NI - Black Hills Stock: Good Company For Stability But Overpriced

2023-06-20 18:22:10 ET

Summary

• Black Hills Corporation is a regulated electric and natural gas utility that services the Great Plains region.
• The company boasts remarkably stable cash flows over time, which could make it a good holding through economic turbulence.
• The company has some forward growth potential, although it is fairly low compared to other things in the sector.
• The company has a very strong balance sheet with low leverage relative to peers.
• The stock price is ridiculously high relative to its forward growth prospects, limiting its appeal.

Black Hills Corporation ( BKH ) is a regulated electric and natural gas utility that provides service to several states in the American Great Plains. The utility sector in general has long been a favorite of conservative investors, such as retirees. There are several reasons for this, including the fact that these companies typically have very stable cash flows and high dividend yields, regardless of the conditions in the broader economy. Black Hills Corporation is certainly no exception to this, as the stock yields 4.00% at the current price.

Unfortunately, the company has very limited near-term growth expectations, which has resulted in it having an exceptionally high valuation. As such, it probably only makes sense as a dividend play right now, but the total return could still lag compared to other companies in the sector.

About Black Hills Corporation

As mentioned in the introduction, Black Hills Corporation is a regulated electric and natural gas utility that provides service to customers in several states in the American Great Plains. The company's electric service is limited to only a few areas, though. Meanwhile, its natural gas operations stretch across a large proportion of the area:

This is something that may give pause to some investors. After all, we have all been hearing about the electrification trend and how that will make natural gas utilities obsolete. While that belief has no basis in reality (see here ), it is still something that tends to impose a headwind on the company's stock price.

While the gas utility operation does have a much wider geographic reach, the company's operating income is much more balanced. Currently, approximately 47% of the company's operating income comes from its electric utility operations and 53% of its operating income comes from its natural gas operations. This positions the company fairly well given the seasonality of both businesses. We especially see this with natural gas, since the primary use of utility-supplied natural gas is for heating buildings during the winter months. This normally results in natural gas utilities having most of their earnings and cash flows during the October to April period. In comparison, electricity tends to enjoy year-round use, but its usage does increase during the summer as air conditioners cause those buildings equipped with them to have higher energy consumption. This should help to reduce the seasonal cash flow fluctuations that we see with pure-play natural gas utilities by boosting the company's revenue during the warmer months. We can, in fact, see this by looking at the company's quarterly operating cash flows. Here they are for the past eleven quarters:

We do see that the company's operating cash flow seems to hold up reasonably well during the quarters that end in June and September, which are usually the weakest for a natural gas utility. The company does still typically see an increase in its cash flows during the first quarter of the year, though. That is certainly expected as the natural gas utility will see a boost during that period. The consumption of electricity does go down during the winter, but since people tend to stay home more, it does not go down by enough to offset the surge in natural gas consumption. Thus, Black Hills will typically see its highest cash flows during the first quarter of the year. This does not alter the overall cash flow stability thesis that I mentioned in the introduction, however. We can see this by looking at the company's trailing twelve-month operating cash flows:

As we can see, during most of the above quarters, there is very little fluctuation from period to period. We do see that four of them are negative numbers, which were entirely caused by a massive negative impact in the first quarter of 2021 due to Winter Storm Uri. This is the storm that froze natural gas pipelines as far south as Texas and caused natural gas prices to spike to unprecedented levels. Black Hills Corporation was hardly alone in seeing a massive negative operating cash flow resulting from this storm as just about every natural gas utility serving the Great Plains experienced the same thing. It is nothing to worry about since that storm was a once-in-a-century event. It is unlikely that a similar event will occur during any of our lifetimes. For the most part, it still should be fairly obvious that Black Hills has pretty stable cash flows during any given twelve-month period.

The reason for this overall stability should be pretty obvious. Black Hills Corporation provides a product that is generally considered to be a necessity for our modern way of life. After all, nearly everybody in the nation has electric service to their homes and businesses. Those buildings that are heated with natural gas likewise have utility services connected to them. As these services are considered to be necessities by those people that have them, the company's customers will typically prioritize paying their utility bills ahead of making other discretionary expenditures. In addition, a person's electric or natural gas consumption does not typically vary with their financial fortunes - an individual will not just start using extra electricity just because their income went up, for example.

