IDU - CMS Energy: Attractive Valuation And Total Return Potential

2023-06-12 09:59:24 ET

Summary

• CMS Energy Corporation is a major electric and natural gas utility in the state of Michigan, with operations covering much of the state.
• The company has very stable cash flows over time, which could prove appealing as the economy appears likely to enter a recession later this year.
• The company has substantial growth prospects and is positioned to deliver a 10% to 12% total average annual return going forward.
• The balance sheet is reasonable, although I would be happier with lower leverage.
• The stock is trading at a very attractive valuation.

CMS Energy Corporation ( CMS ) is one of the largest regulated utilities in the state of Michigan, serving nearly the entire state except for the city of Detroit and the Upper Peninsula. Utilities in general have long been among the favorite investments among retirees and other risk-averse investors for a few very good reasons including their financial stability regardless of macroeconomic conditions. As the United States is widely expected to enter into a recession during the second half of this year, recession-resistant companies like CMS Energy could take on a certain appeal.

Fortunately, this one is not particularly expensive today and it has some forward growth prospects so it could serve pretty well in this capacity. I discussed these things in my previous article on the company. That article was published a few months ago though, so a few things have changed, such as the release of the company's newest earnings report. Therefore, let us revisit our thesis and see if this company still makes sense to buy today.

About CMS Energy

As stated in the introduction, CMS Energy is one of the largest regulated electric and natural gas utilities in the state of Michigan, as its service territory covers the entire state except for the Upper Peninsula and the city of Detroit:

Michigan is one of the more heavily populated states in the nation, so it can be expected that CMS Energy has a respectably-sized customer base domiciled within its service territory. As of the end of the first quarter of 2023, CMS Energy had 1.9 million electric and 1.8 million natural gas customers, so this is certainly true. There are not a lot of utilities with such a large customer count, so this makes CMS Energy one of the larger utilities in the United States.

As I have pointed out in numerous previous articles, however, a utility's size does not have any significant impact on its possession of certain characteristics. The most important of these characteristics for our purposes today is that utilities typically have remarkably stable cash flows that are resistant to fluctuations due to macroeconomic events. CMS Energy certainly qualifies here, as we can see by looking at the company's operating cash flows. Here is CMS Energy's operating cash flow during each of the past eleven twelve-month periods:

As we can see, the company's figures were usually reasonably consistent during each of these periods. However, CMS Energy does still exhibit more fluctuations than some of its peers. There are a few reasons for this, including the fact that the company has considerable exposure to natural gas prices. This comes from the fact that the utility does not necessarily purchase natural gas at the same time that the customers are using it. The American Gas Association explains on its webpage :

Local natural gas utilities often purchase gas during the shoulder months of the year, when it is traditionally at lower prices, and store the gas for later use during the winter. On average, a little less than 20 percent of the natural gas that is used by residential customers over the winter heating season comes from storage. However, on the peak days of the year, usually the coldest days, storage gas accounts for a much larger percentage of the natural gas flowing to customers.

The shoulder months are April and October, which do not usually see much in the way of natural gas consumption but utilities are still buying gas. In addition, while these months usually have lower natural gas prices, that is not always true. Natural gas consumption will also decline significantly during warm winters, like the one that we just experienced. That will have an impact on the company's revenue since natural gas customers do not have to pay for natural gas that they do not use. Thus, a natural gas utility could be exposed to weather-related issues and sudden events that have an impact on natural gas prices (like the outbreak of hostilities in Ukraine last year) that have an impact on its cash flows. However, the natural gas utility sector is still more stable in its financial performance than many other industries and only about half of CMS Energy's business is the natural gas utility so the basic thesis about financial stability still holds true.

The reason for the general financial stability here is that CMS Energy provides a product that is generally considered to be a necessity for a modern lifestyle. After all, how many people do not have electric service to their homes and businesses? The same applies to natural gas for those buildings that use the compound as a fuel for space heating. Indeed, natural gas is even covered by habitability laws in most places. As such, most people will prioritize paying their utility bills ahead of other discretionary expenses during times when money gets tight. As I have explained in several recent articles and blog posts, the high inflation that the nation has been suffering from over the past two years has tightened the finances of many American households. In addition, should the economy descend into a recession later this year, we could see further tightening as recessions frequently mean layoffs and similar events. As such, consumers could begin cutting back on their discretionary spending in the near future but CMS Energy should be able to handle this situation with ease.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied with mere stability. After all, we like to see a company in which we are invested grow and prosper with the passage of time. Fortunately, CMS Energy is well-positioned to deliver on this goal.

The primary way in which the company will deliver growth to its investors is by expanding 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. The usual way that a company grows its rate base is by investing money into upgrading, modernizing, and possibly expanding its utility-grade infrastructure. CMS Energy is planning to do exactly this as the company recently unveiled a $15.5 billion capital investment program for the 2023 to 2027 period:

Unfortunately, the company has not stated exactly how much this will grow its rate base, but we do know that it will not be by the full $15.5 billion. This is because depreciation and amortization constantly reduce the value of the company's in-service assets and that offsets some of the capital spending. In addition, CMS Energy will be retiring some of its assets during the period during which this plan is in effect. As asset retirements remove the value of the retired assets from the rate base, this will also offset some of the spendings.

