ETR - Evergy: A Recession-Resistant Investment To Pick Up In A Market Correction

2023-05-24 17:33:28 ET

Summary

• Evergy, Inc. is an electric utility that serves some of the largest cities in Kansas and Missouri.
• Evergy should enjoy a strong customer base and stable cash flows in a challenging economic environment.
• The company is positioned to deliver an average total annual return of 10% to 12% over the next two years.
• The company boasts one of the strongest balance sheets in the industry and a sustainable 4.17% yield.
• The Evergy, Inc. stock price is currently a bit high, but we may see a correction in the near future that would provide an opportunity to buy in.

Evergy, Inc. ( EVRG ) is a regulated electric utility serving most of Eastern Kansas and Western Missouri. This makes sense, considering that the company is the result of a merger between the Topeka, Kansas, and the Kansas City, Missouri, utilities back in 2018. In general, utility companies have long been among the favorite investments of conservative investors, such as retirees. There are several good reasons for this, including the fact that these companies have historically had remarkably stable cash flows regardless of the conditions in the broader economy. They also tend to have higher distribution yields than many other things in the market, and Evergy's 4.17% current yield is certainly no exception to this.

I last discussed Evergy back in early 2022 and found that it had the potential for very strong growth in the renewable energy sector combined with an attractive valuation. The stock has fallen a bit since that time, as can be seen here:

Unfortunately, so has everything else, and Evergy, Inc. stock is no longer as attractively valued relative to its peers as it once was. This is quite unfortunate, although the rest of the thesis remains intact. In fact, Evergy is quite well-positioned to deliver a very attractive total return over the coming years that will easily match or exceed many of its peers. This is priced into the stock, though, so it might still be a good idea to wait for a market correction before purchasing shares.

About Evergy, Inc.

As stated in the introduction, Evergy is a regulated electric utility that serves most of Eastern Kansas and Western Missouri:

This is not usually thought of as a highly populated area, but it does include a few major cities, including Topeka, Kansas, and Kansas City, Missouri. As such, Evergy's service territory includes 1.7 million customers. Perhaps surprisingly, this makes it larger than many of its peers that operate west of the Mississippi River. However, as I have pointed out numerous times in the past, a utility company's size does not really affect its possession of certain characteristics. The most important of these is that the company will enjoy remarkably stable cash flows regardless of macroeconomic conditions. We can see this by looking at Evergy's operating cash flows. Here they are for each of the past eleven quarters:

The reason for this general stability is that Evergy provides a product that is generally considered to be a necessity for our modern way of life. After all, how many people today do not have electric service to their homes and businesses? While there are still a surprising number of senior citizens that do not have Internet access, which many people would likewise classify as a necessity today, these individuals still have electricity. As such, most people will prioritize paying their electric bills ahead of any discretionary expenses during times when money gets tight. That is a common occurrence during a recession or macroeconomic shock. This is what gives these companies the recession resistance that they are known for.

The near-term economic outlook for the United States is somewhat uncertain. The market is widely expecting the Federal Reserve to either pause on rate hikes or institute one more hike in June before cutting rates as the economy falls into a recession in the second half of 2023. However, the officials at the Federal Reserve have stated that such a scenario is unlikely and that rates are likely to stay at elevated levels for an extended period of time. This would not only cause a severe recession but it could also result in stagflation, as trillions of dollars were pumped into the economy over the last decade without corresponding economic growth. That scenario would severely dampen the ability of consumers to make any sort of discretionary purchases.

As such, it may be a good idea for your portfolio to include a stable company like Evergy, Inc. that should be able to continue to deliver stable cash flows through such an environment. In fact, Evergy may be better positioned than many other utilities for such an event due to the fact that many of the people in its service territory are dependent on agriculture for their incomes, whether directly or indirectly. That is another necessity, so it reduces the chance that its customers will have financial problems and struggles.

There are already reasons to believe that Evergy's customers are in somewhat better shape financially than the customers of most other utilities. For example, the unemployment rate in both Kansas City, Missouri as well as the entire state of Kansas is consistently better than the United States as a whole:

This makes it even less likely that the company's customers will find themselves unable to pay their electric bills. Thus, the utility is not only benefiting from the fact that its customers will want to keep their services active no matter what, but they also consistently have the financial capacity to accomplish that. We can see too that this is not just a recent development too, as the company's service territory consistently had less unemployment both prior to the pandemic-related lockdowns and even during the worst of the pandemic. We can therefore assume that this will remain true during a worst-case scenario for the national economy as well. This should be comforting to those investors that are seeking a margin of safety and stability.

Growth Prospects

Naturally, as investors, we are not only interested in mere financial stability. It is also important to us for a company in which we are invested to grow and prosper. As mentioned in the introduction, Evergy is quite well-positioned for this.

One of the ways in which Evergy will achieve earnings growth 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. As this rate of return is a percentage, any increase to the rate base allows the company to increase the amount that it charges its customers in order to earn that specified rate of return. The usual way that a utility company expands its rate base is by investing money into upgrading, modernizing, or possibly expanding its utility-grade infrastructure. Evergy is planning to do exactly that as it has unveiled a five-year plan totaling $11.6 billion to be spent over the 2023 to 2027 period. The company has, unfortunately, not broken down this spending by year, but it has stated that it should be sufficient to grow its rate base at a 6% compound annual growth rate.

