PPL Corporation (PPL) is one of the largest utility holding companies in the USA. There are 7 companies under the PPL umbrella, with more than 10 million customers not only in this country, but in the UK as well.
To analyze PPL, I will use the analytical approach described in DGI Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio.
PPL’s Dividend Record
PPL is a high-yield, slow-growth stock. Its 5.9% yield puts it in the upper reaches of dividend growth stocks. For comparison, the average yield of all stocks on the Dividend Champions document (CCC) is 2.8%. PPL’s yield is more than twice as high.
Its yield is also higher than most utilities:
[Source: PPL Investor Presentation]
PPL’s dividend increases have been irregular in spacing, but they have resulted in a pretty consistent 3-4% increase per year. That’s a decent rate for a stock that’s available at such a high yield.
In Simply Safe Dividends’ scoring system, PPL’s dividend safety gets a score of 79 / 100, meaning that its dividend is rated as safe and unlikely to be cut. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
PPL’s next dividend increase would be expected to be announced in March for payment in April, 2019.
PPL has been paying dividends each year since 1946. At 17 years, its dividend growth streak makes it a Dividend Contender on the CCC. Per the company’s most recent investor presentation, PPL is committed to growing its dividend, and “The dividend is a key component to PPL’s investment proposition.”
PPL’s Business Model and Quality
PPL, headquartered in Allentown, Pennsylvania, is a utility holding company. Its name and ticker symbol (PPL) hearken back to its origins as Pennsylvania Power and Light.
Through its regulated subsidiaries, PPL delivers electricity to customers in the U.K., Pennsylvania, Kentucky, Virginia and Tennessee; natural gas to customers in Kentucky; and generates electricity from power plants in Kentucky.
Ten years ago, PPL held both regulated and unregulated (competitive) utility enterprises. But it has evolved to its current form in which it holds only regulated companies, which are legal monopolies in their service areas.
PPL operates seven fully regulated utilities and reports its results in three segments:
- PPL Global, which covers regulated distribution of electricity in the UK (about 28% of revenues)
- LKE, which covers regulated transmission and distribution of electricity and gas in Kentucky (42%)
- PPL Electric, which covers regulated transmission and distribution of electricity in Pennsylvania (29%)
PPL’s strategy is to:
- Deliver best-in-sector operational performance
- Invest in a sustainable energy future
- Maintain a strong financial foundation fueled by a growing rate base
PPL expects its businesses to achieve long-term growth in their rate bases, at about 5% per year, driven by significant capital expenditures to maintain existing assets, improve system reliability, and comply with regulations related to coal-fired electricity generation facilities.
PPL expects rate base growth to result in earnings growth for the foreseeable future in all of its geographic segments.
A key part of PPL’s strategy is to maintain their investment grade credit ratings and adequate liquidity positions.
That lowers the cost of borrowing. The counter-side to limiting their borrowing is that PPL must issue shares to help finance its large capital projects. So its share float has been expanding.
Another component of PPL’s strategy is to maintain constructive relationships with its regulators. They do this by maintaining a strong culture of integrity and delivering on commitments to customers, regulators, and shareowners. As to customers, PPL strives to improve customer service, reliability, and operational efficiency.
Here is how PPL pictures its own investment proposition:
Here is my summary of PPL’s business quality rankings:
PPL gets good quality ranks across the board, except from S&P Global Market Intelligence. Their “below average” quality rating is hard to figure, since in the same report, they rate PPL as a 5-star Strong Buy:
Morningstar gives PPL a narrow moat rating, its 2nd-highest category. Utilities generally get narrow moat ratings from Morningstar, based on the monopoly status that they enjoy within their service areas.
In exchange for that monopoly status, regulators set returns at levels that are fair to customers while also offering fair returns for capital providers. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moats.
In PPL’s case, Morningstar believes the narrow moat rating is justified by:
- Constructive regulatory jurisdictions in the USA and UK that allow PPL to earn sufficient returns on capital.