One asset that CMS Energy is planning to retire is its remaining coal-fired power plants. At the start of this year, the company had two coal power plants in operation:

The D.E. Karn plant is in the process of being decommissioned right now and is expected to be fully eliminated by the end of the year. The J.H. Campbell plant is scheduled for a 2025 shutdown. That will allow the company to be exited from the use of coal for electric generation by year-end 2025. This is one of the earliest planned exits from coal in the entire utility sector. That is something that has long been a goal of environmental activists as well as the various environmental, social, and governance funds around the world. These funds command a considerable amount of assets, as I pointed out in the past. Anything that attracts the interest of such large investors could have a beneficial impact on the company's stock price.

Although CMS Energy has not stated the expected impact that its capital program will have on the rate base, it has stated that the growth should allow it to grow its earnings per share at a 6% to 8% compound annual growth rate going forward. When combined with the current 3.21% dividend yield, that works out to a 10% to 12% total average annual return, which is above average for a conservative utility stock.

Financial Considerations

It is always important to look at the way that a company finances 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 maturing debt. That can cause a company's interest expenses to increase following the rollover, depending on the conditions in the market. As interest rates are currently at the highest levels that we have seen in more than a decade, this is an especially big concern today, as nearly any debt rollover will carry a higher rate than the maturing debt had. In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. As such, 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 CMS Energy usually have remarkably stable cash flows, we have seen bankruptcies in the sector before, so this risk should not be ignored.

One metric that we can use to analyze a company's financial structure is the net debt-to-equity ratio. This ratio essentially 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, which is arguably more important.

As of March 31, 2023, CMS Energy had a net debt of $13.913 billion compared to $7.652 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.82 today. That is slightly better than the 1.87 ratio that the company had at the start of this year, so we do see some improvement here. Here is how CMS Energy compares to some of its peers:

As we can see, CMS Energy is somewhat highly levered compared to some of its peers. This is long been a point of concern with this company. However, it no longer appears to be ludicrously so as it is actually the median company in this peer group. Thus, we can probably assume that the firm's debt will not pose an outsized amount of risk to the shareholders. However, considering that we can see that some peers such as Avista Corporation are significantly less reliant on leverage, I would like to see CMS Energy bring its debt down going forward to increase my comfort level.

Dividend Analysis

One of the biggest reasons why investors purchase the stock of utility companies like CMS Energy is that they typically have higher yields than many other things in the market. This is certainly the case with CMS Energy, as its current 3.21% yield is quite a bit higher than the 1.50% yield of the S&P 500 Index (SP500). It is also higher than the 2.57% yield of the U.S. Utility Index ( IDU ), which is rather nice to see. CMS Energy also has a long history of increasing its dividend annually:

This dividend growth history 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 we can purchase 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. The fact that CMS Energy increases the amount of money that it pays out every year helps to offset this effect and maintains the purchasing power of the dividend.

As is always the case though, it is critical to ensure that the company can actually afford the dividend that it pays out. After all, we do not want to be the victims of a dividend cut as 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 pay its dividend is by looking at its free cash flow. The free cash flow is the amount of money that was generated by a company's ordinary operations that is left over after it pays all of its bills and makes all necessary capital expenditures. This is money that can be used for purposes such as reducing debt, buying back stock, or paying a dividend. During the twelve-month period that ended on March 31, 2023, CMS Energy reported a negative levered cash flow of $1.1759 billion. That is obviously not enough to cover any dividends, but the company still paid out $555.0 million during the period. At first glance, this is likely to be concerning as the firm was not able to cover its cash flow out of its free cash flow.

It is not uncommon for a utility to finance its capital expenditures through the issuance of debt and equity. It will then finance its dividends out of operating cash flow. The reason for this is that otherwise, the high costs of constructing and maintaining utility-grade infrastructure over a wide geographic area will otherwise prevent the company from ever paying a dividend or rewarding its investors. Over the trailing twelve-month period, CMS Energy had an operating cash flow of $1.188 billion. This is more than enough to cover the $555.0 million in dividends with a substantial amount of money left over for other purposes. Thus, CMS Energy should probably be able to maintain its dividends going forward.

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 CMS Energy, one metric that we can look at to value it is by looking at the price-to-earnings growth ratio. This is a modified version of the more 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 forward earnings per share growth and vice versa.

According to Zacks Investment Research , CMS Energy will grow its earnings per share at a 7.50% rate over the next three to five years. This is relatively in line with the figure that we used earlier for projecting our average annual total return from the investment so it seems like a very reasonable estimate. This gives the company a price-to-earnings growth ratio of 2.60 at the current stock price. Here is how that compares to the company's peer group:

As we can see here, CMS Energy appears to be attractively priced relative to its peers. It is not the cheapest company on the list, but it is very close to that and well below the peer median. As such, investors could be receiving a good deal if they purchase it as opposed to one of its peers.

Conclusion

In conclusion, CMS Energy currently appears to be a decent investment considering the impending recession. The company's overall business model provides it with a great deal of financial stability in any economic climate. This stability does not preclude growth, however, and the company is reasonably well-positioned to deliver earnings per share growth and total return in excess of many of its peers. When we consider that it is trading at a reasonable valuation, CMS Energy Corporation stock could be worth picking up today.

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