After the bell on Tuesday, FirstEnergy (FE) had some pretty terrible news to tell investors (press release available here). First, management slashed its quarterly payout by 34.5% to $0.36. This cut was the first in the company's 17-year existence. At the previous $0.55 rate, FE was yielding a fantastic 6.84%. However, that high yield was really a warning sign about the dividend's sustainability, especially when you consider FE hasn't raised its dividend since 2008. Based on where shares were trading on the news, FirstEnergy will still yield a solid 4.5%. That yield is of little comfort, though, to investors who have suffered a lousy 12 months when compared to the rest of the utilities sector (XLU).
Unfortunately, the company had more bad news beyond the dividend. FE tightened its 2013 earnings estimate to $2.95-$3.05 from $2.90-$3.10, which gives it the same midpoint of $3.00. While the 2013 update was unsurprising, 2014 guidance was stunningly bad. Management is guiding to $2.45-$2.85, which translates to a mid-point of $2.65. Meanwhile, the street has been looking for $2.82. FirstEnergy is expecting a significant sequential downturn in performance that far exceeds investors' expectations. At the midpoint of guidance, FE has a forward multiple of 12x. For a company with earnings falling 10%, that is not a particularly attractive multiple.
Importantly, this guidance has to leave investors questioning whether FirstEnergy cut the dividend enough. The new dividend will still account for 58% of earnings from FirstEnergy's main regulated business. Dividend payout ratios above 60% are often unsustainable, so if FirstEnergy's business continued to erode, another dividend cut would not be out of the question. At the very least, it is clear that performance will have to improve dramatically before investors could even entertain the possibility of a dividend hike. I would be extremely surprised to see one before 2016.
Now, utilities tend to carry a fair amount of debt due to the stable cash flows and capital-intensive nature of the business. FirstEnergy is no exception, as it carries $20.6 billion in debt against $12.5 billion in equity. FE's debt-to-equity ratio is pretty high at 1.65x, but it is nowhere near panic zone. My bigger concern is the trajectory of debt. At the end of 2009, the company carried $14.9 billion in debt, so it has added $5.7 billion in debt over a four-year period, though its debt-to-equity ratio has declined from its 2009 level of 1.73x thanks to equity added in the Allegheny Energy Merger. Nonetheless, this increase in debt was a warning sign about the dividend.
FirstEnergy has also had a cash flow problem, and in the first nine months of 2013, investing expenditures have exceeded operating cash flow by $604 million. FE also had negative free cash flow in 2012, as its $2.97 billion in cap-ex exceeded operating cash flow of $2.32 billion by $650 million. With rising debt and no excess cash, it was a matter of when, not if, FirstEnergy would cut the dividend. Now, the company has struggled because it had been shifting focus to the wholesale electricity market, which has been disastrous. Sluggish growth in the Northeast has kept electricity demand low, while natural gas plants have had major cost advantages, pushing prices ever lower. In the mid-Atlantic, electricity prices are down to $46 from $84 in 2008; it is no wonder that FirstEnergy's electricity revenue dropped over 7% last year.
FE has recognized its mistake and is now trying to shift back towards the regulated market. It has sold power plants that generated electricity for the wholesale market and cut $1 billion in expenses in this area. The company can use these savings and the $275 million saved by cutting the dividend to fund expansions in transmission lines, as it focuses on regulated growth projects. This necessary investment to power growth with low electricity prices will make free cash flow scarce in 2014 and leave debt reduction out of the question until 2016 or more likely 2017.
This dividend cut was a painful but necessary action for FE to fund a turnaround as it focuses on its regulated business. Still, with an exceptionally weak 2014, FE's stock remains expensive. Investors should also recognize that a rising rate environment will pressure all utility stocks as the yields become less valuable. With unfavorable market factors, declining performance, and heavy cap-ex requirements, investors should avoid FE until it hits 10x earnings or $26-$27. At current prices, investors would be better off with a utility that has executed better, like Consolidated Edison (ED). After this dividend cut, FirstEnergy is still a sell.