AESC - Avista: Good Utility And Attractive Total Return Potential

2023-08-22 07:28:01 ET

Summary

• Avista Corporation is a regulated electric and natural gas utility operating in the Pacific Northwest states.
• The company enjoys stable revenue and cash flow due to customers considering its product a necessity.
• Avista Corporation has plans to invest in infrastructure upgrades and expects to grow its rate base and earnings per share.
• The company should be able to deliver a total average annual return of 10% to 11% over the next three years.
• AVA stock is likely fairly valued at the current price, but it still might be a decent option for someone looking for stability in an uncertain economic environment.

Avista Corporation ( AVA ) is a regulated electric and natural gas utility that operates in the Pacific Northwest states of Washington, Oregon, and Idaho. The company also has a business in Alaska:

A few of these are not exactly the first states that come to mind when choosing to invest in a utility company. In particular, Alaska is sometimes thought of as a rather desolate and cold place with limited infrastructure. It does have a few large cities though, and places like Anchorage do have many of the modern conveniences that many people take for granted. In fact, it is the tendency of many people to take these modern conveniences for granted that make Avista Corporation an attractive investment for anyone that is looking for safety and security. After all, the company enjoys relatively stable revenue and cash flow over time due to most of its customers considering its product to be a necessity for their daily lives. As the United States is showing ever more signs that a recession is approaching, this sort of stability is likely to be much appreciated by most investors today. Fortunately, we do not have to pay through the nose for these things as Avista is currently trading at a very reasonable valuation. In fact, the stock is much cheaper than it was the last time that we discussed the company. Thus, there could be some good reasons to purchase the company's stock today.

About Avista Corporation

As mentioned in the introduction, Avista Corporation is a regulated electric and natural gas utility that operates primarily in the Pacific Northwest states of Washington, Oregon, and Idaho. The company also owns Alaska Light & Power, which supplies electricity to Alaska's state capital Juneau. As might be expected though, the company's operation in the Pacific Northwest accounts for a much greater proportion of Avista Corporation's overall business. The company has approximately 411,000 electric and 377,000 customers throughout the three states in which it operates in that region:

In comparison, Alaska Electric Light & Power Company only has approximately 17,000 customers. Overall, this is far fewer customers than we would expect given the company's fairly large service territory. However, the overwhelming majority of this area is rural and sparsely populated. After all, we have all heard about how majestic some of the large forests in the Pacific Northwest can be. The fact that the company's customer count is not especially high does not prevent it from sharing many of the characteristics that we appreciate with larger utility companies. In particular, Avista Corporation tends to have remarkably stable revenues and cash flows over time. Here are the company's revenues over the past eleven quarters:

As we can see, Avista Corporation's second-quarter 2023 revenues were pretty similar to what the company had in the second quarter of 2022. Likewise, its first-quarter 2023 revenues were quite similar to both the first quarter of 2022 and the first quarter of 2021. We do see that the company's revenues exhibit some quarterly fluctuations, however. In particular, Avista Corporation typically has higher revenues during the winter months than it has during the summer. That is due to its natural gas utility business. As everyone reading this is likely well aware, the primary use of utility-supplied natural gas is space heating. There is much greater demand for that during the cold winter months than during the summer, so the consumption of natural gas is typically higher at those times. Avista Corporation generally bills customers based on their consumption of natural gas every given month, so it makes a great deal of sense that the customers' bills will be higher during the winter. That results in Avista Corporation's natural gas utility bringing in more money during those periods, which extends across the entire business. In contrast, electric consumption is usually more stable throughout the year, although there is a spike in usage during the summer due to air conditioners. That is not nearly as big of a quarterly difference as what the use of natural gas for space heating consumes, however.

As the company's revenues are generally stable over time, it will have a similar amount of money available each quarter to cover its expenses. Thus, we can expect the company's profits and cash flows to be relatively stable over time. That is true when we look at the company's operating cash flows during any given twelve-month period. Here they are for the past eleven such periods:

While we do see a few fluctuations, for the most part, the statement about overall stability holds true here. This is something that is quite nice to see for income-focused investors due to the support that it provides to the dividend. As we will see later in this article, it is ultimately the company's operating cash flow that determines its ability to pay its dividend. The fact that this figure tends to be stable over time allows management to pay out a larger proportion of the company's cash flow to the shareholders than could be done if the company's operating cash flow was highly variable. This is similar to the way that it is easier for a salaried worker to carry a mortgage than it is for someone whose income is primarily commission-based. Thus, we should be able to appreciate the company's overall financial stability.

