2023-11-07 15:02:09 ET
Summary
- CMS Energy Corporation is a regulated utility that serves most of Michigan, offering financial stability and resistance to economic problems.
- The company's stock has underperformed since August, but the entire utility sector has been a poor performer relative to other sectors.
- CMS Energy's growth prospects lie in increasing its rate base, and it offers a 3.50% dividend yield.
- The company's leverage is higher than its peers, and rising interest rates have had an adverse impact on income, so that is a real risk.
- The company looks very cheap relative to its peers, but this may be partly due to its high level of leverage.
CMS Energy Corporation ( CMS ) is a large, regulated utility that serves most of the state of Michigan, except for the city of Detroit, which is served by DTE Energy Company ( DTE ). This is a decent place to be, although Michigan did have some struggles so far this year as the strike by the United Auto Workers had a negative impact on the state's economy. Fortunately, CMS Energy is quite resistant to problems with the economy in general due to its nature as a regulated utility. This is, in fact, one of the core elements of the thesis that I presented in my previous article on this company.
Unfortunately, the company's stock has not delivered an especially impressive performance since we last discussed it on August 22. As we can see here, the company's stock price is down 2.77% since the date that the previous article was published compared to a 0.49% decline in the S&P 500 Index ( SP500 ):
This is certainly disappointing, and it may put some people off of the stock. However, the entire utility sector has generally been a pretty poor performer since the middle of the year. This comes from the fact that companies like CMS Energy tend to have relatively low growth rates and so deliver the majority of their investment returns in the form of direct payments to the shareholders. Indeed, we can see this in the simple fact that CMS Energy currently has a 3.50% dividend yield, which is quite a bit higher than many other things in the market. This causes some of these companies' stocks to trade like bonds, so when rates go up their stock prices go down and vice versa.
Unfortunately, CMS Energy has also underperformed the iShares U.S. Utilities ETF ( IDU ) since the last time that we discussed the company:
This is perhaps even more disappointing, but it may not be completely unexpected. As I pointed out in the previous article regarding this company, CMS Energy has a relatively high level of leverage compared to many of its peers and this puts the company in a challenging position. After all, high levels of leverage are not exactly what a company wants to have in a high-interest rate environment. We will discuss this later in this article.
A few months have passed since we last discussed CMS Energy so of course a few things have changed. In particular, the company released an earnings report that was nothing especially spectacular, but we do not usually expect utilities to report spectacular earnings results. As a few months have passed, we should revisit this company and see if the stock makes sense for a purchase right now.
About CMS Energy
As stated in the introduction, CMS Energy is a regulated utility company that serves most of the state of Michigan, excluding the Upper Peninsula and the city of Detroit. According to the company's website :
CMS Energy's primary business is Consumers Energy, providing natural gas and electricity to 6.8 million of the state's 10 million residents in all 68 Lower Peninsula counties. Consumers Energy is committed to serving our customers and making Michigan a great place to live and work.
This is a pretty high customer count for a utility, and it easily places CMS Energy as one of the largest utilities in the United States despite the fact that its service territory is nowhere near as large as some of the big ones out West. However, as I have pointed out in numerous previous articles on both CMS Energy and other utilities, the company's customer count does not really have a huge impact on its defining characteristics. The biggest of these characteristics is that they tend to enjoy remarkably stable revenue and cash flows over time. We can see this quite clearly by looking at CMS Energy's figures. Here are the company's revenues for the past 11 quarters:
We do see that the third quarter of 2023 came in a lot weaker than the third quarter of the prior year quarter. The same was true of the second quarter of this year. Otherwise, we can see a great deal of stability in its revenues over time.
The fact that the two most recent quarters were lower than in the prior year's quarters does not necessarily disprove the overall thesis about the company's general stability. This is because CMS Energy is affected by weather conditions to a significant extent. This was evident over both the summer and winter months this year. Despite some media reports to the contrary, the summer of 2023 was actually colder than normal across much of the United States. CMS Energy pointed this out in its third-quarter earnings conference call :
To put the weather we have experienced in 2023 into perspective, we are approaching a record level of storm activity this year, which further supports the needed investments in our electric system that Garrick highlighted, and we have seen heating and cooling degree days of 11% and 24% below historical levels respectively on a year-to-date basis.
