Undervalued Dividend Growth Stock of the Week: SCANA Corporation (SCG)

If taking just one action today could positively impact you for the rest of your life, would you not take that action?

What if you could work once and earn forever?

Is that not an appealing proposition?

This is essentially the proposition when one invests in a high-quality dividend growth stock.

When you buy a high-quality dividend growth stock, you’re setting the stage for earning passive and growing dividend income for, potentially, the rest of your life.

Just taking that one action could result in a permanent benefit to your finances and life.

That also converts the income you’re earning today (through your work) into what could be income forever.

Moreover, passive income is so much better than active income for a number of reasons, not the least of which is not having to expend any effort to receive it.

Well, taking “one” action over and over again (by regularly buying up shares in some of the best businesses in the world, building a diverse portfolio in the process) can create a massive paradigm shift in your life, even eventually allowing for financial independence.

I’d know how that works, as I worked hard, saved my money, and invested in more than 100 of the most wonderful companies in the world, building my real-life six-figure dividend growth stock portfolio in the process.

This portfolio generates five-figure and growing passive dividend income on my behalf, rendering me financially independent in my 30s (see my “blueprint” to early retirement.)

I’ve been spending the last seven or so years of my life taking that “one” action as often as possible, buying up shares in high-quality dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list.

And now I’m paid just to wake up in the morning.

You could be in this same position, but you have to take that “one” action as often as possible.

That’s what brings us to today’s article.

I’m going to reveal a high-quality dividend growth stock (culled from Mr. Fish’s illustrious CCC list) that appears to be undervalued right now.

The undervaluation aspect is vital, as this can affect an investment in a variety of ways.

Price, of course, is only what you’re going to pay for something. But value is what that something is actually worth.

Undervaluation confers a number of benefits to the long-term dividend growth investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

These benefits present themselves in a fairly straightforward manner.

First, price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield not only impacts one’s short-term and long-term passive income potential, but it also positively impacts total return, because total return is comprised of both an income (dividends/distributions) component and a capital gain component.

Well, the latter (capital gain) is also potentially boosted via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.

And when there’s a favorable gap between price and estimated intrinsic value, that creates a margin of safety that protects the investor from unmitigated downside that could permanently destroy capital.

With all of this in mind, it’s fairly easy to see why a dividend growth stock would be more appealing when it’s undervalued (instead of fairly valued or overvalued).

Perhaps surprisingly, it’s not all that difficult to estimate the fair value of just about any dividend growth stock out there.

For example, fellow contributor Dave Van Knapp has greatly simplified this process (valuation) via his guide on dividend growth stock valuation.

But I won’t just leave you investors with that.

Get ready to read about a dividend growth stock that appears to be undervalued right now…

SCANA Corporation (SCG) is a holding company that, through its subsidiaries, sells and distributes electricity, as well as providing natural gas services. Operations span across North Carolina, South Carolina, and Georgia.

A utility company like SCANA has unique pros and cons to it, from an investment standpoint.

Pros include the ubiquity and necessity of electricity in a developed society, a captive consumer base, and a monopolistic business model.

Cons include growth limitations, heavy regulation, and a capital-intensive business model.

All in all, though, some exposure to high-quality utilities makes a lot of sense for dividend growth investors, as many utility stocks offer market-crushing yield, which goes a great way toward generating the kind of passive income necessary that one might need to become financially independent.

The issue with a lot of utility stocks is that they’ve been extremely popular in an environment where yield is hard to come by, which has driven up the valuations on many premium utility stocks.

However, SCANA perhaps offers some relative value here (boosting its yield in the process).

So let’s drill down into the dividend metrics first.

The company has been paying an increasing dividend for 17 consecutive years now, which is a pretty strong track record.

And over the last decade, the dividend has grown at an annual rate of 3.2%.

That kind of dividend growth is pretty common when you look at utilities, as their landlocked and heavily-regulated nature can limit growth.

But the great thing here is the yield.

At 5.07%, that crushes most other dividend growth stocks out there, and that goes even for a lot of utility stocks.

Moreover, that yield is more than 120 basis points higher than the stock’s own five-year average yield.

Now, as we’ll get into, there are some good reasons for the spread, but the spread still results in investors who buy in today receiving a much higher yield than what would have otherwise been available, on average, over the last five years.

Meanwhile, the payout ratio is only 57.8%, which means the dividend (and growth of it) appears to be quite secure.

What we’re looking at here is a utility stock with a yield that’s much higher than average, along with a payout ratio that is lower than what a lot of other utility stocks sport.

You don’t often see the two exist simultaneously like that, but that’s what we have here with SCANA.

Of course, we don’t invest in where a company has been, but where it’s going.

But in order to develop an expectation for future dividend growth (as well as the valuation of the business and its stock), we must first look at what the company has done over the last decade in terms of business growth.

So we’ll look at top-line and bottom-line growth over the last ten fiscal years, which serves as a pretty good proxy for the long haul.