The time periods shown above, especially the one for operating cash flow, include a number of different economic environments. For example, the older twelve-month periods include the time when the COVID-19 lockdowns were in effect, which prevented millions of people from working. Once these lockdowns finally ended and people started returning to work, we saw inflation take off. As I have pointed out in numerous previous articles and blog posts, this inflation has begun to strain the budgets of the average American household. This is due to the fact that about 64% of Americans currently live paycheck-to-paycheck , so have no flexibility in their budgets to absorb the rising costs that were brought on by inflation. The fact that real wage growth was down during much of this period did not help matters. Finally, we are seeing signs that the post-lockdown boom may be ending and that the Federal Reserve is beginning to achieve its goal of pushing the economy into a recession. None of these economic changes had any real impact on Avista Corporation's revenues or cash flows, however.

The reason why the company's financial performance seems to be highly resistant to economic fluctuations should be fairly obvious. As mentioned in the introduction, the products provided by Avista Corporation are generally considered to be necessities for our modern way of life. After all, there are not many people in the United States that do not have electric service in their homes or businesses. Indeed, most people take it for granted that any place that they go will have working electricity so that they can charge their smartphones and other devices. The same is generally true with natural gas, as people tend to simply assume that the furnace will begin heating up their home as soon as they use the thermostat to turn on the heat. As such, most people will prioritize paying their utility bills ahead of making discretionary expenses during periods in which money gets tight. As we have already discussed, that is certainly the case for many people today as wage growth has failed to keep up with inflation. Thus, a company like Avista Corporation will almost certainly be better positioned to ride through whatever might be coming down the pipeline for the American economy over the next year or so than a company whose business depends heavily on consumer spending. The Leading Economic Indicators are currently predicting a recession and have been for quite some time, although it curiously has not officially arrived yet. It is uncertain when or if such an event will occur, but that is a good reason to include a company like Avista in your portfolio. If nothing else, it could help reduce your overall exposure to the risk that consumer spending might suddenly drop.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied with mere stability even if that outcome could be better than other companies might experience during a recession. This is because we like to see any company in which we are invested grow and prosper with the passage of time. Fortunately, Avista Corporation is well-positioned to deliver growth to its shareholders.

One way through which the company will deliver growth comes from demographics. A few of the states in which the company operates are experiencing population growth. This chart shows the U.S. Census Bureau's growth rate for each of the four states that Avista Corporation serves:

As we can see, both Washington and Idaho are experiencing population growth, with Idaho actually ranking as one of the most rapidly growing states in the nation:

As shown here, the state is expected to continue to grow at a fairly rapid rate through the end of the decade. There are several reasons for this, including the state's relatively low cost of living and the rising ability for people to conduct work remotely. The latter is an especially important trend going forward as it allows people to live where they please, as opposed to where they are forced to live due to their work.

For our purposes, the fact that two of the states that Avista serves are growing their populations is nice for the company. After all, one of the only ways through which the company can grow is by increasing the size of its customer base. This makes sense, since the more people that are paying monthly utility bills to the company, the more revenue it will have overall. That means that more money will be available to cover the company's expenses and make its way to the bottom-line earnings and cash flow. Unfortunately, Avista Corporation is a regulated utility that is a monopoly in its service area. It has very limited ability to actually grow its customer base through its own efforts. The company is thus thoroughly dependent on population growth in its service territory to grow via this method. Admittedly though, we do not know for certain if this growth is happening in the area that Avista Corporation serves, and the company itself has not mentioned it as a growth driver. Nonetheless, this is still a positive sign for the company's future.