These factors normally result in a utility company having relatively stable revenue and cash flow over time. This is exactly what we want to have in our portfolios today considering the uncertainty across the economy right now.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied with mere stability. We like to see a company that we are invested in grow and prosper with the passage of time. Fortunately, Black Hills Corporation is well-positioned to do this through two methods:

1. Population growth in its service area.
2. Rate base growth.

One of the unfortunate problems with utilities is that they are almost always monopolies whose operations are confined to a single geographic area. That means that their growth is somewhat reliant on the population growth of their service territory. This is something that is completely out of the control of any given utility. Fortunately for Black Hills, its service area is experiencing population growth. Indeed, Colorado was one of the fastest-growing states in the nation from 2010 to 2020 and Black Hills managed to increase its customer count in the state by 11.1% over the 2017 to 2022 period:

It is uncertain how rapidly the company will be able to continue growing its customer count in any of these states going forward, however. The only state that the company services that made the top ten fastest-growing list in 2022 were South Dakota, as population growth in Colorado has fallen off since the pandemic. With that said though, the company's services do not cover the entirety of any of these states. It is confined only to a few areas that have been experiencing real estate development. As the real estate sector has started to weaken recently in the face of rising interest rates, this trend could weaken, but all of these states are relatively affordable compared to the national average so it might be able to continue growing the customer base as people seek to leave expensive areas like California.

As just stated, the second method through which a utility company like Black Hills Corporation can grow its earnings 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 the company to increase the price that it charges its customers in order to earn that specified rate of return. The usual way through which a company increases the size of its rate base is by investing money into upgrading, modernizing, and possibly even expanding its utility-grade assets. Black Hills Corporation is planning to do exactly this as the company has budgeted $3.5 billion for this process over the 2023 to 2027 period:

The fact that the company is providing visibility the whole way out to 2027 is nice to see, particularly considering that there are some utility peers that are not providing comparable visibility. The fact that we do have such visibility into the company's plans makes it easier for us to make long-term projections that aid with investment planning. The plan as presented should allow Black Hills to grow its earnings per share at a 4% to 6% rate over the period. When we combine this with the current 4.00% dividend yield, we get an expected total annual return of 8% to 10%, which is decent but also a bit lower than some of the company's peers will likely deliver over the same period.

Interestingly, the company's projected earnings per share growth is a bit more than it has delivered historically. Over the 2017 to 2022 period, the company has only managed to grow its earnings per share at a 3.4% compound annual growth rate:

We do see that the company's net earnings grew much faster than its earnings per share. This is due to the fact that the company issues both equity and debt to finance its capital expenditures. Naturally, the new stock dilutes some of the earnings per share growth. This is common for utilities, and we will discuss it later. It does, unfortunately, throw the company's 4% to 6% earnings per share growth guidance into doubt, however, since that would be an improvement over the 2017 to 2022 period during which time the company managed to grow its rate base at a 9.4% compound annual growth rate. Analysts are only projecting a 2.20% earnings per share growth rate through 2027, which lowers our total return projection to 6.20% annually. That is much lower than many of the company's peers are positioned to deliver over the period.

Thus, the company appears positioned to deliver a reasonable, but not a phenomenal, total return if it manages to deliver earnings per share growth that is close to its guidance. However, its historical track record shows that this may be somewhat optimistic.

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 normally accomplished by issuing new debt and using the proceeds to repay the existing debt since very few companies have the ability to completely pay off their debt with cash as it matures. As new debt is issued with an interest rate that corresponds to the market interest rate at the time of issuance, this process can cause a company's interest expenses to increase following the rollover in certain market conditions. This is a very real concern today since interest rates are at the highest levels that we have seen since 2007.

In addition to interest-rate risk, a company must 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. Although utilities like Black Hills Corporation typically have remarkably stable cash flows through any economic conditions, there have been bankruptcies in the sector before so this is not a risk that we should ignore.

One ratio that we can use to analyze 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 a bankruptcy or liquidation event.

As of March 31, 2023, Black Hills Corporation had a net debt of $4.440 billion compared to $3.1917 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.39 today. Here is how that compares to some of the company's peers:

As we can clearly see, Black Hills Corporation has a fairly conservative financial structure relative to its peers. This is a positive sign as it should indicate that the company's debt will not pose an outsized risk to its investors. Thus, we probably do not have to worry too much about the company's financial structure.

