2023-08-24 21:53:44 ET
Summary
- Utilities have lost their appeal compared to risk-free investments with higher yields, and require consideration before investing in to ensure enough upside and returns.
- Consolidated Edison (ConEd) is facing pressure to deliver upside in a world of increased WACC and higher risk-free rates.
- ConEd's current valuation does not offer a 15% annualized rate of return, making it less attractive for investors.
- I consider the company to remain a "HOLD" here.
Dear readers,
Utilities as a whole have lost some of their shine, fairly naturally, in a world where investors are able to get over 4% yield on a risk-free basis. That makes utilities yielding 3.5% but less than 4% with a small upside a bit questionable as investments, even if that utility comes with A-rated fundamentals and very solid trends.
Consolidated Edison ( ED ) is one such utility. The company is a play I've looked at before, which typically trades at a premium to its fundamentals and its NYC exposure. But I don't think it would be unfair to say that the Big Apple has lost some of its shine over the past two years, and I don't believe it would be wrong to say that the whole utility sector is under pressure to deliver upside in this world of increased WACC and higher risk-free rates.
We need either significant overall upsides from the reversal or in terms of the valuation, or we want a much higher yield if we're investing in utilities or any companies with relatively low growth rates. There are utilities that offer this - Enel ( OTCPK:ENLAY ) is one such that I'm invested fairly heavily in.
Consolidated Edison, as I see it, is not.
So let's see what sort of upside or rate of return this company could deliver if invested in here.
Consolidated Edison - becoming a trickier investment in this context
I was a buyer of ConEd back in 2021 when the company started touching the low 16x P/E, compared to the almost 20x P/E it usually trades at, offering a 4% yield in a zero-interest rate environment with a BBB+ grade credit. Under such circumstances, investing in a company like ConEd was an easy choice.
The company is conservatively leveraged with less than 48% long-term debt to capital, it has very good overall profitability. In fact, when it comes to multi-utilities, ConEd is one of the better companies in the entire sector, with a gross profit margin of over 48% and a net margin of almost 16%. The company remains at the overall forefront in terms of ESG, it has a diverse customer base and continually provides good and reliable earnings. At one time, that might have been enough for investors to convince them to invest in the company - but this is not the case anymore.
ED has been buying back a large number of shares over the past few quarters $1B worth to be exact, as well as investing over $1.65B in CECONY during 1Q23. The company also received regulatory approval for rate plans at a 9.25% RoE and an equity ratio of 48%, which for the time being ensures part of the company's continued profitability moving into 2025E.
The company's 49 consecutive dividend increases also mean that ED is soon to be a Dividend King, which is rare overall in the market and the S&P500, but very rare in the utility sector.
The fact is that I've been neutral or negative to an investment in the common shares in Consolidated Edison for quite some time. Since my article back in September of 2022, the company has returned negative 8%, which is well below the market average. The same is true for the returns for my article since February of this year, with a negative RoR of about 1%.
Seeking Alpha Consolidated Edison RoR (Seeking Alpha)
So investing in ED hasn't been a good idea for over a year at this point - and this is likely to continue going forward, at this valuation as well.
ConEd's current work is focused on the green energy/clean energy transition. The company has a growing asset base expected to grow at a 6% three-year rate base CAGR, which comes with substantial required investments for what the company considers a clean energy future. To ensure that this is possible, the company has a very strong balance sheet and good financial management, as evidenced by its current credit rating.
Utilities are, on a high level, very good investments to hold for income. That's how I invest in them - for an income, hopefully, compounded by the potential for a valuation reversal.
Consolidated Edison has many things going for it. I'm talking about the solid history of plan approvals from the NYSPSC, and the selections of various ConEd-related projects, such as the Propel NY Energy transmission project, where CET has a 41.7% interest.
The fact that ConEd is raising prices to where certain members of the community or citizens are having trouble paying their heating or utility bills is nothing that is unique either to ConEd or even to the US. Prices for utilities, such as power, heat, and water are up everywhere, and there have been periods in Europe when customers had a very hard time paying their bills when power prices spiked. When I read things like this, I don't consider it an argument against investing in the company.
At the same time, it's very important to realize that as with all regulated business, regulators are motivated to keep prices for consumers low, because there is a political component to these companies and their decisions.