The primary method through which Avista Corporation will generate forward earnings growth is by increasing the size of its rate base. The rate base is the value of the company's assets upon which regulators allow it to earn a specified rate of return. As this rate of return is a percentage, any increase to the rate base allows Avista to positively adjust the prices that it charges its customers in order to earn that regulatory-allowed rate of return. The usual way through which a utility grows its rate base is by investing money into upgrading, modernizing, or possibly even expanding its utility-grade infrastructure. Avista Corporation is planning to do exactly this, as the company has outlined a three-year, $1.425 billion spending program with that goal in mind:

It is a little disappointing that Avista has only provided a three-year horizon with respect to its spending plan. At this point in time, we have seen many of the company's peers provide spending plans stretching out to 2027 or beyond. The longer horizon makes it easier for us as investors to determine where the company will be at some date in the future. Naturally, the more visibility that we have, the more accurate our projections are. That is something that could be especially important for anyone that is looking to hold the stock for an extended period of time. It would be nice for Avista to provide more than just a three-year plan, but this is all that we have right now.

The company's capital spending program as outlined above should be sufficient to grow its rate base at a 5% compound annual growth rate over the 2023 to 2025 period. This should be sufficient to grow the company's earnings per share at a 4% to 5% rate over the projection period. The reason why earnings per share growth may be somewhat lower than rate base growth is because the company has to finance this spending somehow. That financing could include the issuance of equity, which would dilute the current common shareholders. While that is not ideal, it could be better than attempting to issue a substantial amount of debt at today's interest rates.

When we combine this projected earnings per share growth rate with the company's current 5.46% dividend yield, we get a 10% to 11% total average annual return over the next three years. That is a very reasonable total return from a conservative utility stock.

Financial Considerations

It is always important that we investigate the way that a company is financing its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is usually accomplished by issuing new debt and using the proceeds to repay the existing debt. After all, very few companies have sufficient cash on hand to repay their debt as it matures. This process can cause a company's interest expenses to go up following the debt rollover, depending on the conditions in the market. As of the time of writing, the effective federal funds rate is at the highest level that we have seen since 2007 and the target federal funds rate is at levels that have not been since 2001. As such, it is a fairly safe bet that any debt rollover today will cause a company's interest expenses to go up. In addition to interest-rate risk, a company must also make regular payments on its debt if it is to remain solvent. Thus, an event that causes a company's cash flows to decline could push it into financial distress if it has too much debt. While utilities like Avista Corporation tend to have remarkably stable cash flows over time, there have been bankruptcies in the sector before so this is a risk that we should certainly not ignore.

One metric that we can use to evaluate a company's financial structure is the net debt-to-equity ratio. This ratio tells us the degree to which a company is financing its operations with debt as opposed to wholly-owned funds. It also tells us how well a company's equity can cover its debt obligations in the event of bankruptcy or liquidation. That is arguably the most important thing.

As of June 30, 2023, Avista Corporation has a net debt of $2.9066 billion compared to $2.4004 billion of shareholders' equity. This gives the company a net debt-to-equity ratio of 1.21 today. This is slightly better than the 1.25 ratio that the company had when we last discussed it (using its fourth-quarter 2022 numbers), which is a good sign as it indicates that the company is strengthening its balance sheet. Here is how Avista Corporation compares to some of its peers:

We can see that Avista generally compares pretty well to its peers, which has been the case ever since we started discussing this company. This tells us that the company is not overly reliant on debt to finance its operations. That is a good sign and should indicate that we do not need to worry too much about the company's debt load.

Dividend Analysis

One of the primary reasons that investors purchase shares of utility companies is because these entities frequently have higher dividend yields than many other things in the market. This comes from the fact that utilities tend to have very low growth rates, so they have opted to pay out a significant proportion of their cash flows to the shareholders in order to provide an acceptable rate of return. As the market does not assign particularly high multiples to the stock of these companies, the dividend ends up being a sizable percentage of the stock price. Avista is certainly not an exception to this, as the company yields a whopping 5.46% at the current price. This is one of the highest yields currently available in the utility sector. It is clearly higher than the 1.49% current yield of the S&P 500 Index ( SPY ) and is even above the 2.67% current yield of the U.S. Utilities Index ( IDU ). Avista has a long track record of raising its dividend on an annual basis:

The fact that the company has a track record of raising its dividend every year is something that we very much like to see in an inflationary environment, such as the one that we are in today. This is because inflation is constantly reducing the number of goods and services that can be purchased with the dividends that the company pays out. This can make it feel as though we are getting poorer and poorer with the passage of time, which is a particularly big problem for retirees or for anyone else that is dependent on their portfolios for income. The company's annual dividend increases help to offset this effect and maintain the purchasing power of the dividend.

