Understanding NextEra's Dividend Cushion Ratio

| About: NextEra Energy, (NEE)


Adjusted earnings per share at electric utility NextEra has grown at a ~8% CAGR since 2004, and operating cash flows have strength has followed.

NextEra is now targeting a 65% dividend payout ratio by 2018 and expects to grow its payout 12-14% per year through 2018. Nice.

Most large public utility holding companies have raw, unadjusted cash-flow-derived Dividend Cushion ratios below 1. Let's explain what all of this means.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Financial performance has been solid for US electric utility holding company NextEra (NYSE:NEE) recently. Adjusted EPS has grown at a ~8% CAGR since 2004 and operating cash flows have strengthened, helping generate robust free cash flow of over $2 billion in each year from 2013-2015. The company recently updated its dividend policy, and it is now targeting a 65% payout ratio by 2018 and expects to grow its payout 12-14% per year through 2018. This represents an acceleration of growth from the 8.4% CAGR in the dividend since 2004. The firm has positioned itself well to capture the coming transition to renewable energy, and we can only expect continued growth in its dividend at this point; shares currently yield ~3.1%. Investors must be aware of NextEra's massive debt load, however (see red bar in image below).

Image source: Valuentum

Most large public utility holding companies have raw, unadjusted cash-flow-derived Dividend Cushion ratios below 1, indicating that future expected free cash flows over the near term are completely absorbed by net debt obligations and future expected dividend payments (over a 5-year future forecast period). Utilities' high dividend payout ratios (dividends paid per share divided by earnings per share) and elevated capital outlays--both of which prevent the buildup of cash on the balance sheet--coupled with the ballast of hefty debt obligations, which are higher on the capital structure than any equity concerns, prevent most utilities from receiving a healthy Dividend Cushion ratio, a proprietary Valuentum measure and a pure financial-statement based comprehensive assessment of the coverage of the dividend. NextEra's Dividend Cushion ratio currently sits at 0.2 (divided the numerator, the left bar, by the denominator, the right bar).

Image source: Valuentum

Utilities are among the most popular stocks for many income investors, a notion that has only intensified after years and years of loose monetary policy that has helped drive dividend yields of many utilities well past those of risk-free assets such as the 10-year Treasury bill. Utilities equities are generally considered "safer" investments relative to most other business models due in part to their fixed rate of returns through regulatory support and "monopolistic" characteristics that are common to their operations. All of this sounds great, but that doesn't mean their dividends are iron-clad. If anything, we want income investors to be aware of the tangible dividend risks of the group.

Shown below: The Definition of the Dividend Cushion Ratio

How utilities (NYSEARCA:XLU) perform as we move into a Trump administration and combat a new, rising interest rate environment will be interesting. Should the yields on risk-free instruments continue to expand, some income investors may switch to the risk-free option of Treasury bonds, pressuring utility equity prices in the process (utility stocks are widely used as income-oriented vehicles). However, potential tax cuts at the corporate level coupled with the timing of regulatory agreement updates could provide a period of elevated profit margins for some players in the sector. No matter what happens, we'll be watching the industry in coming quarters. Lets dig into the remainder of NextEra's investment considerations.

NextEra's Investment Considerations

Image source: Valuentum

Investment Highlights

• NextEra is composed of FPL, one of the largest US electric utilities, and Energy Resources, a leader in renewable generation. The firm boasts an investment-grade credit rating and has generated steady adjusted earnings-per-share and dividends-per-share growth for years. The company was founded in 1984 and is based in Florida.

• We have generally liked the utility's above-average and highly visible growth trajectory. It has a rate agreement through 2016, and plans to file in 2016 for rate relief beginning in 2017. A final decision is expected in the fourth quarter of the year.

• Over the last decade, Energy Resources has invested ~$23 billion in renewable energy in wind and solar generation. These investments have been bolstered by tax credit extension, carbon regulation, and ongoing technological advances. Renewable energy development opportunities have never been stronger.

• We like that the firm's energy portfolio is only of moderate risk. Roughly 85% of adjusted EBITDA comes from regulated and long-term contracted operations. The company also has one of the strongest balance sheets in the industry (its credit is A-).

Business Quality

Image source: Valuentum

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. Our measure of ROIC is different than that which utilities use internally.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. NextEra's 3-year historical return on invested capital (without goodwill) is 5%, which is below the estimate of its cost of capital of 8.4%. As such, we assign the firm a ValueCreation™ rating of POOR.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

Image source: Valuentum

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. NextEra's free cash flow margin has averaged about 12.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At NextEra, cash flow from operations increased about 24% from levels registered two years ago, while capital expenditures expanded about 24% over the same time period.

Valuation Analysis

We think NextEra is worth $112 per share with a fair value range of $90-$134. Even for relatively stable utilities, we use a margin of safety in our practice.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7%.

Our model reflects a 5-year projected average operating margin of 31.1%, which is above NextEra's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For NextEra, we use a 8.4% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

Image source: Valuentum

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $112 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for NextEra. We think the firm is attractive below $90 per share (the green line), but quite expensive above $134 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion

Future Path of Fair Value

Image source: Valuentum

We estimate NextEra's fair value at this point in time to be about $112 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of NextEra's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $138 per share in Year 3 represents our existing fair value per share of $112 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: The XLU is included in Valuentum's Best Ideas Newsletter portfolio.

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