It has been more than a year ago since I written about Wisconsin Energy (NYSE:WEC), and subsequently added the company to my portfolio of dividend stocks. Since then, we have seen a 23% increase in stock price, its dividend increase twice to a level 24% above what it was then, and some remarkable evidence of its nature as a rock-solid high growth dividend stock.
For those who are new to the company, here is some short background information:
Wisconsin Energy was founded in 1981, and the company generates and also distributes electric energy. It generates electricity from coal, natural gas, wind, biomass and also from hydro-electrical sources; and then it provides electric utility services to a variety of industries, including the mining, food products and the retail industry. It also generates and sells steam. It is also the largest electric and gas utility company in Wisconsin, with 1.1 Million electric customers and another 1.1 Million natural gas customers. Besides all these, the company also invests in and develops real estate, like business parks and commercial real estate projects.
|TTM Income||$611.20M (P/E: 18.8)|
|TTM Sales||$4.95B (P/S: 2.30)|
|Book Value per Share||$19.50 (P/B: 2.58)|
|Return on Equity (ROE)||14.10%|
|EPS Growth Past 5 Years||10.80%|
Do refer to my previous article for the main structure of the buy thesis. A substantial part of the buy thesis has largely remained the same. In this follow-up article, I will be focusing on the key changes between then and now. As the company has evolved since then, there has been both good and bad developments in the company's prospects.
One plus point that has been evident over the past year is the company's accelerating dividend growth. The company grew dividends by 20.4% from 2012 to 2013, and has increased dividends by further 8% this year. Besides this, the company has also recently announced that dividends would be grown by a further 8.3% to $1.69 annualised, which represents a yield of 3.4% on the last closing price. This is in line with management's promises in 2012 to increase payout ratios to the 65%-70% range, which is near the industry average for utility stocks. In light of a forward payout ratio of 63% (drawing closer to management targets), I expect dividend growth to slow down slightly (nearer to the growth rates of earnings) going forward.
A chart showing Wisconsin Energy's dividend payments over the past 10 years can be found below:
Conservative Management - Beating Earnings Estimates
In addition, Wisconsin Energy management has continued their multi-year streak of earnings beats. As shown in the chart below, all of Wisconsin Energy's earnings reports over the past 4 years has beaten EPS estimates. This shows that the Wisconsin Energy management team is very conservative in laying out their plans and estimates each quarter. This quality of under-promising and over-delivering is an outstanding one that will ensure both the company's continued success in the industry and the satisfaction of shareholders.
An earnings beat can also mean an increase in stock price, especially if it is significant. Hence, this can also bring some possible short-term price appreciation for shareholders
Courtesy of zacks.com
Acquisition of Integrys Energy
In June 2014, Wisconsin Energy announced that it would purchase Integrys Energy for $9.1B. This deal, which is expected to bring a considerable amount of positive synergies for Wisconsin Energy (which will change its name to WEC Energy after the acquisition), will be completed next year.
Courtesy of wisconsinenergy.com
First and foremost, the acquisition will expand the area that Wisconsin Energy will be supplying, and increase the company's power generating capacity from its current 6020MW to over 8700MW with the addition of Integrys' power generators. The acquisition will also allow the company to operate 7 regulated electric and utility companies, making the combined company a leading electric and gas utility and the Midwest and also the 8th largest natural gas distribution company in the USA.
In addition, the acquisition will also increase Wisconsin Energy's stake in the American Transmission Company (NYSEMKT:ATC) from around 20% to 60%. This will make the combined company the majority shareholder in the ATC. The ATC was founded in 2001 as the first multi-state, transmission-only utility in the USA, focusing only on the transmission of electric power from the generator to the areas where it is needed. This will give the new, combined company more flexibility in the transmission of electricity, and also an extra income source as a toll road if other utility companies are using it to transmit electricity.
With all these benefits, the company's management is expecting a long-term EPS growth rate of between 5% and 7% and for dividend growth to continue accelerating towards their target of a payout ratio between 65% and 70%.