The big thing to note here is that cooling degree days were 24% below historical levels during the first three quarters of 2023. That is important because one of the biggest drivers of electric consumption during the summer months is air conditioning. It takes a great deal of electricity to run an air conditioning system and the fact that the summer of this year was colder than normal means that the company's customers did not have to run their air conditioning systems as often, thus consuming less electricity than normal. That translates into a year-over-year revenue decline, all else being equal.
Fortunately, though, CMS Energy's operating income held up much better. As we can see here, the company's third-quarter 2023 earnings numbers showed a very slight improvement over the prior-year quarter:
This supports our thesis reasonably well, as we would like to see a company's income at the very least remain stable over time. Ideally, we want to see growth, but stability is much better than declining income. I explained the reason for this overall stability in my previous article on CMS Energy:
The reason for the company's general stability over time is that CMS Energy provides a product that is generally considered to be a necessity for our modern way of life. After all, there are very few people in the United States who do not have electric service in their homes and businesses. In fact, most of us take for granted that the lights will come on when we flip a light switch. The same necessity status applies to natural gas for anyone that is living in a home that is heated by natural gas. We expect that our furnace will come on when we want it to and largely take it for granted that the furnace will have sufficient fuel to do so. As such, most people will prioritize paying their utility bills ahead of discretionary expenses during times when money gets tight.
One of the biggest theses presented for the market strength that we saw last week is that the United States will soon enter a recession that will force the Federal Reserve to cut interest rates fairly dramatically. One of the defining characteristics of recessions is that the unemployment rate increases and people have less income that they can spend. In such a case, it seems unlikely that they will opt to skip paying their electric or natural gas bills, as most people would want to keep these services working and find places to cut elsewhere. Thus, a company like CMS Energy would probably hold up better during a recession than firms that operate in other sectors of the economy. This is something that could prove attractive to those investors who are looking for a safe place to ride through economic problems.
Growth Prospects
Naturally, mere stability is unlikely to be attractive to any investor. After all, we can get stability and a much higher yield by investing in short-term Treasuries or a money market fund than in CMS Energy. We need to see the company grow and prosper over time in order to be deserving of our investment dollars. Fortunately, CMS Energy is well-positioned to deliver on this goal.
The primary way through which the company will accomplish this goal is by increasing its rate base. I explained the concept of rate base in my last article on this company:
The company'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 increase the amount that it charges its customers in order to earn that allowed rate of return. The usual way through which a utility grows its rate base is by investing money into upgrading, modernizing, or possibly expanding its utility-grade infrastructure. CMS Energy is planning to do exactly that, as the company has presented a plan to spend a total of $15.5 billion over the 2023 to 2027 period on improving its infrastructure.
Overall, this rate base growth should be sufficient to boost CMS Energy's earnings per share at a 6% to 8% compound annual growth rate over the long term. When we combine this with the company's current 3.50% dividend yield, the stock should be able to deliver a total average annual return of 10% to 11% over the long term. That is a reasonable total return that is generally in line with other utility companies. It is admittedly nothing fantastic compared to the expected total return that we can get from certain other sectors, but considering the current conditions in the market a high-yielding company with relative stability might be a more attractive option than taking on risk by investing elsewhere.
Overall, CMS Energy does appear to be offering a reasonable projected total return in today's market.
Financial Considerations
As I pointed out in the previous article on this company:
It is always important that we investigate the way that a company is financing its operations before investing 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 since very few companies have the ability to completely pay off their debt with cash as it matures. Unfortunately, this can result in a company's interest expenses going up following the rollover in certain market conditions.
As I pointed out in a recent article , we have started to see quite a few utilities report rising net interest expenses over the past year or so. CMS Energy is no exception to this, as we can see here:
This is simply being caused by the current interest rate environment. Utility companies in general tend to have a lot of debt due to the high costs of constructing and maintaining a utility-grade infrastructure network over a wide geographic area. Unfortunately, this also means that they tend to be exposed to a rising rate environment as their profits are insufficient to allow them to easily wipe out their debt as it matures. Thus, their interest expenses tend to increase fairly quickly in such an environment.
That is another possible reason why the utility sector as a whole has proven to be very interest-rate sensitive recently. As we discussed in the introduction, CMS Energy has almost been trading like a bond over the past few months. This is despite the fact that this is an operating company that is able to deliver earnings growth over the long term. Unfortunately, though, the company's rising interest expenses will act as a headwind for this growth and make it lower than it would have been in a more accommodative financial environment.
