2023-12-13 07:11:36 ET
Summary
- I estimate ED's intrinsic value around $37.4B, or 108 per share - an 18% upside.
- Selling its clean energy business for $6.8B, allows Consolidated Edison to stabilize and revitalize the fundamentals.
- Dividends may not be covered by performance, but the company is moving in the right direction.
- Key risks include foreign grid attacks and insufficient free cash flows.
While a utility stock may seem like a safe play for investors, companies such as Consolidated Edison ( ED ) carry with them their own set of burdens and we will evaluate their future prospects despite the solid dividend yield.
Consolidated Edison Operating Energy Regions (Investor Presentation)
Consolidated Edison is a utility that delivers and produces electricity. As of 2022, the company produces about 20% of the electricity it delivers to its customers in New York City and Westchester County. The remaining 80% of the delivered electricity is purchased from other generators, such as power plants.
The company will experience an increase in demand ( p. 16-17 ) with a peak around 2040, primarily due to electrification of urban areas and the uptake of electric vehicles.
Selling The Clean Energy Business Reveals Hints About Future Behavior
In 2022 Consolidated Edison decided to focus on core delivery competencies and sold its clean energy business to RWE in March 2023. The sale was valued at $6.8B. This division included a portfolio of solar and wind farms, as well as a development pipeline of over 24 GW of renewable energy projects. At the announcement, the CEO stated "...Consolidated Edison to sharply focus on our core utility businesses and the investments needed to lead New York's ambitious clean energy transition." In my opinion, it's good to see the company focusing on core strengths, however, their venture into clean energy is a sign of how interconnected the company may be with the current regulatory zeitgeist, and investors may want to price-in the cost of doing the bidding of regulators in subsequent business cycles.
Performance Will Stabilize Post Divestiture
In the last 12 months, ED made $15.25B in revenue, $2.355B in net income, adj. EPS of 4.07, and around $2.4B of unlevered free cash flows.
Looking at the future, for 2023, ED expects its adj. EPS to be around $5.05, excluding impacts related to the sale of the Clean Energy Businesses (approximately $2.24 a share after-tax). This indicates a 25% reduction of EPS from the last 12 months EPS of $6.77. For the year after that, analysts are expecting a stabilization of EPS for FY 2024 of $5.29, equivalent to 4.75% growth.
Dividends May Not Be Covered By Performance
In the last 12 months, ED paid out a total of $1.106B in dividends. The dividend is regular, as the company has been paying it out for more than 29 years, it has a 7.8% CAGR since 1994, and a more recent five-year CAGR of 5.8%.
In evaluating dividend payments, it's important to see if the dividend is affordable going forward. In order to do this we will look at the cash flows available to equity investors (FCFE).
Consolidated Edison Free Cash Flows Analysis (Author, data from FMP)
In the last 12 months, ED made $1.2B in levered cash flows (FCFE), sufficiently covering the $1.1B dividend expenses. Unfortunately, the company has a history of producing lower FCFE and the average five-year FCFE production amounts to $685.2M according to my calculations , and -1.7B, according to Seeking Alpha's data . Indicating that on average the company is short on covering dividend commitments.
If we take out the debt financing the company uses to cover dividends, we will see that in the last five years, on average ED's FCFEs were -$477M. For this reason, I think it was wise to move with the divestiture of ED's clean energy business, as it provides an inflow of cash, as well as an opportunity to restructure operating expenses, which may further stabilize the business.
Finally, the company has capital expenditures of around $500M, which have decreased due to inflows from divestitures of around $3.9B. In the last five years ED typically had CapEx around $4B, which may continue in the future.
DDM Valuation Reveals 11% Alpha
Given that ED is a stable utility company paying out regular dividends, we will use a simple one-stage dividend discount model ((DDM)) to assess if the company is producing a return equivalent to its risk. In order to do that, we will take the company's current dividend payments of $1.106B, and assume they grow at the 10-year T-Bond rate, while giving the stock a cost of equity of 6%.
Note, we calculate the cost of equity as: risk-free rate + enterprise risk premium * beta. This equals 7.2% = 4.2% + 4.3% * 0.7
From this, we will use the single-stage DCF formula to calculate the intrinsic value of ED:
Intrinsic value = Dividend / (Cost of Equity - Growth)
$36.9B = $1.106B / (0.072-0.042)
This assumes that the dividend is safe, and grows at a long-term stable rate. We add the $540M in cash and get an intrinsic value of $37.4B or $108 per share. This is 18% above today's price, and with an expected return of 7.25% per year (equivalent to our cost of equity), it means that ED has an alpha (risk-return asymmetry) of 11%.
Most of the calculations are outlined here, but you can view the supplementary information in my model.
FCFE Model Indicates A Slightly Lower Intrinsic Value
Alternatively, we can value the potential dividend, i.e. the levered free cash flows. As the FY 2024 target net income is $3B, I will use it as our starting point, and assume that ED is able to convert 60% of net income to FCFE. This gives us $1.8B of future FCFE. Revisit the image above to get a better sense of why I'm assuming that not all net income converts to cash flows.
Next, we will use our cost of equity of 7.2%, but since FCFE is much harder to grow, I will assume only a 2% long-term growth rate.
With that, our FCFE value comes out to: $1.8B / (0.072-0.02) = $34.6B
We add back cash and get an intrinsic value of $35B or $101 per share. Should you change the growth rate to be between 1.3% to 1.8%, you will find that ED trades around intrinsic value.
In both of the outlined cases, it seems that the stock trades slightly above intrinsic value and has a positive alpha above the expected return.
Somewhat Better Among Peers
Finally, we are going to evaluate ED, versus peers in the electric utility industry. For our fundamental comparison with Consolidated Edison, I used NextEra Energy ( NEE ), Dominion Energy ( D ), Duke Energy ( DUK ), and Public Service Enterprise Group Incorporated ( PEG ).
The chart shows how much they have grown the revenue and margins on the vertical axis, and their EV to EBIT pricing on the horizontal, while the size of the circles represents their debt to capital - as an aspect of risk.
Consolidated Edison's Fundamental Peer Comparison (Author, data from FMP)
We can see that NextEra had the highest performance in the last 12 months, while ED is in a stable middle relative to peers. We can also note that ED has a relatively lower debt to capital burden compared to D and DUK which shields the company from increases in fixed costs.
Finally, we have PEG on the top left, which indicates both high performance and low pricing. The stock markedly deviates from peers, and maybe a good lead to investigate further.
Risks To My Thesis
An odd phenomenon of Chinese-sponsored grid hacks and disruptions ( 1 , 2 , 3 ) is happening across the US. Should this turn out to be a viable vector for attack, the US and individual companies affected will have to rethink investing in grid security. Additionally, the damage from such attacks may be unpredictable but likely short term.
While the company's debt has stabilized around $24B, an increase in debt levels may mean more expensive refinancing and an increase in fixed costs. On the other hand, divestments and restructuring could be used to stabilize the capital structure.
Regulation is on the rise in the industry, and the company is facing increasing requirements that can put pressure on its operational efficacy.
Conclusion
Consolidated Edison stands out from peers as having more manageable debt levels, while taking steps to consolidate the business and focus on core competencies. It would be ideal to see dividends being covered by performance, and while the company is not there yet, it seems to be taking steps to improve performance.
Using both a dividend discount model and a levered cash flows valuation model, we can see that ED is fundamentally undervalued, with a possible 11% upside above the expected return.
Should the company continue to grow while streamlining its core business, it can prove to be a stable stock for investors.
For further details see:
Consolidated Edison: Undervalued And Stabilizing The Business