Interestingly, the company's earnings guidance is only for the 2021 to 2025 period. Over this time, it expects to grow its earnings per share at a 6% to 8% compound annual growth rate:

This works out to a 10% to 12% total average annual return when we combine the earnings per share growth with the current 4.17% dividend yield. That is a bit higher than most of the company's peers, which is rather nice to see. With that said though, I would have liked the company to have provided some guidance out to 2027 since that is the end date of its current rate base growth plan. If the company is expecting 6% rate base growth annually, that probably means that its long-term earnings growth target is about 6%. That brings the average annual total return down to 10%, which is in line with its peers but not any better than its peers.

Financial Considerations

It is always important that we investigate 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 existing debt. This can cause a company's interest expenses to increase in certain market conditions. As of the time of writing, the federal funds rate is at the highest level that we have seen since 2007 so that is a very real risk to the company's cash flows today. 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 its cash flows to decline could push it into financial distress if it has too much debt. Although utilities like Evergy usually have remarkably stable cash flows, there have been bankruptcies in the sector before so this is not a risk that we should 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 will cover its debt obligations in the event of bankruptcy or liquidation, which is arguably more important.

As of March 31, 2023, Evergy, Inc. had a net debt of $12.322 billion compared to $9.5017 billion of shareholders' equity. This gives the company a net debt-to-equity ratio of 1.30 today. Here is how that compares to some of the company's peers:

As we can clearly see here, Evergy appears to be quite well-financed relative to most of its peers. This is a good sign as it indicates that the company is probably not employing an excessive amount of debt in its financial structure. Thus, investors should not have to worry too much about the company's use of leverage.

Dividend Analysis

One of the biggest reasons why many investors purchase shares in utility companies is because these companies tend to have higher yields than many other sectors. This comes from the fact that utilities have lower growth rates than companies in some other sectors, so they cannot depend on the market to award their investors substantial capital gains. As such, they rely on paying out a significant percentage of their cash flows as dividends in order to deliver a competitive total return. I explained how this works in a recent article . Evergy, Inc. is no exception to this as its common stock yields 4.17% as of the time of writing. In addition to a high yield, the company has a long history of growing its dividend on an annual basis:

This is something that is quite 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 pay with the dividend 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 the company raises its dividend every year helps to offset this effect and maintains 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 dividend that it pays out. After all, we do not want to be the victims of a dividend cut since that would reduce our incomes and almost certainly cause the company's share price to decline.

The usual way that we judge a company's ability to afford 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 and is left over after it pays all of its bills and makes all necessary capital expenditures. This is therefore the money that the company can use to reduce debt, buy back stock, or pay a dividend.

In the twelve-month period that ended on March 31, 2023, Evergy, Inc. had a negative levered free cash flow of $520.6 million. That is obviously not enough to pay any dividends, but the company still paid out $544.2 million in dividends over the full-year period. At first glance, this is likely to be quite concerning.

However, it is not unusual for a utility to finance its capital expenditures through the issuance of debt and equity. It will then pay the dividends out of operating cash flow. The reason that this is done is that it is extremely expensive to construct and maintain utility-grade infrastructure over a wide geographic area, and these expenses are sufficient to prevent the company from ever generating a positive free cash flow. In the most recent trailing twelve-month period, Evergy reported an operating cash flow of $1.8997 billion, which was easy enough to cover the $544.2 million that was paid in dividends with a substantial amount of money left over. Overall, this dividend is probably sustainable over an extended period.

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 Evergy, Inc., 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 forward earnings per share into account. A price-to-earnings ratio of less than 1.0 is a sign that a stock may be undervalued relative to its forward earnings growth and vice versa.

There are very few stocks that have such a low ratio in today's richly-valued market , however. Thus, the best way to use this ratio for valuation is to compare Evergy, Inc. against its peers to determine which company has the most attractive relative valuation

According to Zacks Investment Research , Evergy will grow its earnings per share at a 5.20% rate over the next three to five years. This is a bit less than the company's guidance, but it is probably pretty reasonable considering the 6% rate base growth. At this earnings per share growth rate, Evergy has a price-to-earnings growth ratio of 3.14 at the current stock price. Here is how that compares to the company's peer group:

This comparison does not look nearly as good for Evergy, Inc. as the financial structure comparison did. Here, we can clearly see that Evergy appears to be rather expensive relative to its earnings per share growth. This echoes the point that I made in the introduction to this article. As such, it might be best to wait for a market correction before buying in. This market correction may happen in the near future as the eventual resolution of the debt ceiling talks will almost certainly drain liquidity from the market and result in a sell-off.

Conclusion

In conclusion, Evergy, Inc. has a lot to offer any investor given the current uncertain economic environment and the company's overall stability in the face of it. The company's service area historically has lower unemployment than the national average, ensuring a customer base that should have the financial wherewithal to handle challenging economic conditions. Evergy, Inc. also has fairly significant forward growth prospects and a strong balance sheet .

The biggest problem here is that Evergy, Inc. stock appears to be a bit expensive at the current price, so it might be best to wait for a market correction before buying in. Fortunately, we may see that market correction within the next few weeks.

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