I often write about the attractive nature of investing in companies that offer ubiquitous and necessary products and/or services.
But why is that?
Easy. It comes down to managing risk.
Now, I’m not talking about volatility. Stock prices go up and down. Besides, short-term volatility should be looked at as a long-term opportunity for someone investing for the long haul.[ad#Google Adsense 336×280-IA]But when I think about risk, I think about permanent loss of money.
And the odds of permanent loss are a lot lower when you’re sticking to the companies providing products and/or services that are ubiquitous and/or necessary.
Well, what is more ubiquitous and necessary than electricity?
Imagine living just a week without power.
Imagine how much your quality of life would suffer.
Electrical power is something that is completely and absolutely necessary, which means those companies that provide a regular and reliable supply of it can make for solid long-term investments.
Take a look at Wisconsin Energy Corp. (WEC), for instance.
Utilities aren’t fast-growing investments. They’re generally not going to quickly double.
But investing in a utility isn’t about taking on a lot of risk and quickly doubling your money. It’s about limiting risk and investing in a company that provides an absolutely necessary service to millions of people.
Wisconsin Energy Corp. is a holding company that, through its subsidiaries, provides electric, gas, and steam energy utility services to approximately 2.1 million customers throughout Wisconsin and the Upper Peninsula of Michigan.
What are the odds that those 2+ million people are going to continue paying WEC for electricity and natural gas service for the next 10 or so years?
I’d say pretty good.
Looking out over the longer term, I think there is a possibility of alternative energy like solar increasing in prevalence and perhaps reducing the need for electricity from major incumbents like WEC. In the meanwhile, however, the company benefits from holding monopolistic control over clients across much of Wisconsin and part of Michigan.
In exchange for that, WEC is heavily regulated by the government to make sure its prices are reasonable and competitive in relation to its costs. As such, their absolute growth potential is limited relative to their own costs of doing business and the overall market in which they operate.
So let’s see how that juxtaposition plays out – we’ll take a look at what kind of growth WEC has managed over the last decade, which will give us some idea as to what to expect when looking out over the foreseeable future. It’ll also help us with valuing the business.
Revenue was $3.816 billion in fiscal year 2005. The company increased that to $4.997 billion in FY 2014. That’s a compound annual growth rate of 3.04%.
Earnings per share is up from $1.31 to $2.59 over that period, which is a CAGR of 7.87%.
Bottom-line growth is definitely more impressive, helped by improving margins and returns as well as the fact that WEC, unlike a lot of other major utilities, hasn’t diluted shareholders through the regular issuance of equity over the last decade.
S&P Capital IQ predicts that EPS will grow at a 5% compound annual rate over the next three years, which is on the low end of current management guidance.
So the growth here actually isn’t bad when you look out across the universe of utility stocks. In fact, EPS growth over the last decade rivals that of a lot of stocks in the consumer space where branded products provide enviable returns and wide economic moats.
But perhaps where WEC shines brightest is in regards to their dividend growth track record.
They’ve increased their dividend for 12 consecutive years now, which qualifies them to be included in David Fish’s venerable Dividend Champions, Contenders, and Challengers list.
While not the lengthiest streak in the universe of utility stocks, their dividend growth is among the absolute strongest around.
WEC has increased their dividend at an annual rate of 14.2% over the last 10 years, which is almost unheard of for a utility.
Even with that incredible dividend growth, the payout ratio still remains a very reasonable 66.5%.
That’s high in absolute terms, but relatively low for a utility.
Because of limited growth opportunities, utilities typically return the majority of profit back to shareholders in the form of a hefty dividend.
And the dividend is indeed hefty – the stock currently yields 3.73%.
Now, there are a lot of utilities out there with higher yields, but you’d be very hard pressed to find a better combination of yield and growth.
The company also maintains a fairly healthy balance sheet insofar as utilities are concerned. They have a long-term debt/equity ratio of 0.95 and the interest coverage ratio is 4.93. These numbers are comparable to similar-sized utilities.
Profitability, however, ranks near the top of the industry. WEC has averaged net margin of 11.93% and return on equity of 13.28% over the last five years. Extremely respectable results here which indicates a favorable environment.
There’s definitely a lot to like here. You’ve got a business model that exists to provide millions of people with necessary and ubiquitous services… services that people can’t really live without.
And Wisconsin Energy has produced some of the best growth in the industry over the last decade. In addition, the upcoming $9.1 billion acquisition of Integrys Energy Group, Inc. (TEG) – pending regulatory approval – could provide additional upside via synergies with complementary geographical footprints, while WEC believes the deal will be accretive to EPS in the first full calendar year after closing.
However, one should also carefully consider the fact that utilities are naturally limited in terms of growth by the very nature of the business model since they’re heavily regulated by the government. Nonetheless, WEC has proved that robust growth is possible within their regulatory environment.
The stock trades hands for a P/E ratio of 17.83 right now. That valuation has come down quite a bit since the beginning of the year – the stock is down more than 14% YTD – and the stock is now more compelling than perhaps at any other point over the last year or so.
Utilities in general have been weak since 2015 kicked off, which makes sense since many utility stocks were bid up to unwarranted levels as investors sought yield in a low-rate environment. However, the five-year average P/E ratio for WEC is only 16.4, so that’s something to be aware of.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term growth rate. That growth rate appears fair as it’s in line with WEC’s long-term EPS growth rate and also well below the dividend growth rate over the last 10 years. The moderate payout ratio and anticipated growth moving forward are also factored in. The DDM analysis gives me a fair value of $51.42, which indicates this stock is potentially 14% undervalued.
Bottom line: Wisconsin Energy Corp. (WEC) provides a necessary and ubiquitous service to millions of customers, which is unlikely to materially change over the foreseeable future. And an upcoming acquisition could help improve future prospects, even while considering that WEC sports some of the best growth and profitability metrics in the entire industry. The stock appears to be a more compelling value after a severe drop since the beginning of the year. I’d take a strong look at this stock here.
— Jason Fieber[ad#wyatt-income]