Does Westar Energy Belong In Warren Buffett's Energy Portfolio?

| About: Westar Energy, (WR)

Summary

Westar Energy shares climbed 20% since my purchase in August 2015.

Investors of Westar Energy should expect a dividend increase.

A look back on Buffett's investments in energy.

In August 2015, I wrote Westar Energy (NYSE:WR): Why I'm Buying This Midwest Utility. The stock is up 20% since then. The stock may run another 5% to 7% before topping out at $49 per share. This is a good time for short-term traders to take profits. I bought shares at $37.03 per share Aug. 27 and Aug. 30, 2015, the stock has grown into 8.3% of my portfolio. WR climbed another $0.71 per share or 1.6% on Tuesday, a day when U.S. indexes were down -1.8%.

Westar Energy is a progressive utility that is moving into alternative energy, with renewable energy to account for 17% of planned generation mix for 2016, up from 9% in 2015. Coal is set to decline to 44% from 48%. Natural gas is set to decline slightly to 32% of generation from 35%.

I imagine Warren Buffett has looked at Westar Energy over the years, the company is based in Topeka, just 161 miles south of Omaha. Buffett and his partner Charlie Munger have purchased businesses in Topeka before, including Kansas Bankers Surety Co. in 1996. And they have done a lot of business in Kansas City, too, including the purchase of Helzberg's Diamond Shops and the construction of Nebraska Furniture Mart.

Investors have seen Westar Energy change from multiple business ventures in the 1990s to a pure-play utility since the early 2000s, with investment grade bonds.

Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) has been doing business with Westar Energy for several years through a joint-venture to build high capacity electrical transmission in south-central Kansas. Prairie Wind Transmission is a joint venture between Westar Energy, Berkshire Hathaway and Electric Transmission America. The 108-mile, 345-kilovolt line serves the wind farms in the region. That venture is a superhighway of transmission that earns money for carrying electricity.

While many energy companies are losing revenues, Westar Energy will grow its revenues while cutting some expenses. The Kansas Corporation Commission recently awarded Westar a rate increase that went into effect in the fourth quarter 2015. The rate case will add about $78 million in revenues, a 3% increase.

On the capital front, Westar spent over $1 billion in air quality investments in the past five years. The company is winding down expenses in air quality, from upwards of $200 million annually to less than $30 million 2016. That is a big savings.

Westar is trading at a premium to its peers. Buffett paid a high multiple for Precision Cast Parts. Buffett has been buying Phillips 66 (NYSE:PSX), Berkshire Hathaway is now 13.7% owner of Phillips 66.

For many years, Buffett stayed away from oil and gas and electric businesses, preferring instead for higher margin consumer products businesses like Sees Candy and Coca-Cola (NYSE:KO). But while the dot com boom was going in 1999, Buffett bought over 70% of MidAmerican Energy, later increased ownership to 89%, now part of Berkshire Hathaway Energy.

In 2002, Buffett purchased Northern Natural Gas at 7 times earnings from Dynegy (NYSE:DYN) for $928 million, a discount to the $1.5 billion Dynegy paid for it from Enron. In the 1970s and early 1980s Northern Natural Gas had been based in Omaha but Ken Lay took the company headquarters to Houston with the formation of Enron.

Westar's dividend

One reason for Westar Energy's outsized stock performance lately is the likelihood the company will raise its dividend. Westar's dividend payout ratio is 65% of earnings compared with payout ratios by peers like Dominion (NYSE:D) with a payout ratio of 84.2%. Westar is getting another $78 million in revenue in 2016 due to increase in rates approved by the Kansas Corporation Commission. With more money coming in, it's possible Westar could raise its dividend by $0.04 to $0.05 per year to around $1.49 annually from trailing 12 months of $1.44.

I suspect we will probably hear something about the possible dividend increase at the company's fourth quarter conference call. The company plans to announce Q4 and full-year results on Feb. 24, 2016. I expect earnings per share to be soft, due to mild weather, we may see a short term slide in the stock.

Risks

Mild weather in Kansas may hurt earnings in the short term. Demand for power from energy companies will decline. Among Westar's commercial clients are chemical and oil businesses that may cut back on consumption of electricity due to reduced demand for their products.

I think Westar Energy belongs in Berkshire Hathaway Energy's portfolio of businesses. This is a blot-on acquisition that will run itself while sending regular earnings to Berkshire Hathaway in Omaha. However, I doubt Buffett will pay 21 times earnings for the company. The odds of Buffett buying Westar Energy are probably less than 50% at its current valuation.

Conclusion

I see a strong future in wind generation in Kansas. Tax credits make this a cheap alternative source of power for Westar Energy. Westar Energy is deserving of being one of Buffett's businesses. Mark Ruelle, CEO and president of Westar Energy, has been doing a great job of managing the business. He has plenty of quality people underneath him. I am holding my Westar Energy stock for the solid dividend, yielding 3.3%. Buffett likely won't buy the company at current multiples of valuation, but I wouldn't rule it out either. If we see an extraordinary correction, a bunch of stocks get cheap, including this one, he might consider it. Outside of an extraordinary event, this stock will likely trend down if there is a mild spring and summer. So far this winter has been mild. If the stock ever falls to $39 per share again, I might consider buying more Westar Energy. In some ways, I prefer Buffett does not buy this stock. Westar Energy stock has outperformed Berkshire Hathaway in the past 12 months. Berkshire Hathaway does not pay a dividend. Westar is likely to increase its dividend in 2016.

Disclosure: I am/we are long BRK.B, WR, KO, D, PSX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.