In the introduction to this article, I pointed out that CMS Energy is a bit more leveraged than many of its peers. We can see this by looking at the company's net debt-to-equity ratio and comparing it to its peers:
Company | Net Debt-to-Equity Ratio |
CMS Energy Corporation | 1.97 |
DTE Energy Company | 1.88 |
Avista Corporation ( AVA ) | 1.22 |
Exelon Corporation ( EXC ) | 1.68 |
Entergy Corporation ( ETR ) | 1.85 |
This confirms that CMS Energy is more reliant on debt to finance its operations than many of its peers, which could represent a very real risk. This could, in fact, be one reason why the company has underperformed its index for the past few months. After all, the higher its leverage the more its expenses will be affected by rising interest rates.
Dividend Analysis
One of the biggest reasons why investors invest in utility companies is because they tend to have higher yields than many other things in the market. This comes partly because of their low growth rates. After all, as we saw earlier in this article, CMS Energy only delivers a 6% to 8% earnings growth rate over time so that would not be satisfying to any investor without some additional return from somewhere. CMS Energy pays a 3.50% dividend yield at the current price, which helps to bring its prospective total return up to an acceptable level.
As is the case with many of its peers, CMS Energy also raises its dividend annually:
This is something that is very nice to see today, as the high level of inflation that has been dominating the economy has caused the purchasing power of the company's dividend to decline. That is naturally a big problem for anyone who depends on the dividend to provide some of the income that they need to function in their daily lives. The fact that CMS Energy increases its dividend annually helps to offset this effect and ensures that the company's dividend does a reasonable job of holding its value over time.
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 that reduces our income and almost certainly causes the company's stock price to decline.
The usual way that we determine a company's ability to maintain its dividend is by looking at its free cash flow. During the twelve-month period that ended on September 30, 2023, CMS Energy had a negative levered free cash flow of $1.1159 billion. That is obviously not enough to afford any dividends, but the company still paid out $904.4 million to its shareholders over the period. At first glance, this seems almost certain to be concerning as the company is clearly failing to generate enough cash through its ordinary operations to cover its dividends.
However, it is very common for a utility to finance its capital expenditures through the issuance of debt and equity. The company will then pay its dividends out of operating cash flow. This is due to the enormous capital expenditure that the company has to incur in order to keep its rate base steady due to depreciation, let alone the additional money needed to grow the rate base. This is why utilities tend to have rising debt over time, which can be problematic when interest rates increase.
During the trailing twelve-month period, CMS Energy had an operating cash flow of $4.0070 billion. That was easily enough to cover the $904.4 million that was paid out as dividends and leave the company with a lot of extra money that could be used for additional purposes. Overall, the company's dividends appear to be reasonably safe at the current level and we probably do not have to worry about a dividend cut.
Valuation
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 in line with the 6% to 8% growth rate that the company should be able to get simply from its rate base growth, so it seems pretty reasonable. This gives the company a price-to-earnings growth ratio of 2.37 at the current stock price.
Here is how that ratio compares to the company's peers:
Company | PEG Ratio |
CMS Energy Corporation | 2.37 |
DTE Energy Company | 2.71 |
Avista Corporation | 2.56 |
Exelon Corporation | 2.70 |
Entergy Corporation | 2.50 |
Here we can see that CMS Energy appears quite cheap compared to its peers. It is also, obviously, a bit cheaper than the last time that we discussed it. However, as we also saw, this company has a bit higher debt level than its peers so that could be one reason why it is trading at a lower ratio than other utilities. Thus, there is a bit of a risk-reward trade-off here as CMS Energy may continue to underperform if rates remain high or especially if they rise further.
Conclusion
In conclusion, our general thesis about CMS Energy being a recession-resistant investment for the current environment continues to look like a solid thesis. Unfortunately, the company's high leverage is a major strike against it since it seems likely that any near-term recession will be accompanied by very high interest rates as the Federal Reserve struggles to control inflation.
CMS Energy Corporation is reasonably well positioned for earnings growth even in such an environment, however, and the fact that it raises its dividend annually helps provide further insulation for investors against economic weakness. Overall, this company might be worth considering for your portfolio if the high leverage does not frighten you.
For further details see:
CMS Energy: High Leverage A Concern, But Company Is Strong Financially