FPL Group: Undervalued, But With Limited Upside Potential

| About: FPL Group (FPL-OLD)
According to Value Line Investment Survey, "FPL Group, Inc. is a holding company for Florida Power & Light (FPL-OLD), a utility engaged in the generation, transmission, distribution, and sale of electricity to 4.5 mill. customers in a 27,650-sq.-mi. area in eastern & southern Florida. NextEra Energy Resources is a nonregulated power generator with nuclear, gas, & wind ownership."
At the forefront of the concerns for FPL Group is the recent rejection by state regulators for a rate increase. On January 14, 2010, FPL Group was turned down for the requested rate increase of $1 billion in 2010 and $250 million in 2011. As bad as this seems for FPL Group the decline in the stock price seemed to have anticipated the outcome with the peak of the price on December 11, 2009 at $56.25. After December 11th, the stock of FPL Group fell to $51.50 the day before the rate decision came due. In my estimation, any decline in the price of FPL after the decision was simply reactionary on the part of speculators who were caught on the wrong side of the trade. FPL fell to its lowest point at $45.57 and has risen steadily since.
According to Dow Theory, FPL has the following upside targets (based on the peak of $72.56 on December 5, 2007 and the decline to $37.08 on October 10, 2008.):
  • $48.90
  • $60.73
  • $72.56
FPL has the following downside targets (based on the February 2, 2000 low at $18.41 to the peak of $72.56):
  • $45.48
  • $36.43
  • $27.42
  • $18.41
Of particular concern to me is the fact that we are in the 5th year of an inflationary cycle. As noted in the right hand column of our website, inflation seems to have a 50-year full cycle which according to Dewey and Dakin's book Cycles: The Science of Prediction, would have begun in 2005/2006. It is important to note that Dewey and Dakin's book was published in 1947 and indicated the subsequent peaks and troughs in the inflation rates since. The impact of this thesis is quite relevant to FPL Group and all utility companies since they rely almost exclusively on borrowing to fund their current and future operations. The higher their borrowing costs the more the impact to the company's earnings.

With the aforementioned interest rate issues in mind, I would like to reference Investment Quality Trends' view that FPL Group is considered undervalued when the stock has a dividend yield of 9%. With the current annual dividend of $2, FPL Group would be selling for $22.22 if yielding 9%. If we were to assume that FPL Group were to fall between the current yield of 4.10% and 9%, the FPL Group would fall to the level of $30 when yielding 6.5%. These estimates to the downside should be paramount to the consideration of the investment in utilities. What concerns me the most with utilities is the prospect of a decline similar to the period from 1965 to 1974. In that period, the yield on the Dow Jones Utility Index went from 3% all the way up to 12% (Source: Weiss, Geraldine, Dividends Don't Lie, Longman, 1988).

According to Value Line Investment Survey, FPL normally trades around 1.34 times the per share dividend divided by the "interest rate" (1.34x $2/interest rate). Valueline doesn't tell us by which interest rate we should apply to the company, so I have decided to apply the 30, 20, and 10 year U.S. Treasury rate. The following are the mean prices that FPL would trade at for each interest rate scenario:
  • 30-year rate- $55.71
  • 20-year rate- $57.63
  • 10-year rate- $67.68
Based on the 30 year rate, FPL is selling 14.84% below the historical mean value. I chose the $55.71 value since it was the most conservative figure.
Considering all the issues that are present in an increasing interest rate environment going forward, we're going to take a look backwards and examine the fundamentals of FPL Group. According to Morningstar.com, FPL is selling 28.5% below the average P/E over the last 10 years. In terms of the price-to-book ratio, FPL is selling 29.33% below the 10-year average. The extremes based on the 10-year average for FPL are that the stock is selling 14% below the average based on a price-to-sales ratio and 57% below the average on a price to cashflow basis over the same period.
Again, my concern with the fundamental data on utilities since 1980 is that it is based on a falling interest rate environment which is highly favorable to borrowers. The opposite should be true in what I believe lies ahead for interest rates. If I were to invest in this stock, I would buy, as my limit, only half of my normal position and no more.

Disclosure: No positions