Investors in FirstEnergy (FE) managed to catch a small break towards the end of the trading year, which was been really difficult for the utility company.
Poor revenue growth, continued pressure on earnings, the buildup in leverage and the consequential uncertainty about the fat quarterly dividend paycheck heavily ways on the shares.
I don't share the optimism from analysts at Wells Fargo and remain on the sidelines given these concerns which could still depress the share price in the coming period.
Wells Fargo Turns Bullish
Analysts at Wells Fargo (WFC) upgraded FirstEnergy from "Market Perform" to "Outperform" on the final trading day of the week. At the same time, analysts boosted the valuation range from $35-$36 to $39-$40. The midpoint of the guidance suggests that shares have 23% upside from current levels.
Analyst Neil Kalton believes the valuation is more of a risk/reward proposition as the company moves towards a regulated-centric strategy, warranting higher valuation multiples.
The regulated utilities valuation is pegged at $35 per share, which in its turn is based on a 14 times 2015 earnings per share estimate of $2.54. The competitive energy operations could potentially provide meaningful upside if the economy continues to recover, Kalton notes.
For this scenario to work out, Kalton sees a 40% dividend cut being necessary, reducing the annual payout to $1.32 per share. This would result in about $1.5 billion in additional internal generated equity in the period 2014-2017, substantially mitigating its external equity needs.
For 2014 Well Fargo now sees earnings of $3.00 per share.
At the start of November, FirstEnergy released its third quarter results. The company holds $222 million in cash and equivalents, while operating with $20.58 billion in total debt, resulting in a very high net debt position of $20.36 billion.
Revenues for the first nine months of the year came in at $11.27 billion, down 4.3% on the year before. Reported GAAP earnings plunged from $918 million to just $250 million for the period. The company took $473 million in impairment charges as well as a $132 million loss on debt redemptions so far this year.
At this pace annual revenues are seen around $14.6 billion, while correcting for one-time expenses, earnings could come in around $800 million.
Trading around $32 per share, the market values FirstEnergy at $13.4 billion. This values equity in the firm at 0.9 times annual revenues and 16-17 times "normalized" earnings for this year. Excluding special items, the company guided for earnings of $1.25 billion, 10-11 times earnings.
The very fat quarterly dividend of $0.55 per share provides investors with an annual dividend yield of 6.9%.
Some Historical Perspective
Long term investors in FirstEnergy have seen a lack of capital gains, although the very fat dividend paycheck has provided them with nice returns in the meantime.
Between 2004 and 2008 shares doubled to $80 per share, to see shares fall towards $40 again in 2009. In recent year, shares have traded in a $30-$50 trading range, yet in 2013 alone shares have lost some 23% already with shares currently trading at $32 per share.
Between the calendar year of 2009 and 2012, FirstEnergy has increased its annual revenues by some 18% to $15.3 billion. Earnings fell by 12% to $770 million at the same time as the outstanding share base rose by 40% in the meantime.
FirstEnergy had a few problems in recent years. Among this was the large exposure to the "competitive" market instead of the safer "regulated" market during the recession. In 2009 these business were about 50/50 while the company is already 80% focused on regulated markets now, looking to expand this number even further in the future.
These competitive markets, the short term pain of closing older uneconomical coal plants and various other one time charges are hurting earnings and the prospects of the firm. The company has been paying out fat quarterly dividends of $0.55 per quarter for years now, adding to the company's debt. As such, the net debt pile has increased from $14 billion to over $20 billion in just a few year's time.
The annual cash flows of $900 million required to service these dividends, match reported earnings or even exceed them. As such the safety of this dividend, especially with an increase in leverage, falling sales and falling earnings is decreasing. These are no good prospects for the 2nd largest retail supplier of electricity in the US, with over 6 million customers.
The situation gets even more dire knowing that the company recently approved a nearly $3 billion additional investment plan in the transmission operations for the period 2014-2017, adding even more to the debt position. Note that returns on these investments in terms of lower maintenance costs etc. make this more than worthwhile, yet it still adds to the debt in the short term.
Further investments are needed to boost the renewable generation as well, as still 50% of generation is based on coal, with renewable generation making up little over 10% of total electricity generation. Management aims to boost this percentage to 23% by 2018 which seems quite ambitious and will require investments as well. At least these targets make the company well compliant with State regulations, requiring utilities to generate at least a fifth of total generation on average through renewables by 2024.
Still, I believe the underperformance this year is warranted, as the dividend by no means is safe. Even if the company would drastically cut its dividend to $1.00-$1.50 per annum, the company would pay a competitive dividend, while generating sufficient cash to fund expenditures and contain leverage. Such a move would furthermore provide the market with a huge amount of clarity, as the current dividend uncertainty is causing an overhang on the shares.
Given the premium GAAP earnings valuation, the dangerous leverage and unsustainable dividends, I don't see compelling upside at current levels given the structural weak revenue forecasts. That being said, shares are no outright short either. Note that shorting shares requires you to pay dividends to the rightful owner.
I remain on the sidelines and do not get lured in the very high dividend yield at the moment.