We’ll then compare that to a near-term expectation for future EPS growth.

Investigating these numbers in conjunction with one another should paint us a picture of SCANA’s overall business growth, which will more or less serve the dividend growth.

SCANA’s revenue has moved from $4.621 billion to $4.227 billion from fiscal years 2007 to 2016.

This is a bit disappointing. That’s obviously not what we want to see. I keep in mind that notable revenue growth is actually uncommon for many utilities out there, but you still want to see the dial move in the right direction, if only a bit.

The company’s earnings per share advanced from $2.74 to $4.16 over this period, which is a compound annual growth rate of 4.75%.

That’s actually rather strong bottom-line growth.

And I say that in relative terms considering not only SCANA’s top-line growth over this period, but it’s also true relative to a lot of utilities out there. Plus, it’s appealing relative to the 10-year dividend growth rate, which is why we see that modest payout ratio.

The excess growth has been driven by a significant improvement in profitability across the board.

While SCANA has been efficiently run over the last 10 years, they made a critical error by gambling on a massive and ill-fated nuclear project that has since been abandoned after its contractor, Westinghouse, went bankrupt.

This mistake is estimated, after all is said and done, to put $2.2 billion of SCANA’s capital at risk of permanent loss.

This overhang is serious, although the stock’s valuation has been chopped as a result. In fact, the stock is down 25% over the last three months, after these issues have been realized and digested by the market. That has lopped ~$2.4 billion off of SCANA’s market cap.

Said another way, SCANA made a mistake, but the stock has been massively repriced as a result. While this is no consolation to investors who bought in prior, you’re starting from a compressed valuation now that factors in the issues at hand, leading to what could be a recovery in the stock as the business eventually recovers and moves on.

Looking forward, CFRA believes that SCANA will compound its EPS at an annual rate of 0% over the next three years.

CFRA recently (negatively) revised all of its numbers regarding SCANA, which is appropriate.

But it’s admittedly difficult to estimate where SCANA is going to be over the next three years. EPS will definitely suffer in the near term, but the ubiquitous and necessary nature of the company’s products and services means they’ll move on and right the ship. I think the company’s future is bright, but it’ll have to fly through some clouds in the interim.

The company’s balance sheet is fairly solid, considering that it’s a capital-intensive utility.

The long-term debt/equity ratio is 1.13, while the interest coverage ratio is approximately 3.5.

Profitability has improved dramatically of late, even being a point of strength of business.

Over the last five years, SCANA has averaged net margin of 12.50% and return on equity of 11.45%.

SCANA is a business that’s in somewhat of a transition, which is an interesting way to think about a utility. However, “this too shall pass” is a theme I keep in mind when looking at their troubles regarding the failed nuclear project. It will likely cost the company (ultimately the shareholders) quite a bit of money, but that cost has largely been shouldered by shareholders who bought the stock before the massive repricing.

As such, I think the stock looks fairly appealing on a valuation basis here…

The stock is trading hands for a P/E ratio of 11.40 right now, which is very favorable relative to the stock’s five-year average P/E ratio of 14.8. Some of this compression is warranted, but the business will eventually rebound, bringing the valuation back to a more historical norm. This multiple is also substantially lower than both the industry average and the broader market. And the yield, as shown earlier, is much higher than its own recent historical average.

How cheap might the stock be? What would be a fair estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in a 8% discount rate and a long-term dividend growth rate of 3.5%.

The discount rate is lowered due to the higher yield.

And that long-term model for DGR is very conservative when you look at the payout ratio, the demonstrated long-term EPS growth, and the dividend growth track record of the company.

While this stock has never made sense to me in the past due to the combination of dividend growth and yield, the much higher starting yield, combined with what’s still a very strong business, makes it more appealing than it has been in a very long time.

The DDM analysis gives me a fair value of $56.35.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

This fair value is quite a bit lower than where the stock was just a few months ago, which is why I never really found the stock a compelling investment. However, the current price of the stock is now well below that fair value estimate. That said, let’s see how my valuation compares to what professional analysts have come up with, which will add value and depth to the conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates SCG as a 4-star stock, with a fair value estimate of $64.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates SCG as a 4-star “BUY”, with a fair value calculation of $52.92.

I came out somewhere in the middle there, but averaging the three numbers out gives us a final valuation of $57.78. That would indicate the stock is potentially 19% undervalued right now.

Bottom line: SCANA Corporation (SCG) is a company providing ubiquitous and necessary products and services. Its customer base can’t live without the electricity and natural gas services SCANA provides. While they made a mistake with their nuclear project, investors looking at this stock today benefit from the repricing that’s occurred, significantly marking the stock down and providing for the possibility of 19% upside. And that’s on top of a massive 5%+ yield. If you’re looking to invest in a utility, SCANA might be one of the more outstanding long-term opportunities available.

— Jason Fieber

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