Undertaking Practical Projects For Safety
In addition, Wisconsin Energy's management has been (and will be) undertaking more practical projects for the safety of their infrastructure, instead of focusing on other projects for more ambitious projects such as expansion. As shown in the slide below, one of Wisconsin Energy's points of focus over the next few years will be to upgrade their old, outdated infrastructure that might possibly compromise safety and efficiency. This shows how the management team knows their priorities, without neglecting the maintenance of their old infrastructure. It is no wonder, with such qualities, why Wisconsin Energy clinched the award for being the most reliable utility company in the USA for 2013.
After the USA in general experienced an especially chilling winter in 2013, with phrases such as "polar vortex" commonly seen, weather this year has been considerably milder. The summer of 2014 was not as warm as usual, with articles stating that this year's summer was just an extension of spring. This has decreased the electricity usage of American households, which has taken a toll on the earnings of Wisconsin Energy. For instance, Wisconsin Energy's EPS in Q3 2014 declined from a year-ago $0.60 to an adjusted $0.57, which was due, in part to a 2% decrease in revenues to $1.03B year-on-year. The earnings release can be accessed here.
Additionally, this mild weather is expected to continue this winter and also into next year. As shown in this National Geographic article, temperatures this winter in the Midwest (the region which Wisconsin is in) are forecast to be 16% warmer than in the 2013-2014 winter. This factor, with better than expected replenishment of fuel stocks, means that the average household will spend as much as 27% less this winter.
Although this is great news for people, this will also bring decreased profits for utilities like Wisconsin Energy going forward, especially after experiencing a great boost in earnings from the harsh winter last year. In fact, analysts have already reflected such a trend in their estimates, with sales expected to decline 13% in Q4 2014 (year-on-year) and to decline by 2% in Q1 2015 (year-on-year). EPS figures are also expected to decline by around 10% year-on-year for each of the two quarters mentioned above. Such slower growth may take a toll on capital appreciation and the growth rates of dividends over the short term. But, I believe that this, in no way, impacts the company's favourable future prospects.
The government has been placing many regulations on utilities such as Wisconsin Energy of late, as part of a movement to reduce pollution to make the USA more environmentally-friendly. For example, the government has set targets for the company to meet in terms of the amount of energy to be powered by cleaner forms of energy such as natural gas (instead of coal) within a limited amount of time. Additionally, as shown in this news article, one of We energies' power plants was converted from a coal-fired plant to a natural gas-burning plant instead. The change was needed since the plant previously lacked pollution regulations imposed by the government.
More recently, the Environmental Protection Agency (EPA) proposed a regulation that would reduce carbon dioxide emissions from coal plants by up to 30% by 2030 as compared with 2005 levels, as shown here. With the regulation expected to come into effect in the near future, the company can expect to divest more funds towards projects to reduce emissions of harmful pollutants, and towards cleaner forms of energy or even renewable energy sources. All these regulations will cause higher expenditures, resulting in lower earnings and margins, which will not in the best interests of the company.
I will be using the conventional DCF valuation method to value Wisconsin Energy.
First and foremost, I will be calculating the discount rate (weighted average cost of capital) for both the current time period and the terminal time period (11 years later). I will be using the WACC formula in the image below.
Courtesy of Investopedia.com
With the risk-free rate (10 Year Treasury Bonds) at 2.08%, the Equity Risk Premium taken to be 6%, and Wisconsin Energy's beta at 0.38, the company has a cost of equity of 4.36%
|Cost Of Equity=2.08%+(0.38*6%)|
|Cost Of Equity=4.36%|
Since Wisconsin Energy's interest expense this year of $252M has been generated from $5.26B in debt, we get a cost of debt of 4.80%. After tax of 36% (average tax for WEC over the past 5 years), the company's cost of debt is 3.07%.
The company had $5.243B in debt and $4.263 in equity as of fiscal year 2013. Weighting the cost of debt and the cost of equity by these two figures, we generate an initial WACC of 3.65%.
