LNT - Utilities Are Still Undervalued And Some Are A Buy

2023-12-01 10:49:46 ET

Summary

• The Utility sector has struggled due to rising interest rates and inflation, resulting in share price declines and high dividend yields.
• California Water Service Group, Alliant Energy, and WEC Energy Group are identified as buying opportunities in the utility sector.
• These companies have faced challenges but offer strong dividend growth, and solid dividend safety, and are undervalued compared to historical values.

Of all the sectors, Utilities have struggled in the past year because of rising interest rates and inflation. Despite gains in the past month, the sector is still down around 10%.

Share price declines have resulted in rising dividend yields. Climbing interest rates on U.S. Treasury bills and bonds are usually inversely correlated to utility stock dividend yields. As a result, some utilities are carrying the highest yields in a decade or more. Further, the companies have not stood still; they often grow their rate base, increasing earning dividends.

Consequently, many utility stocks are trading at low valuations, below their trailing five- and ten-year averages but carrying high dividend yields. In earlier articles, we identified several utilities that were buys and some with high yields for income .

Interest rate sensitivity is a risk, but eventually, rates will steady and reverse. The Federal Reserve has paused for two consecutive meetings. Moreover, inflation is near 3% and trending lower. Hence, investors should look hard at utilities. This article discusses California Water Service Group ( CWT ), Alliant Energy ( LNT ), and WEC Energy Group ( WEC ), which we view as buys.

Why Have Utility Share Prices Declined?

The utility sector struggles are widespread and not isolated to a few companies. Only three of the gas, electricity, and multi-utilities we track have positive returns. In addition, all the water utilities we track are down year-to-date.

The table below shows the gas, electricity, and multi-utilities we track. The average return is almost -13%, placing them in correction territory.

Similarly, all the water utilities we track have negative returns, with an average of about -16.5%.

However, the cause is not poor operational performance across the sector. Instead, investors often select safer U.S. Treasuries over higher-yielding equities. The thought process is usually, why risk principle in stocks when bonds and T-bills are safer and yield more?

The bottom line, though, is this industry and sector underperformance presents investors with a buying opportunity.

California Water Service Group

California Water Service Group ( CWT ) is the first stock on our list. It started in the San Jose area but has expanded to four other states. Today, it is the third-largest water and wastewater treatment company in America. The firm operates through five state businesses: California Water Service, Hawaii Water Service, New Mexico Water Service, Washington Water Service, and Texas Water Service. Total revenue was $846.4 million in 2022 and $781 million in the last twelve months.

The most extensive operations are in California, with ~496,400 connections and two million customers. Outside its home state, the company is growing by small, tuck-in acquisitions. It now has 6,200 customers in Hawaii, 37,500 in Washington, 10,700 in New Mexico, and 2,200 in Texas.

The firm has faced recent challenges because its costs are higher and revenue is lower. The expiration of revenue adjustment mechanisms at the end of 2022 has caused operational revenue to decline. The utility received a rate increase approval in April 2023, which should alleviate some higher costs. Also, the return on equity and rate of return will be higher in 2024 because the California Water Cost of Capital Mechanism triggered again on September 30, 2023. For this reason, we expect operational revenue to be higher in 2024.

From a divided perspective, California Water is one of the three water utility Dividend Kings. It has a lengthy dividend growth streak of 56 years. The average annual dividend growth rate is ~6.8% in the past five years and ~4.7% in the last decade, indicating acceleration.

The forward dividend yield is only ~2.1%, the highest since March 2018. The utility has yielded over 3% in the past, but the reputation of water utility stocks has made them attractive to income investors. That said, the forward dividend yield exceeds the five-year average of ~1.68%.

California Water's dividend safety is excellent, with a 57% payout ratio. Operating cash flow [OCF] of $187.4 million in the past twelve months easily covers the dividend payout of $57.8 million. Moreover, the credit rating agencies give the utility an A+ upper medium investment grade score. In addition, Portfolio Insight's dividend quality score, a measure of safety based on growth, profitability, and the balance sheet, is an 'A+,' meaning little risk of a cut exists now.

