a bottom, if this holds and begins to break to the upside this should prove to be an excellent opportunity to invest in ALLETE Inc.

Source: Allete Inc.: A 3.98% Yield Coupled With A Significant Increase In Earnings