- Monopolies in service territories that allow the company exclusive rights to charge approved rates.
- Efficiencies of scale.
The regulatory situation in the UK is in a state of flux, as the regulator there is seeking comments on proposed redesigns for its rate structures for utilities beginning in 2021. However, PPL has stated that the preliminary “consultation” document from the regulator “does not apply to electricity distribution network operators…and does not have any impact on PPL’s current business plans or [power distribution] operations. A full consultation related to [electricity distribution operators] will begin in 2020, with new rates…not taking effect until April 2023.”
That introduces a “known unknown” into PPL’s future regulatory framework in the UK, potentially beginning in 2023. Until then, PPL’s profitability in the UK appears to be solid.
Value Line gives PPL a middling Financial Strength Grade of B++, its 4th-highest rank on a scale of 9 levels. Let’s look at some key financial categories and see if we agree.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity (also known as net assets or assets minus liabilities).
The average ROE for all CCC stocks is 17%, and for S&P 500 companies it is about 13%. The following chart shows PPL’s ROE 2008-2017.
PPL’s TTM (trailing 12-month) ROE is 13%.
Overall, PPL’s ROE results are OK, in the average range. There’s no consistent pattern of rising or falling.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.
High leverage creates risk. The higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.
A typical D/C ratio for large companies is 50%. PPL’s debt runs a little higher, but still is within a moderate range., especially for a utility with large capital needs.
PPL’s high-investment-grade credit rating (A-) means that it can borrow at better rates than many other companies.
A little further on, we will see that PPL’s keeping its debt under control has a downside in that PPL must issue more shares to help finance its capital investment programs.
Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range. By comparison, PPL’s record is quite a bit better.
As you can see, PPL’s operating margin has been improving for almost a decade, more than tripling in the past 8 years, to a high level in the 40% range.
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.
PPL has delivered positive earnings every year, with increases in 5 of the past 9 years. There is no consistent pattern of either rising or falling earnings.
The consensus forward earnings growth estimate by analysts covering the stock is 4-5% per year over the next 3-5 years, which is typical for a utility and in line with PPL’s own projections.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.
Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.
For most companies, free cash flow is a very important metric. But for utilities, earnings are a better guide. A utility’s free cash flow is usually low or negative due to their continuing capital investment projects. Utilities pay off the interest on their borrowing with their cash flows, which reduces their free cash flow numbers. The investments have long payback periods, and assuming good regulation, it is rare that the investments don’t pay off in the long run.
This chart shows free cash flow for all publicly traded utilities 2002-207. As you can see, it is normal for a utility to have negative free cash flow.
PPL’s free cash flow follows the general pattern.
Whereas for most companies this would be a terrible FCF record, it’s OK for a utility. PPL stated in its most recent investor presentation that it expects to have positive cash flow by 2021.
Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
Again, the picture with utilities is different, because of their need to fund capital projects. The projects are funded with debt and equity (issuing new shares). We saw earlier that PPL maintains a moderate debt level, but they have been issuing new shares steadily.
Here is a summary of the items above:
I have no disagreement with Value Line’s middling ranking of PPL’s financials as B++. The financial picture is typical for a utility as well as for a slow-growth, mature company.
PPL’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a baseline “fair value” reference line, shown by the orange line on the following chart. The black line is PPL’s actual price.
PPL’s actual P/E is 11.8 (circled), which is less than the 15 used to draw the orange reference line. That suggests that the stock is undervalued.
To calculate the degree of undervaluation, we make a ratio out of the P/Es: 11.8 / 15 = 0.79. In other words, PPL is undervalued by 21% as estimated by this first method.
We can calculate a fair price by dividing the actual price by the valuation ratio. We get $28 / 0.79 = $35 for a fair price.
Note that I round all dollar amounts to the nearest dollar. That’s to avoid creating a false sense of precision in making valuation assessments. Since valuation involves future events, it cannot be precisely known.
Step 2: FASTGraphs Normalized. The second valuation step is to compare PPL’s current P/E to its own long-term average P/E. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation that was used in Step 1.