Following this, we calculate the final (terminal) WACC for Wisconsin Energy. For the cost of equity, we will assume that the risk-free rate in the USA stays at 2.08%, the equity risk premium stays at 5%, and the that the company's beta remains constant at 0.38. This yields a cost of equity of 4.36% once again.
For the cost of debt, we will assume that Wisconsin Energy has a debt/equity ratio of 85.35%, the industry average for the electric utility industry. In addition, we will also assume that the company's cost of debt decreases from its current 4.80% to 4.09%, which is 2% above the risk-free rate- more typical of companies experiencing stable growth.
Applying the same formula, we generate a final WACC of 3.56%, slightly lower than the initial WACC.
Now, we will estimate the revenue, EBIT and FCF growth Wisconsin Energy will experience over the next 10 years. Here are some assumptions I made during the valuation process:
Revenue Growth Forecast: With analysts expecting revenue growth rates of 2.8% next year (2015) due to expected mild weather, I will be conservative and will assume that revenues grow at 2.80% over the next 5 years, before slowing down from Year 6 to Year 10 at a constant rate to reach 1.46% in the terminal year. Since a general rule of thumb is for the terminal growth rate to not exceed the risk-free rate, the terminal growth rate in this valuation is set at 70% of the current risk free rate of 2.08%.
Operating Margins: Operating Margins are expected to converge towards the industry average operating margins of 17.26%. Operating margins are assumed to stay constant throughout the first 5 years of the valuation, before declining at a constant pace from Year 6 to the terminal year.
Tax Rate: The effective tax rate for Wisconsin Energy is at 36% this year, even though the average effective tax rate for the electric utility industry is 31.82%. Hence I assumed that the company's tax rate would decline from 36% to 31.82% at a constant rate between Year 1 and the terminal year.
Reinvestment (Initial Years): Reinvestment refers to the amount the company will spend to grow itself in one fiscal year. It is the sum of Capital Expenditures and the change in Non-Cash Working Capital. I will assume that the company has a Sales/Capital ratio of 0.545 (average for electric utilities industry). Hence, the reinvestment figures you will see in the image of the excel spreadsheet below will adhere to this figure for the first 10 years of the valuation.
Reinvestment (Terminal Year): The reinvestment rate in the terminal year will be computed by taking the terminal growth rate, divided by the final WACC calculated earlier in the valuation.
With the above assumptions, we get the following numbers:
All values in Millions
By adding the Present Discounted Value of the FCFF values over the next 10 years, we get a value of $4.261B. The terminal value will be calculated by the formula below, and then discounted to give a present value of $13.798B.
|Terminal Value=Terminal Year Cash Flow/(Final WACC- Terminal Growth Rate)|
|Present Value of Terminal value= Terminal value/(Final WACC)^10|
|Present Value of Terminal value= $19.549B/ (1.0356)^10|
|Present Value of Terminal value= $13.774B|
By adding the two present values up (PV of Terminal value at $13.774B and PV of FCF values of $4.258B), we get a total present value of $18.059B. Adding the company's current cash holding and subtracting off its current debt holding, the final value of equity is $12.841B. Dividing by its current 225.52M shares outstanding, wits per-share value is $56.94. This is a 13% premium to the last closing price is $50.38.
In conclusion, even though Wisconsin Energy faces some challenges in the near future such as stricter government regulations and milder weather, the company's buy thesis and dividend policies are still very attractive to me. Besides this, it is also worthy to mention that many of the projects that the company is undertaking will be beneficial to it over the long term, whereas many of the challenges (such as mild weather) are shorter-term in nature. Furthermore, a DCF valuation of the company indicates that there is a margin of safety, with 13% upside in WEC shares from current levels. Hence, I believe that Wisconsin Energy will continue to be a long term buy for new investors, and also a long term hold for my dividend portfolio.
Disclosure: The author is long WEC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.