This utility, like the others, is seldom undervalued. It typically trades at a price-to-earnings [P/E] ratio of 30X to 38X. The forward P/E ratio is now ~27X earnings, a relative deal compared to historical values. We view this utility as a long-term buy for dividend growth investors.

Alliant Energy

The second stock on this list is Alliant Energy Corporation ( LNT ), a natural gas and electricity utility in Wisconsin and Iowa. It primarily has regulated operations but also sells wholesale power in adjacent states. The utility's subsidiaries are Interstate Power and Light Company [IPL] and Wisconsin Power and Light Company [WPL]. Alliant serves approximately 995,000 electric and 425,000 gas customers and also owns 16% of American Transmission Company, 50% of the Great Western Wind Project, and unregulated power generation.

Total revenue was $4,205 million in 2022 and $4,124 million in the past twelve months.

Alliant is the dominant utility in the two states. Currently, the company is focused on reliability and renewable energy. From the reliability perspective, it is placing electric lines underground and standardizing on 25kV transmission. Roughly 26% of its grid is underground, with improved reliability compared to peers and lower operating expenses. About 5% of transmission lines are high voltage, which improves operational efficiency and grid reliability with room for load expansion.

Similarly, Alliant is expanding its renewable energy generation with wind and solar power. It is the third-largest regulated wind producer and will be in the top five for regulated solar by 2024. Approximately 40% of retail power is sourced from renewable generation.

The formula seemingly works because the utility grows earnings per share at 7% to 9% annually. The dividend also grows at 5% to 7% per year, with a 60% - 70% payout ratio. Success has allowed Alliant to become a Dividend Contender with 20 years of growth. But a declining share price has pushed the dividend yield up to 3.6%, compared to a five-year average of 3%. It is the highest dividend yield since 2015.

Dividend safety is solid, too, with a forward payout ratio of ~61%. In addition, an OCF of $625 million covers the $447 million required for the dividend. The dividend quality grade is an outstanding, 'A+.'

Alliant is undervalued based on earnings multiple of about 17.3X, below the five-year and ten-year ranges. The elevated yield and the below-average P/E ratio make the equity a deal. We view Alliant as a long-term buy.

Western Energy Group

The third stock on our list is WEC Energy Group ( WEC ), a regulated electricity and natural gas utility. Like Alliant, it operates in Wisconsin and the surrounding states. The company serves roughly 4.7 million customers in Wisconsin, Illinois, Michigan, and Minnesota. The utility also has 60% ownership of American Transmission Company. Besides its core footprint's generating, transmission, and distribution infrastructure, WEC has 2,000+ MW of wind and solar generation in South Dakota, Nebraska, Kansas, Illinois, and Texas.

Total revenue was $9,597 million in 2022 and $9,234 million in the last twelve months.

WEC Energy Group is transitioning to renewable energy. They are slowly eliminating coal as a power source, with a target date of 2032. Coal will mainly be a backup fuel. Instead, the utility will generate power from renewables [wind, solar, battery storage], nuclear, and natural gas. As a result, operations and maintenance costs should be lower. Along these lines, the company is expanding its regulated renewable footprint, and the asset base should grow to 2028.

The utility is another Dividend Contender with 20 years of increases. The growth rate is around 6% to 7.5% annually in the past five years. The last increase was in December 2022; we expect another one in December 2023. The forward yield is ~3.8%, more than one percentage point greater than the 5-year average and near a decade high.

The excellent yield and annual growth come with acceptable dividend safety. The payout ratio is 65%, and the OCF of $2,540 million more than covers the dividend cash outlay of $968 million. In addition, the dividend quality grade is excellent at an 'A+.' Lastly, it has an A- / Baa1 lower-to-upper medium-grade investment rating. Little risk exists for a dividend cut.

WEC Energy Group is clearly undervalued based on dividend yield and P/E ratio. The valuation is ~18X, less than the 5-year and 10-year ranges. The utility is a buy because of undervaluation, yield, and dividend growth.

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