CMSD - WEC Energy Group: Adversely Impacted By Warm Weather But Still A Good Utility

2023-05-22 05:28:38 ET

Summary

• WEC Energy Group is a regulated utility serving four states in the northern Heartland, including the city of Chicago.
• The company's natural gas operations were adversely impacted by a warmer-than-normal winter, but its overall stability remains intact.
• The company is positioned to deliver a 10% to 11% total average annual return through 2027.
• The company has a strong balance sheet and an attractive dividend yield.
• WEC stock is arguably overpriced, so it may be best to wait for market weakness to buy in.

WEC Energy Group ( WEC ) is a regulated electric and natural gas utility that primarily operates in Wisconsin and the surrounding states. The utility sector in general has long been among the favorite investments for conservative investors, such as retirees. There are some very good reasons for this, including the general stability of the sector and the fact that many utility companies pay out remarkably high dividend yields. WEC Energy Group is no exception to this as the stock's current 3.47% yield is much higher than the broader S&P 500 Index ( SPY ) or even the U.S. Utilities Index ( IDU ). Unfortunately, the stock has significantly underperformed the index lately, as WEC Energy Group has dropped 16.96% over the past year compared to only a 9.34% drop in the index:

This does not necessarily mean that WEC Energy Group is a bad investment, however. The company does boast many of the characteristics that we usually appreciate in the utility sector, as well as the potential for a solid total return going forward. As some readers may recall, I have discussed this company before. But that was a few months ago, so let us update our thesis.

About WEC Energy Group

As stated in the introduction, WEC Energy Group is a regulated electric and natural gas utility that operates in Wisconsin, Minnesota, and parts of both Michigan and Illinois:

This is not generally considered to be one of the most highly populated regions of the United States, although WEC Energy Group does provide natural gas service to the city of Chicago, Illinois, and the surrounding suburbs. That alone represents a substantial number of people as Chicago is the third-most populous city in the United States with a population of 2.7 million. For its part, WEC Energy Group has 4.6 million retail customers in its service territory, which actually makes it one of the largest utilities in the nation. The size of a utility is generally irrelevant to its characteristics, however, as most utilities have a very similar business model. The most important of these characteristics is that WEC Energy Group has very stable cash flows over time and through any economic conditions. We can see this quite clearly by looking at the company's operating cash flow. Here are WEC Energy Group's operating cash flows for each of the past eleven twelve-month periods:

As we can see, the company's operating cash flows were generally very stable. We did see a bit of a decline in the most recent period though, which was caused by a warmer winter than normal. The company's Executive Chairman, Gale Klappa, explained in the first quarter 2023 earnings press release :

We experienced one of the mildest winters in history. For example, this was the second-warmest winter in Milwaukee since 1891. We continue to focus on the fundamentals of our business -- financial discipline, operating efficiency, and customer satisfaction. And we're confident that we can deliver another year of strong results, in line with our original guidance for 2023.

The fact that this was such a warm winter meant that the company's customers did not need to consume as much natural gas as usual to heat their homes and businesses. This is the biggest reason why natural gas prices have declined as severely as they have over the past few months:

I discussed this to a greater degree in a recent blog post . The fact that the company's customers used less natural gas than normal over the course of the winter reduced the company's sales of natural gas, and naturally, the revenue and cash flow that the company would receive from those sales. This does not alter our thesis, however, as such a warm winter is likely to be a one-off event and we will probably see natural gas consumption return to a normal level next year. We can still see that this did not have an outsized impact on the company's trailing twelve-month operating cash flows though as the decline between the twelve-month periods ending on March 31, 2023 and December 31, 2022 was $280.7 million or 13.62%. That still shows much more stability than companies in many other sectors experience from quarter to quarter.

The reason for this stability is that WEC Energy Group's product is the provision of electric and natural gas services to homes and businesses. Most people consider that to be a necessity for modern life, so they will usually prioritize paying their utility bills ahead of making more discretionary expenses. That is something that is very important today as we are seeing a growing number of signs that the American economy may enter a recession in the near future. One of the defining characteristics of a recession is that many people see their financial situations worsen and discretionary income decline. The incredibly high inflation that we have experienced in the United States over the past eighteen months has had the same effect. Thus, a company like WEC Energy Group that will not be particularly impacted by an economic downturn will likely prove to be a better near-term performer than something that is highly dependent on consumer spending or business expansion.

WEC Growth Prospects

Naturally, as investors, we are not likely to be satisfied by mere stability. We like to see a company in which we are invested grow and prosper over time. Fortunately, WEC Energy Group is well-positioned to accomplish this. The primary way through which the company will do this is by growing its rate base. A utility's rate base is the value of its 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 positively adjust the prices that it charges its customers in order to earn that allowed rate of return. The usual way in which a utility grows its rate base is by investing money into upgrading, modernizing, and possibly even expanding its utility-grade infrastructure. WEC Energy Group is planning to do exactly this as the company recently unveiled an updated five-year plan. Under this plan, WEC Energy Group will spend $20.100 billion on infrastructure upgrades over the 2023 to 2027 period:

This represents a $2.4 billion increase over the company's previous five-year plan. Unfortunately, it will not grow the company's rate base by $20.1 billion over the period. Rather, this is expected to take the company's rate base from $26.5 billion today to $38.4 billion at the end of 2027. There are two reasons why this plan will not grow the company's asset base by as much as it is spending. One reason for this is depreciation, which is constantly reducing the value of its assets in service. Thus, something that is put into service this year will be worth less in 2027, which creates a drag on the company's rate base and forces it to spend enough money to overcome this effect and still grow the rate base. The second reason why the projected rate base growth is less than the money that is being spent is that the company will be retiring some of its assets over the period. For example, the company retired the Weston 2 power plant back in February and is planning to retire 126 megawatts of old natural gas power plants between now and the end of 2024. Once these power plants are removed from service, they will not contribute their values to the company's rate base at all. It should be fairly easy to see how this will offset some of the company's planned growth spending.