Dividend Analysis

As mentioned in the introduction, one of the biggest reasons why investors purchase utility companies like Black Hills Corporation is because of the fairly high dividend yields that these companies usually possess. This is due to the fact that these firms usually have fairly low growth rates, so they pay out a significant portion of their cash flows to the investors. As their multiples are also not particularly high, the dividend ends up being a significant percentage of the total stock price. Black Hills Corporation is certainly no exception to this as it currently pays out a 4.00% dividend yield, which is well above the 1.66% dividend yield of the S&P 500 Index ( SP500 ). Black Hills Corporation offers more than just a high yield though as the company has historically increased its dividend every year for the past 52 years:

This is something that is very nice to see during inflationary periods 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 dividend that the company pays out. This can make it feel as though an investor is getting poorer and poorer with the passage of time. That is an especially big problem for a retiree that is dependent on their portfolios for the income that they need to pay their bills and finance their lifestyles. The fact that the company increases the amount that it pays out annually helps to offset this effect and helps to maintain the purchasing power of the dividend.

As is always the case, we want to 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 as that scenario would both reduce our incomes and almost certainly cause the stock price to decline.

The usual way that we judge a company's ability to cover its dividends is by looking at its free cash flow. The 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 all necessary capital expenditures. This is therefore the amount that can be used for things that benefit the shareholders, such as reducing debt, buying back stock, or paying a dividend. During the twelve-month period that ended on March 31, 2023, Black Hills Corporation reported a negative levered free cash flow of $123.1 million. That is obviously not enough to pay any dividends, yet the company still paid out $159.6 million in dividends during the period. At first glance, this is likely to be concerning as the company did not earn 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 debt and equity. I mentioned this earlier in this article. The company will then pay its dividends out of operating cash flow. The reason for this is that it is incredibly expensive to construct and maintain a utility-grade infrastructure network over a wide geographic area. These expenses would otherwise prevent the company from ever paying a dividend if it was dependent on its free cash flow for this purpose. During the trailing twelve-month period, Black Hills Corporation reported an operating cash flow of $649.4 million. That was more than sufficient to cover the $159.6 million in dividends with a substantial amount of money left over for other purposes. Overall, the company's dividend is probably pretty safe.

Valuation

It is always critical that we do not overpay for any asset 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 Black Hills Corporation, we can value it by using the price-to-earnings growth ratio. This is a modified version of the familiar price-to-earnings ratio that takes a company's forward 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 its forward earnings per share growth and vice versa. However, there are very few companies that sport such low ratios in today's overheated market . Thus, the best way to use this ratio today is to compare Black Hills Corporation to its peers and see which company offers the most attractive relative valuation.

According to Zacks Investment Research , Black Hills Corporation will grow its earnings per share at a 2.20% rate over the next three to five years. This gives the stock a price-to-earnings growth ratio of 7.62 at the current price. This is easily one of the highest ratios in the sector, which we can clearly see by comparing Black Hills against its peers:

This further confirms that Black Hills Corporation appears to be very expensive relative to its peers. In fact, if we use the 4% earnings growth figure that the company guides to, it would have a price-to-earnings growth ratio of 4.19 at the current price. That still looks expensive relative to its peers and it is above the company's historical earnings per share growth rate. Thus, the only real conclusion that we can draw here is that Black Hills is very expensive at the current price and should be considered an income play, not a total return investment. It fails even as a dividend play since the current 4.00% yield is less than a money market fund would deliver. Thus, the best option here appears to be staying on the sidelines until the stock price declines somewhat.

Conclusion

In conclusion, Black Hills Corporation is a very stable natural gas and electric utility that should prove quite solid during any economic turbulence. The near-term future of the economy is quite uncertain, as most economists are predicting a recession during the second half of the year but consumer discretionary spending is remaining remarkably resilient . Still, it would not hurt to have some exposure to companies that will be unaffected by economic events. While Black Hills Corporation looks quite good in that area, the stock appears to be very expensive right now. Thus, Black Hills Corporation stock really is a dividend play at this point, and the yield is not high enough for it to be an especially good one.

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