FirstEnergy (FE) is a diversified energy company headquartered 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 18,000 megawatts. The company's market capitalization is about $15.7 billion, and is traded on the New York Stock Exchange. At its current stock price, FirstEnergy offers a high-dividend yield of 5.8%, which is even higher than some high-yield peers like Duke Energy (DUK) or Southern Company (SO). However, as it is usually the case with some high-yielding companies, FirstEnergy's dividend quality is poor and its high-yield reflects fundamentals woes instead of undervaluation.
First Energy was formed in 1997 through the merger of Ohio Edison Company and Centerior Energy Corporation. It currently serves more than 6 million customers in 6 states, and has more than 16,500 employees. The company's revenues are primarily derived from electric service provided by its utility operating subsidiaries and the sale of energy and related products and services by its unregulated competitive subsidiaries. It has also some transmission operations which include 20,000 miles of high-voltage lines and three regional transmission operation centers.
Electric utility companies are under increasing legislative pressure to adopt cleaner electricity generation methods while maintaining competitive prices. This requires cleaner fuel sources, such as nuclear or wind power, instead of coal. On this point, FirstEnergy as a long way to go, given that its sources of generation are 60% coal, 20% nuclear, 11% renewables, 7% natural gas, and only 2% oil. Therefore, the company is much more susceptible to 'green legislation' than some of its major peers, like Exelon (EXC) or Duke Energy that rely much more on cleaner fuel sources like natural gas.
Regarding the company's financial performance, it has been negatively affected by weak power markets during the past few quarters. In 2012, FirstEnergy's revenues declined by 5.2% to $15.3 billion. Its EBITDA was stable from the previous year at close to $4.2 billion, reaching an EBITDA margin of 27.4% which is higher than for most of its peers. On the other hand, its net profit declined by 13% to $770 million, impacted by asset impairments. Its earnings-per-share declined by 16% to $1.84, compared to $2.21 per share in 2011. During the first six months of 2013 the company's results remained weak, leading to lower revenues, a steep drop in operating income, and a negative EPS on the second quarter. For the first half of the year its EPS was only $0.08, compared to $1.10 in the same period of the past year.
This financial performance is mainly justified by weak power fundamentals, which led the company to recently close 2 gigawatts [GW] of coal plants as response to this sustained weak market. This is clearly a sign FirstEnergy sees little improvement on power markets soon, and decided to save cash instead of being positioned to a possible recovery over the next few months.
FirstEnergy's dividend has been stable at $2.20 per share annually over the past few years. The company pays quarterly dividends of $0.55 per share, providing a steady income stream to its shareholders. This may lead to the conclusion that FirstEnergy is a reliable and sustainable opportunity for income investors, but looking at its coverage the conclusion is not the same. Moreover, as the company faces weak power markets, dividend growth should basically not exist over the next few years. Indeed, based on analysts' estimates FirstEnergy is expected to pay an unchanged dividend of $2.20 per share at least until 2015.
The dividend payout ratio has been very high over the past few years, which is a first warning sign that FirstEnergy's dividend may not be sustainable. The payout ratio was close to 100% in 2010 and 2011, increasing considerably in 2012 to 120% due to lower earnings. Although the utilities sector is mature and relatively stable which enables utilities to pay a high proportion of its earnings to shareholders, a dividend payout ratio close or above 100% is clearly unsustainable and way above the industry average of between 60-70%.
Based on cash flows, the dividend coverage is also poor. In 2012, the company's cash flow from operations ($2.3 billion) was not enough to finance capital expenditures (close to $3 billion), leading to negative free cash flow before dividends. As the company decided to pay an unchanged dividend, it was fully financed from debt leading to higher balance sheet leverage and poor dividend quality. Going forward, the recent plant closures will save some cash and lead to lower capex, which the company expects to be close to $2.3 billion in 2013. Therefore, FirstEnergy should be able to finance its capex but not its dividends, which is not sustainable forever.
Regarding its balance sheet, the company's indebtedness is high like most of its peers. At the end of the second quarter of 2013, FirstEnergy's net debt stood at close to $12 billion. This equals a net-debt-to-EBITDA ratio of 2.8x, which is high but below the average within its sector. The company's management recognizes this is an issue, and has taken several steps to reduce leverage such as asset sales, cost cutting, and a plan to issue equity in late 2013. This will reduce the company's leverage and will be supportive for its dividend policy.
Although FirstEnergy's high-dividend yield of 5.8% may appear tempting for income investors, its dividend quality is low and its risk is therefore quite high. Thus, a dividend cut may happen over the next few years, which would eliminate the only thing that makes currently FirstEnergy's stock attractive. Moreover, despite the company's weak fundamentals it is trading at almost 13x its 2013 estimated earnings and 8.7x EV/EBITDA, which is clearly not cheap and makes FirstEnergy a high-yield stock to avoid.