PPL’s 5-year average P/E of 13.7 (circled) is higher than the 15 used in the first step, but the stock still appears undervalued.
Using the same calculation methods as above, we get the following results for PPL’s valuation.
- Valuation ratio: 11.8 / 13.7 = 0.86
- Fair price: $28 / 0.86 = $33
Step 3: Morningstar Star Rating. Morningstar takes a completely different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
My experience with Morningstar is that they take a comprehensive and detailed approach. They make logical and conservative projections of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money.
The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar gives PPL 4 stars on their 5-star scale, meaning that they consider the stock to be undervalued.
Morningstar calculates that PPL’s fair price is $31, meaning that it’s selling at a 10% discount.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa). This chart shows PPL’s current yield (green dot) compared to its 5-year average (horizontal line).
PPL’s 5-year average yield is 4.4%, while its current yield is 5.9%. Current yield higher than historical average suggests undervaluation.
Again, we use a ratio to compute the degree of undervaluation: 4.4% / 5.9% = 0.75, or 25% undervalued. In this method, I cut off valuation gaps at 20%, because this is an indirect way to measure valuation.
So using a valuation ratio of 0.80, PPL’s fair price computes to $28 / 0.80 = $35.
Finally, I average the 4 valuation methods.
All 4 valuation methods are in agreement that PPL is undervalued. They are in a fairly tight range, and together suggest a fair price of $34.
A couple of other points of comparison also fall into the same range:
- CFRA has a 12-month price target of $35.
- Jason Feiber made PPL his Undervalued Dividend Growth Stock of the Week in mid-November. He calculated a fair price of $35.22 at that time.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
- They present fewer occasions to react emotionally to rapid price changes like sudden price drops that can induce a sense of fear.
- There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
PPL’s beta is much lower than the market’s as a whole, with a 5-year beta of 0.4 compared to the S&P 500 (defined as 1.0). That means that its price has been 60% less volatile than the index.
This is a positive factor, although one could argue that it hasn’t meant anything in the past few months:
In November, PPL’s price was up a few percent for the year. Now it’s down more than 10% from its high.
Of course, the silver lining is that price plunge is why it’s undervalued now and yielding almost 6%.
In their most recent report on PPL, CFRA shows the recommendations of 16 analysts who cover the company. Their average recommendation is 3.6 on a scale of 5, where 5 means “buy” and 3 means “hold.” The rating of 3.6 translates to “buy/hold.” This is a slight positive indicator.
What’s the Bottom Line on PPL?
Here are PPL’s positives:
- Good dividend record: High yield (5.9%) combined with steady annual growth in the 3-4% range. Current yield is quite a bit higher than it’s been in the past 5 years, so its income is “cheap” to buy.
- Good Dividend Safety grade of 79/100 from Simply Safe Dividends, suggesting that the dividend is safe and unlikely to be cut. Management has stated that it is committed to the dividend and dividend growth.
- Solid business model: Owns regulated electric and gas utilities in PA, KY, and the UK. All regulators are considered decent for customers and companies alike.
- Narrow moat rating from Morningstar, good Safety rating from Value Line.
- Acceptable financials, highlighted by excellent profitability. B++ financial rating from Value Line. A- credit rating from S&P (high investment grade).
- Low-beta stock over past 5 years.
- Stock is around 18% undervalued.
And here are PPL’s potential pitfalls:
- It is dependent on continuing favorable rate decisions from all 3 of its regulators for continued profits and growth.
- Slow predicted growth rate in 4-5% range per year.
- New regulatory regime in the UK may become problematic after 2023; too soon to say yet.
Overall, I see PPL as an attractive investment opportunity at its current valuation and high yield. If it could deliver 4%/year dividend growth on top of its initial yield of nearly 6%, that would be a good deal for most dividend growth investors.
That said, this is not a recommendation to buy, hold, or sell PPL. Any investment requires your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how and whether it fits your personal financial goals.
— Dave Van Knapp