As is always the case though, it is important that we ensure that the company can actually afford the dividends that it pays out. After all, we do not want to be the victims of a dividend cut since such an event would reduce our incomes and almost certainly cause the company's stock price to decline.

The usual way that we judge a company's ability to cover its dividend is by looking at its free cash flow. Free cash flow is the amount of cash that was generated by a company's ordinary operations and is left over after it pays all of its bills and makes any necessary capital expenditures. This is therefore the amount that is available to reward the shareholders through things such as share buybacks, debt reduction, or dividends. In the twelve-month period that ended on June 30, 2023, Avista Corporation had a negative levered free cash flow of $321.3 million. That is obviously not enough to pay any dividends, yet the company still paid out $134.9 million to its shareholders over the period. At first glance, this is something that is likely to be quite concerning, as the company clearly does not have sufficient free cash flow to cover its dividends.

However, it is not uncommon for a utility to finance its capital expenditures through the issuance of common stock and debt. It will then finance its dividends out of operating cash flow. The reason that this is done is because of the incredibly high costs involved in constructing and maintaining utility-grade infrastructure over a wide geographic area. These costs are such that it would be impossible for the company to ever provide a return to its investors if it attempted to finance everything solely through its internal cash generation capacity. During the twelve-month period that ended on June 30, 2023, Avista Corporation reported an operating cash flow of $187.8 million. That was enough to cover the $134.9 million that it paid out to the shareholders, along with leaving a bit of extra money that can be used for other purposes. However, the coverage is quite tight, and I would like to see a bigger difference between the operating cash flow and the dividend in order to add a margin of safety to this position.

Valuation

It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a utility like Avista Corporation, we can value it by looking at the price-to-earnings growth ratio. This is a modified version of the familiar price-to-earnings ratio that takes a company's earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 is a sign that the stock may be undervalued relative to the company's earnings per share growth and vice versa. However, there are very few stocks that have such a low ratio in today's richly valued market . As such, the best way to use this ratio for our purposes today is to compare Avista Corporation to its peers in order to determine which company has the most attractive relative valuation.

According to Zacks Investment Research , Avista Corporation will grow its earnings per share at a 6.35% rate over the next three to five years. That is actually quite a lot higher than the company's rate base growth, so it may be difficult for the company to achieve. However, that earnings per share growth gives the company a price-to-earnings growth ratio of 2.29 at the current price. Here is how that compares to the peer group:

With the notable exception of The AES Corporation, Avista appears to be much more attractively valued than many of the other companies in the sector. As we saw earlier though, The AES Corporation has a substantially higher debt load, which may explain the seemingly cheap valuation.

It is important to note though that the above chart was constructed using Zacks' estimates of the earnings per share growth rate of each of these companies. As was mentioned, the figure might be a bit high for Avista Corporation based on its rate base growth. If we assume that Avista will only achieve the 5% earnings per share growth rate that corresponds with its rate base growth, the company's price-to-earnings growth ratio increases to 2.91, which makes it the most expensive company shown above. As such, the company might not offer as attractive a deal as it may seem right now.

Conclusion

In conclusion, Avista Corporation offers a great deal of financial stability to investors that are uncertain about the economy. After all, this company should be able to weather any economic conditions due to the fact that its products are necessary for modern life. It is also likely to deliver a reasonably attractive total annual return on average through a combination of earnings growth and dividends. The only real question here is the valuation. If analysts are correct about the company's earnings per share growth, then it is trading at a very attractive price right now. However, analysts may be too optimistic here and a slower growth rate suddenly makes the company's stock look expensive. My personal thoughts are that it is probably fairly priced, but I also would be dollar cost averaging into a position as opposed to buying it all at once.

For further details see: