As of 17th May 2019, NextEra Energy (NEE) recorded a total return of 406.77% over the previous 10 years, beating the S&P 500 return of 299.23%. Such out-performance is quite outstanding, given NEE is just a utility company. On the other hand, NEE had been growing its dividend payment for 24 years, which is undoubtedly a very appealing attribute from the eyes of income investors.
NEE’s principal business is composed of two parts: (1) FPL, which is the largest electric utility in Florida; and (2) NEER, which focuses on clean and renewable energy. Most of FPL’s revenue is derived from retail customers. Such revenue is directly attributable to charges FPL ask for providing service, which is subject to the approval of the Florida Public Service Commission (FPSC). Depending on the term and length of the franchise agreement in concern, FPL is effectively the sole service provider in the stated municipalities and countries in Florida.
FPL’s low-cost service is another strength of its operations. As stated in its 2018 annual report, FPL’s 2018 average bill for residential 1,000 kWh bill was “well below” (around 14%) the average of reporting competitors within Florida. FPL’s low-cost service not only reduces the possibility of customers opting for self-generation, but it also strengthens FPL’s ability to thrive in a tightening rate-regulated environment.
As for NEER, more than 80% of its revenue was derived from wholesale markets. While the degree of competition might be higher, comparing to NEE’s retail-based operation in Florida, NEER’s competitiveness is sustained through its ability to obtain long-term contracts. Around 90% of NEER capacity was sold under long-term contracts as at the end of 2018. Incentives from governments, local or federal, to promote green and clean energy can also contribute to NEER’s profitability.
Simply put, the nature of NEE’s business and its strategy to offer low-cost service and to enter into long-term contracts are major attributes to NEE’s widening economic moat and competitive advantages.
Thesis & Recommended Actions
Long term dividend growth record of NEE is tempting for long-term income investors. However, at today’s price ($198.98 on 17th May 2019), investors are likely to experience a sizeable downward price adjustment that could wipe out 5 to 7 years of dividends returns.
To benefit from NEE’s strong and stable operation, while limiting the downside risk that comes with the overpriced common-stock, investors could instead allocate part of their portfolio in the junior subordinated debentures issued by NextEra Energy. Investors can secure a decent and stable income, while sitting-and-waiting for NEE’s shares to become attractive again.
This article will first deduct the possible payoffs from investing in the common stocks (NEE), comparing to our proposed strategy i.e. investing in the debentures (NEE-J or NEE-K) and switching back to NEE at a reasonable price. We wanted to first demonstrate how investors could benefit from, or secure a more remarkable return via, investing in NEE-J or NEE-K. Then, we will explore the validity of the underlying assumptions.
Potential Payoff (Buy-and-Hold: NEE)
First, we assume an investment horizon of 5 years. Since predicting the future is meaningless (no one can predict the future), there is no point in gauging what the future growth of NEE could possibly be. Instead, we assume that the past performance is an adequate indicator of a firm’s future performance, at least in the short-to-medium foreseeable future e.g. 3-5 years.
We wanted to see how returns of a buy-and-hold strategy in NEE at this point in time could differ from our proposed strategy, i.e. investing its debentures and waiting for NEE’s downside risk to materialise. Therefore, we assume that the current stock market rally is coming to an end, possibly within the next 5 years. It could be next year; it could be 2021 or 2023. If so, NEE’s valuation multiples will mean-revert to a more sustainable level e.g. 10-years average. After the reversion, we assume that the multiples will gradually increase at a rate that is similar to what had happened after the 2008 financial crisis (around 5.76% per year), which takes into the account of the gradually recovering market sentiments.
Using the figures provided in NEE’s May 2019 presentation, NEE’s adjusted EPS and dividends per share for the previous 10 years’ period are as follow:
Expected adjusted EPS for the next 5 years are:
To measure the potential dividend returns, we assume NEE would maintain a payout ratio of 60%. The payout ratio is calculated based on NEE’s adjusted EPS. It should be noted that NEE’s payout ratio has increased quite a bit in the past 10 years, from 46.67% in 2009 to 57.66% in 2018.
Expected future dividends per share are as follow:
If nothing bad happens within the next 5 years’ period, and NEE’s current multiple (25.84x) for the foreseeable future is sustained by market sentiment, NEE’s share price at t+5 is expected to be $281.77 (Adjusted EPS of $10.90 and a multiple of 25.84x). Including the expected income return, an investor buying NEE at today’s share price will earn a total return of roughly 55.98%.
However, if something bad does happen within the next 5 years’ period, perhaps a full-blown trade war, NEE’s share price is assumed to fall back to a more sustainable level, with a price/adjusted EPS ratio of 16.72x which is the 10-year average.
After falling to the 10-years average, we assume that the multiple would gradually rise with the recovering market sentiments.
The second row of the table below shows the expected share price right after it reverts back to a reasonable level. The third row shows the gradually-recovered expected share price at t=5. For t+5, row 2 and row 3 entries have the same value in that there is no subsequent recovery from the fall in stock price (investment horizon of 5 years assumed).
To explain the rationale behind, we take “t+1” and “t+3” as examples.
First, we assume the stock rally is coming to an end at t+1 and NEE stock is going to fall to a level that is consistent with a price/adjusted EPS ratio of 16.72x. Past EPS growth is assumed to be maintained in the foreseeable future, such that the adjusted EPS at t+1 would be $8.25 per share. The expected stock price is, therefore, $138.05.
Second, we assume that the market sentiment could recover gradually after the significant downfall, and NEE’s multiples would gradually increase at a rate of 5.76% (calculated based on the post-2008-09 data). As the market sentiments continue to recover for four years (t+2 to t+5), the expected Price/Adjusted EPS ratio would be 20.92x at t+5. As the adjusted EPS of NEE grows for four periods to $10.90 at t=5, the expected share price of NEE at t+5 would be $228.13. Taking into account of all the dividends received, the total return will be approximately 29.03%.
If the stock rally ends in t+3, NEE would first fall back to $158.66 (adjusted EPS of $9.49 and price/adjusted EPS of 16.72x). As market sentiments recover, expected multiples would grow from 16.72x for two periods (t+4 and t+5) to 18.71x at t+5, resulting in an expected share price of $203.96 (adjusted EPS of $10.90). Total return would be 16.88%.
Repeating the same process, an investor buying NEE at today’s price with a buy-and-hold strategy will have the following total return, assuming NEE’s downside risk materialise in t+1, t+2, t+3, t+4, t+5 respectively.
Potential Payoff (start with NEE-K or NEE-J, switch into NEE at a reasonable price)
Our proposed strategy is that investors could first put their money into exchange-traded debentures and sit-and-wait for the downside risk of NEE to materialise.
It should be noted that we are not attempting to time the market! What we wanted to do is to stay away from NEE when its valuation is expensive, and get back into NEE when the valuation is reasonable.
Therefore, when estimating the expected return from the proposed strategy, we do not assume that an investor would be able to buy back NEE at a price/adjusted EPS of 16.72x, instead, we assume that an investor would switch from NEE-K or NEE-K to NEE at a multiple that is somewhere in the middle of 16.72x (our target level) and 25.84x (today’s multiple). In our calculation, we used an adjusted EPS of 21.28x.
Let’s go through the process step by step:
First, we assume that the $198.98 that could have used to purchase NEE is invested in NEE-K or NEE-J instead. When NEE falls back to a reasonable level i.e. price/adjusted EPS of 21.28x, all NEE-J or NEE-J is sold and switched into NEE’s common stocks. For example, if the downside risk materialises at t=1, investors could switch out from the debentures with the original amount of $198.98 together with the interest earned for period 1 (~5%) and buy 1.1894 shares of NEE (although the share is not supposed to be divisible, it’s merely a portfolio size problem). Investors could then earn NEE’s dividend from t=2 to t=5 and eventually sell NEE at t=5, earning a total return of 55.50%.
The expected returns for each of the scenarios (downside risk materialises at t=1, t=2, t=3, … etc.) are as follow:
Defensive stocks not so defensive when overvalued
We have demonstrated how the proposed strategy could be a better approach when investing in NEE. Bull markets come and go (same for bear markets); Share price rises and falls. The recent bull market has a span of approximately 10 years, we know it is going to end. It could be this year, triggered by the trade war. It could be next year, triggered by something else. Or it could be 3 or 4 years later. We don’t know. No one can predict that. What we can do is to prepare. Instead of speculating or attempting to time the market, the simplest thing to do is to stay away from over-valued stock and put our money into something that is less correlated with the broader market.
Utility stocks are “empirically” meant to be relatively less correlated with the broader market, compared to industries like banking, insurance or consumer discretionary. However, an over-valued, or “hot”, utility stock like NEE may not be able to stay defensive when the broader market cools down.
NEE’s current valuation multiples vs. 5-yr. average (as of 17th May 2019):
- Price/Sales: 5.62 vs. 3.64
- Price/Earnings: 33.33 vs. 17.36
- Price/Cash Flow: 13.81 vs. 9.91
- Price/Forward Earnings: 23.98 vs. 19.35
- EV/EBIT: 27.27 vs. 15.53
Mean-reversion of NEE’s valuation multiple (Price/ Adjusted EPS)
Based on the brief time-series comparison of NEE’s valuation above, it is reasonable to conclude that NEE is over-valued, especially when NEE’s growth potential, as a utility stock, is really not that attractive. NEE’s much-higher-than-average valuation multiples can be explained by the recent 10-year bullish market that has inflated asset prices and the flight-to-safety caused by the US-China trade war.
But how far could NEE fall? No one knows. The assumption used in the above analysis is that NEE would mean revert back to its 10-year average. People price stock according to their expectation of the business. Investors are willing to pay an expensive price to buy growth stocks because they believe that the “growth premium” that they paid for is going to be compensated by the actual business growth in the future. For example, a stock with P/E of 50x today may seem expensive, but when its earnings grow 5 times, e.g. $1 to $5, the actual P/E for an investor who paid for the stock at 50x would become 10x. However, investors’ expectations for business growth tend not to be based on the business itself, but also the broader market sentiment. This is because investors tend to extrapolate recent trend into the future. When everything is falling, investors’ growing fear would stop them from paying an expensive “growth premium” to purchase growth stock. When investors think that they overpaid for a certain stock and fear that they are never going to recoup what they’ve paid, they would dump the stock to limit their losses. These kinds of behaviours are likely to be overreacted. Warren Buffett’s famous quote – “Be fearful when others are greedy and greedy only when others are fearful” are most certainly based on such overreaction of the market participants.
So, when assuming that NEE would fall back to a more reasonable level, we are actually suggesting that the “growth premium” embedded in NEE’s stock price is unjustified by NEE’s actual growth potential.
In the past five years, NEE’s average operating income for the period was 4541 million. When compared with an earlier period, says 2009 to 2013, during which the average operating income was 3242 million, NEE’s operating income appears to have grown quite a bit. However, if we look at the trend of average operating income figures, longer-term growth was in fact slowing. Declining growth in longer-term average in both revenue and operating income is obvious.
Such a decline could be attributed to NEE’s growing scale of business operations. The organic growth of its existing business is limited to the demographic conditions and acquisition of new projects is unlikely to have a meaningful contribution to the growth of NEE, especially when compared to the much larger scale of NEE’s current operation.
