KRE - Hawaiian Electric: Surprisingly Good Stability But Population Decline A Drag

2023-06-12 18:16:05 ET

Summary

• Hawaiian Electric Industries, Inc. is the largest electric utility in Hawaii as well as one of the largest banks.
• The company is very well insulated against economic shifts, as even the tourism hit from the pandemic only had minimal cash flow impact.
• The population of Hawaii is declining, which could prove a drag.
• The company has a strong balance sheet relative to its peers.
• The company is very expensive relative to its earnings per share growth.

Hawaiian Electric Industries, Inc. ( HE ) is the largest regulated electric utility in the U.S. state of Hawaii, serving most of the Big Island, Oahu, and Maui. This is probably not the first place that an investor looking for a utility holding will think of to put their money, but Hawaii needs electricity just like any other modern region. For its part, the company has many of the characteristics that have long made the utility sector in general one of the favorite holdings of conservative, risk-averse investors like retirees. Indeed, there is a reason that these companies are sometimes called "widows and orphans" stocks.

Hawaiian Electric Industries is unique in the sector, though, as it also owns the third-largest bank in Hawaii. While banking is generally perceived as riskier than utility service, the unique characteristics of the island's economy allow it to offer the same overall stability that investors have enjoyed with utilities for many years. The company does not disappoint in terms of dividends either, as its 3.80% yield should be reasonably attractive to most income-focused investors. Overall, the company should prove to be a reasonable holding for today's environment considering that the economy has a high risk of falling into a recession in the second half of the year.

About Hawaiian Electric Industries

As stated in the introduction, Hawaiian Electric Industries is the largest regulated electric utility in the U.S. state of Hawaii. The company provides electric service on the islands of Hawai'i, Maui, and O'ahu, which are by far the three most populated islands. As stated in the introduction, the company also owns the American Savings Bank, which is the third-largest bank in the state. However, the electric utility accounts for the majority of the company's financial performance and 72% of its profits:

As such, we can consider Hawaiian Electric to be an electric utility, although the bank does account for enough of the company's profits that we should not ignore it completely. This is a bit different than some other utilities in which the non-utility operation accounts for only a very small portion of earnings.

As I have mentioned in numerous previous articles, one of the defining characteristics of utilities is that they enjoy remarkably stable finances regardless of the fluctuations and conditions in the broader economy. This comes from the fact that their services are normally considered to be necessities. After all, just about everybody has electric service to their homes and businesses and the amount that they consume does not usually vary that much with the economy. Hawaiian Electric Industries is no exception to this rule, which we can clearly see by looking at the company's operating cash flows. Here they are for each of the past eleven trailing twelve-month periods:

As we can see, the company's cash flows do not vary much over time. This is something that may be surprising considering the impact that the bank has on the company's financial performance, but it provides support for the statement that I made in the introduction about the unique characteristics of the island marketplace providing benefits to the bank. The period above includes 2020, which was one of the worst years for the Hawaiian economy in history due to the negative impacts that the lockdowns had on tourists. As we can see though, that event did not really hurt Hawaiian Electric Industries very much. Thus, it appears that this company should be able to weather even terrible economic circumstances without facing too much in the way of adversity. As I have mentioned in numerous previous articles, the U.S. economy is generally expected to enter a recession later this year. A company like this could prove to be a solid holding in such a scenario as it will have fewer adverse impacts than a company that is more dependent on consumer discretionary spending.

Naturally, as investors, we are unlikely to be satisfied by mere stability. We like to see a company in which we are invested grow and prosper with the passage of time. Fortunately, Hawaiian Electric Industries' electric utility is well-positioned to accomplish this.