Despite the fact that not all of the company's spending will be directly accretive to the company's rate base growth, its capital investment program should still result in rate base and earnings growth. In fact, the plan as presented should allow the company to grow its earnings per share at a 6.5% to 7% annual rate over the 2023 to 2027 period. This represents a continuation of the company's historical earnings per share growth. Over the past twenty years, WEC Energy Group has managed to grow its earnings per share at an approximate 9% compound annual growth rate:

When we combine the company's projected five-year growth rate and its current 3.47% yield, investors should be able to expect a 10% to 11% total average annual return through 2027. That is a very reasonable return for a conservative utility stock!

Financial Considerations

It is always important to 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, which can cause a company's interest expenses to increase following the rollover in certain market conditions. As of today, interest rates are at the highest level that we have seen since 2007 so that is a very real concern today. 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 WEC Energy Group tend to have remarkably stable cash flows, this is still a risk that we should not ignore.

One metric that we can use to measure the financial structure of a company 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. This ratio also tells us how well the 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, WEC Energy Group has a net debt of $17.861 billion compared to $11.9877 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.49 today. Here is how that compares to some of the company's peers:

As we can clearly see here, WEC Energy Group generally compares very well with its peer group in terms of leverage. This is a clear sign that the company is not relying too heavily on debt to finance its operations, so investors should not have to worry about the company's leverage.

Dividend Analysis

One of the primary reasons why investors purchase stock in utility companies is because of the very high yields that these companies typically possess. WEC Energy is certainly no exception to this as the company's current 3.47% dividend yield is substantially higher than the 1.54% yield of the S&P 500 Index. It is also higher than the 2.55% yield of the U.S. Utilities Index. Thus, the stock could be appealing to an income-seeking investor, although its current yield is still well below the current U.S. inflation rate. Fortunately, WEC Energy Group has a long history of raising its dividend on an annual basis. We can see this here:

This is very nice to see in today's inflationary environment. 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. The fact that it pays us more money with each passing year helps to offset this effect and makes it more likely that the dividend can maintain its purchasing power over time.

Naturally, though, it is critical 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 stock price to collapse.

The usual way that we judge a company's ability to pay its dividend is by looking at the 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 its bills and makes all necessary capital expenditures. This is therefore the money that can be used for things such as reducing debt, buying back stock, or paying a dividend. In the twelve-month period that ended on March 31, 2023, WEC Energy Group had a negative levered free cash flow of $627.7 million. That is obviously not enough to pay any dividends, yet the company still paid out $934.4 million in dividends over the period. This is likely to be concerning at first glance as the company's free cash flow is clearly insufficient to cover the payout.

However, it is common for a utility to finance its capital expenditures through the issuance of common stock and debt. It will then pay for its dividends using operating cash flow. This is done because it is incredibly expensive to build and maintain utility-grade infrastructure over a wide geographic area and as a result, a utility will almost always have a negative free cash flow that would otherwise preclude the issuance of dividends. During the trailing twelve-month period that ended on March 31, 2023, WEC Energy Group had an operating cash flow of $1.780 billion. That was sufficient to cover the $934.4 million in dividends that were paid out over the period with a substantial amount of money left over. As already discussed, the first quarter of this year was weaker than normal for the company and it still had no real trouble covering the dividend. Thus, investors should not have to worry about any potential dividend cut here.

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 WEC Energy Group, we can value it by using the price-to-earnings growth ratio. This ratio 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 are undervalued in today's expensive market . This is especially true in the low-growth utility sector. As such, the best way to use this ratio today is by comparing WEC Energy Group to its peers in order to see which stock offers the most attractive relative valuation.

According to Zacks Investment Research , WEC Energy Group will grow its earnings per share at a 5.76% rate over the next three to five years. That is less than the earnings per share that we calculated based on the company's rate base growth, but it is still sufficient to provide an acceptable total return when combined with the company's dividend. Assuming that the Zacks estimate is correct, WEC Energy Group has a price-to-earnings growth ratio of 3.40 at the current price. Here is how that compares to the company's peer group:

WEC Energy Group appears to be very expensive compared to its peers when using this ratio. However, this figure is using the 5.76% earnings per share growth assumption from Zacks. If we use the 7% figure that we calculated earlier based on the company's projected five-year rate base growth, WEC Energy Group has a price-to-earnings growth ratio of 2.79 at the current price. That is still a bit expensive compared to its peers, but it is not completely out of line. The takeaway here is that it may be best to wait for WEC Energy Group to drop a bit further before buying in, although it does not appear to be horribly priced today.

Conclusion

In conclusion, our thesis for WEC Energy Group still appears to be intact. The warmer-than-normal winter did have an adverse impact on the company, but it still continues to enjoy reasonably stable cash flows and solid forward growth prospects. The company's balance sheet is quite reasonable, and the dividend is attractive. The only real problem here is that the stock appears to be a bit expensive today, but that could correct itself at some point. In particular, a U.S. debt ceiling deal could push down stock prices due to the rapid decline of liquidity and give a better entry point for investors.

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