I think it's important to realize that future raises of prices are unlikely to be as good as historical raises because some of the inflationary increases for wage, goods and services are likely, at least as I see it, going to come from the company's current profit margin. Even if you don't 100% believe that, I believe you should expect or be open to this possibility because we're talking about one of the most fundamental things that people need for survival - heat, power, and water (in this case, power/heat). That's why we've seen across multiple geographies support packages for consumers aimed at reducing the stress of their bills for these things, but haven't seen it for things like gas. Even something as crucial as gas can be argued not to be as ubiquitous as power.
So while utilities and multi-utilities like ED are in a great position overall, due to their regulated nature and essential monopoly in their various service areas, this comes at the cost of control. I believe the impact of this is likely to be felt more going forward because, unlike most other companies or sectors, utilities can't raise their prices without approval.
That's why despite my love for utility investing, I'm actually discounting many of these companies more on a forward basis.
There is a lot to like about ConEd. I do not believe it an exaggeration to say that ConEd is probably leading the charge for ESG and green energy across the US. I find no company that's going as "all-in" in terms of meeting climate goals, having their customers meet climate goals, and pushing for utility-owned renewables and utility-owned energy storage projects - many of which are already operational. So from that perspective, ConEd continues to be attractive.
The problem is, as an investor in the stock market I want at least 15% annualized RoR in any investment I currently make - and this is irrespective of any ESG push the company is making. As an investor, I'm focused on my returns, not on any one company's "green transition".
And for ConEd, what we're seeing in valuation is currently telling us the following.
Consolidated Edison is not cheap - and the upside is far from 15%
So, a conservative 15% annualized rate of return. Even if we were to accept the company's historical premium of 19.6x as gospel, that leaves us with a forward annualized RoR of 11.4% per year until 2025E.
Don't get me wrong. I do not question the earnings growth forecasts, because this is one of the very few companies where FactSet analysts have a 100% 1, and 2-year accuracy rate. They always hit the mark, never beating, never failing (at least not for the last 10 years). That makes these average 6% earnings growth forecasts more than simply "indicative". It makes them almost secure, as I see it.
However, that's not the same thing as the company trading at that multiple or above it, which is what we've seen since I went neutral/"HOLD" on the company some time ago.
Let's say that the company normalizes to a P/E 15x. It's rare, but it could happen in a rising interest rate environment and if some changes or unforeseen impacts hit the company. Then the return we'd see for ConEd is close to zero.
I tend to prefer investments that not only deliver in an upside or premium scenario, but that give me 15% or above even in the case they perform below expectations. It's not impossible to find such investments today on the market, which is why this one becomes less interesting.
15 analysts follow Consolidated Edison (Source: S&P Global). The company has a price target range of $73 on the low side and $103 on the high side, with an average of $88/share. That's around 2% below the current price the company is trading at. It also means that out of 15 analysts, 9 are at "HOLD" and 3 are at "SELL". Only 1 analyst has a "BUY" rating on the company, and this is despite some fairly positive valuation trends for investing (in that the company has actually become cheaper).
The message conveyed here is actually the same that I would consider relevant for the company. It's not cheap enough yet. My own PT for ConEd was previously $85/share. I went back and forth between keeping it or giving it a slight share price target cut - but in the end, I decided to keep it. The company could, in a high-valuation scenario be worth $85/share. That's the point at which a positive estimate for the company results in a 15% annualized RoR. I wouldn't necessarily invest at that time - there would still be better alternatives out there.
But I wouldn't be as averse to investing in the company there.
I've also looked at the options chain to see if there are some attractive PUT or buy-write premium returns to take advantage of - but every play, no matter what the expiration or strike price hasn't really delivered any sort of upside or scenario that I would be interested investing in.
My previous stance for Consolidated Edison was a "HOLD" - that is also the stance that I hold now.
Here is my thesis for the company.
Thesis
My thesis for Consolidated Edison Is as follows:
- Consolidated Edison is a top-quality utility with a great set of assets and a good set of fundamentals. At the right valuation, the assets here are backed by incredible safety and a good geographical population base.
- However, unless the valuation is right, you're at risk of putting your capital to "work" at below 7% annualized RoR even with yield.
- At the current valuation, I would consider this company to be a "HOLD" and a rotation target due to overvaluation. I trimmed it and sold it off to watchlist status, and I believe you can consider the same.
- I consider ED a "HOLD". PT is $85/share.
- Selling put options is not valid either - the company is too expensive for that to be of interest.
Remember, I'm all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- The company is currently cheap
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
Due to not fulfilling my valuation-related criteria, this company warrants only a "HOLD", and I believe you can rotate it here.
For further details see:
Consolidated Edison: A Utility That's Still Expensive For What It Offers