Unfortunately, the company will not be able to accomplish this growth through demographic trends. According to the U.S. Census Bureau , the population of Hawaii has been declining over the past few years:

The state is fourth in the country in terms of population decline rate year-over-year. The only states whose populations are declining more rapidly are Illinois, New York, and Washington, D.C. in that order. The reasons that are normally cited for the population decline are the state's high cost of living and lack of economic opportunities outside of the tourism industry. The COVID-19 pandemic made it even worse since that reduced tourism to the island and reduced the influx of outside money to the state's economy. However, the actual reasons for this population decline are not critical for our purposes today except for the fact that these appear to be causes that will not be reversing soon. Thus, there is little reason to believe that the state's population will begin to grow again in the near future. This naturally has an adverse impact on Hawaiian Electric Industries since it reduces the number of customers in the state that are paying their electric bills every month. This applies downward pressure on the company's revenue and by extension, net income as less money is available to cover its fixed costs.

Hawaiian Electric Industries is attempting to make up for this by growing 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 increases the amount that the company can charge its customers in order to earn that specified rate of return. The usual way that a company grows its rate base is by spending money on upgrading, modernizing, or even expanding its utility-grade infrastructure. Hawaiian Electric Industries is planning to do exactly that, as the company has budgeted approximately $1.020 billion to $1.38 billion over the 2023 to 2025 purpose for this task:

I will admit that I would have preferred to see more visibility into the company's future spending plans than this. After all, many of the company's peers have provided investors with projected investments extending out to 2027, which is nice because it allows us to make better predictions about where the company will be at that time.

The capital spending program as detailed above should be able to grow the company's rate base sufficiently for the electric utility to deliver a 5% earnings growth rate through 2025. However, that is for the electric utility alone and, as we already discussed, the electric utility does not account for all of the company's earnings per share.

The fact that Hawaiian Electric Industries owns the third-largest bank in Hawaii is likely to be concerning to some readers considering the problems that we have been seeing with Silicon Valley Bank, Silvergate, Signature Bank, and others. The U.S. Regional Banking ETF ( KRE ) is down 24.04% year-to-date, which clearly emphasizes the fear that many investors have with respect to this sector:

As of the time of writing, the American Savings Bank has total deposits of $8.157 billion, so it is nowhere near as large as many regional banks but it is still one of the largest in Hawaii. However, it has not been suffering from some of the problems that are facing the other banks. In particular, the bank's deposit base has not been declining. As we can see here, the bank's deposit base as of March 31, 2023 is very much in line with where it was over the past few years:

A declining deposit base is the major problem that affected the banks that have collapsed or have nearly collapsed. Basically, the banks purchased long-dated U.S. Treasury securities that declined in value when interest rates went up. This would not have been a problem normally since these securities are free of default risk. However, once people began pulling their deposits out of the banks, the banks were forced to sell their securities at a loss and were thus unable to cover all of their deposits. It is not a case like back in 2008 when the securities that the banks were buying were bad. Thus, the fact that this bank has not seen its deposits decline is a good sign as it means that this bank does not have to sell its assets at fire sale prices to satisfy the demands of the depositors. This stable deposit base is partly due to the fact that Hawaii is isolated from the rest of the United States (and the world) and people do not have many options if they want to keep their money close to home and easily accessible. Thus, the American Savings Bank should have much more stability than other banks in terms of its deposit base.

Financial Considerations

It is important that we 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 its operations 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 at maturity, a process known as a debt rollover. Unfortunately, this can cause a company's interest expenses to increase following the rollover as there is no guarantee that it will be able to borrow new money at the interest rate of the original debt. As domestic interest rates are currently at the highest levels that we have seen since 2007, that is a very real concern right now. 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 Hawaiian Electric Industries clearly has remarkably stable cash flows over time, we have seen bankruptcies in the utility sector before as well as failed banks so this is not a risk that we should ignore.

One metric that we can use to judge a company's debt 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 the company's equity will cover its debt obligations in the event of a bankruptcy or liquidation event, which is arguably more important.