NEE’s recent acquisition of Gulf Power Company is a case in point. Gulf Power Company is going to add 2,300 MW of generating capacity to NEE’s current operations. Comparing to NEE’s current generating capacity of 45,500 MW, the potential growth in revenue is merely 5.05% and the opportunity cost of capital associated with the acquisition is not dismissive. NEE paid $4.47 billions of cash and assumed $1.3 billion of Gulf Power’s debt. After taking into account the acquisition expenses and the financing expenses that come with the assumed debt, the net income growth from this sort of acquisition is likely to be less than the incremental revenue growth.
Small-scale acquisitions can add value to NEE but are unlikely to bring exceptional growth. Demographic conditions that could affect NEE’s electricity operation, especially FPL’s retail business, are out of NEE’s control. When the stock rally comes to an end, market sentiment is likely to cool down. Investors will be less likely to pay for an expensive “growth premium” attached to NEE’s current stock price.
However, will NEE fall back to a level that gives a multiple of 16.27x? We can’t be sure but we can still check out how the potential return would change if the extent of the potential fall is not as significant as we assumed. Our scenarios assume that NEE’s Price/ Adjusted EPS would fall from a current 25.84x to a 10-years average of 16.27x, which implies a 35% fall in the multiple that the market is giving to NEE’s valuation.
Tables below show the expected potential returns if our expected multiples (a gauge of market sentiments) only fall for 25% to 19.38x or 15% to 21.97x.
Buy-and-hold NEE, assuming multiples revert back to 19.38x:
Proposed Strategy, assuming multiples revert back to 19.38x:
Buy-and-hold NEE, assuming multiples revert back to 21.97x:
Proposed Strategy, assuming multiples revert back to 21.97x:
Adjusted EPS Growth of 7.21%
Another assumption that was used in the above scenarios is that the NEE is able to maintain its current adjusted EPS growth of 7.21% per year. While the future growth is very unlikely to stay at exact 7.21% per year, we would say that such 7.21%, calculated based on NEE’s past 10 years’ growth, is an adequate and effective “proxy”.
If past performance cannot be counted on when estimating the future, every investment decisions are more or less speculation or gambling, in that no one can predict the future. In NEE’s case, it is reasonable to suggest that its past performance is reliable when predicting its future performance.
Theoretically speaking, NEE as a utility stock is meant to be stable and safe, due to the wide economic moats that are usually associated with utility companies. Demand for its products and services are relatively stable and has a rather low correlation with overall economic performance. Therefore, considering the stability inherent in NEE’s business (stable demand and protection from economic moats), NEE’s past performance is an adequate indicator of its future performance. Still, it would make sense to check out how a lower-than-expected and higher-than-expected growth rate would affect the expected outcome.
Tables below show the potential payoff if the expected growth of adjusted EPS is lower than and higher than the expected rate by 1%.
Buy-and-hold NEE, assuming adjusted EPS growing at 6.21%:
Proposed Strategy, assuming adjusted EPS growing at 6.21%:
Buy-and-hold NEE, assuming adjusted EPS growing at 8.21%:
Proposed Strategy, assuming adjusted EPS growing at 8.21%:
NEE’s economic moat is wide and deep. Its management has demonstrated a strong commitment to increasing distributions to shareholders, with a good track record of 24 years of dividend growth. Its dividend was unaffected by the 2008-09 crisis. Its dividend paying capacity should be adequate for the next 10 years. There is no doubt that NEE is a good business.
The only downside is if the stock rally really does come to an end. For NEE’s Price/Earnings to revert back to its 10-yr. average, the negative price return is large enough to wipe out at least 5 years of dividend return.
For long-term investors interested in establishing a position in NextEra Energy, the current valuation is unlikely to offer any exceptional return but entails great downside risk. It is not unreasonable to first get into NEE's debenture to secure a stable income and sit-and-wait for NEE’s valuation to look attractive again.
- Avoid NEE at current valuation
- Buy NEE-J or NEE-K instead, to earn an income yield of ~5%
- Wait for NEE’s valuation to fall back to an attractive, or at least reasonable, level e.g. price/ adjusted EPS of 16.72x to 21.28x
Disclosure: I am/we are long NEE.PK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.