As of March 31, 2023, Hawaiian Electric Industries had a net debt of $3.2044 billion compared to $2.2722 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.41 today. This is slightly better than the 1.44 ratio that the company had the last time that we discussed it following the release of its fourth-quarter earnings results. Here is how the company compares to some of its peers:

As we can clearly see, Hawaiian Electric Industries compares reasonably well to its peers in terms of financial structure. Of this peer group, only Otter Tail Corporation has lesser leverage, and that company has substantial manufacturing exposure. Overall, the fact that Hawaiian Electric Industries does not appear to be more heavily reliant on debt to finance its operations than peers is likely a sign that the company is making appropriate use of leverage. We should not have to worry too much here.

Dividend Analysis

One of the biggest reasons why investors purchase shares of utility companies is that these companies frequently have higher dividend yields than just about anything else in the market. Hawaiian Electric Industries is not an exception to this as the stock yields 3.80% as of the time of writing, which is well above the 1.66% yield of the S&P 500 Index ( SP500 ). The company also has a long history of boosting its dividend on an annual basis:

The fact that Hawaiian Electric Industries increases its dividend each year is something that is very nice to see during inflationary periods, such as the one that we are experiencing today. This is because inflation reduces the number of goods and services that we can purchase 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, particularly for those individuals that are relying on their portfolios to provide for their lifestyles. The fact that the company increases the amount that it pays out helps to offset this effect and helps to maintain the purchasing power of the dividend.

As is always the case, 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 since that 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 finance its dividend is by looking at its free cash flow. Free cash flow is the money that was generated by a company's ordinary operations and is left over after the company pays all of its bills and makes all necessary capital expenditures. This is therefore the money that is available for tasks such as reducing debt, buying back stock, or paying a dividend. During the twelve-month period that ended on March 31, 2023, Hawaiian Electric Industries reported a negative levered free cash flow of $828.3 million. That is not nearly enough to pay any dividends, but the company still paid out $154.4 million during the period. At first glance, this is likely to be concerning as this company cannot pay its dividends out of its free cash flow.

With that said, it is quite common for a utility to finance its capital expenditures through the issuance of equity and debt and then pay its dividends out of operating cash flow. The reason for this is that it is incredibly expensive to construct and maintain utility-grade infrastructure over a wide geographic area. These costs are sufficiently large that the utility would never be able to invest in its own infrastructure if it had to finance dividends out of free cash flow. During the trailing twelve-month period, Hawaiian Electric Industries had an operating cash flow of $542.8 million. This was clearly enough to cover the $154.4 million in dividends that was paid out during the period with a substantial amount of money left over for other purposes. The company's dividend appears to be sustainable at present.

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 Hawaiian Electric Industries, we can value it by looking at the company's price-to-earnings growth ratio. This ratio is a modified version of the more familiar price-to-earnings ratio that takes a company's earnings growth into account. A price-to-earnings ratio of less than 1.0 is a sign that the stock may be underpriced relative to the company's earnings per share growth and vice versa.

According to Zacks Investment Research , Hawaiian Electric Industries will grow its earnings per share at a 4.35% rate over the next three to five years. This is a lower rate than many other utilities, but admittedly the negative population growth in Hawaii is likely to be a drag on growth. This earnings growth estimate gives the company a price-to-earnings growth ratio of 3.88 at the current stock price. Here is how that compares to the company's peer group:

As was the case the last time that we looked at this company, Hawaiian Electric Industries appears to be considerably expensive relative to its peer group. This significantly reduces the appeal of the company in the eyes of value-oriented investors, who may want to wait for the share price to come down a bit before buying in.

Conclusion

In conclusion, Hawaiian Electric Industries offers an interesting proposition for risk-averse investors right now. The company has historically exhibited remarkable stability through challenging economic conditions and thus will probably do so again as the United States enters a recession. However, the fact that the population of Hawaii is declining will prove to be a drag on the company's earnings and its expensive share price will hurt the market performance. On the plus side, the company's balance sheet is very strong and its bank is uniquely positioned for the Hawaiian market. Hawaiian Electric Industries, Inc. stock might be worth considering for its high yield, but I would wait for a better entry price.

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