Summary
- MGE Energy's business is mostly as a regulated utility, with the majority of regulated operations being electricity supply along with some gas supply operations.
- For the five years from 2016 to 2021 MGE Energy grew electric utility customer numbers by an average 1.3% per year.
- For the five years from 2016 to 2021, MGE Energy grew electric utility net income by an average 9.5% per year.
- A regulated utility growing net income at ~7 times the rate of growth in customer numbers would appear prima facie unsustainable in the longer term.
- After considerable research and analysis, I identified possible contributing factors to MGE Energy growing net income at a faster rate than growth in customer numbers. Please read on.
Investment Thesis
MGE Energy ( MGEE ) has grown net income at a significantly faster rate than growth in customer numbers over the last five years. Given that regulated utilities pricing to customers is strictly regulated, allowing only recovery of costs plus a reasonable return, it is not immediately apparent how this could happen. There have been increases in electricity average revenues per kWh. But these are only averaging at 1.0% per year for commercial and industrial retail customers and 0.5% for residential customers. The dichotomy in growth rates between net income and customer numbers has occurred over at least the last five years. My investigations reveal some possible reasons for the higher net income growth.
Customer mix - Non-residential retail customers pay on average far lower tariffs than residential retail customers, so presumably net income margin is lower for non-residential. While I do not have a precise analysis available between customer numbers for non-residential and residential, I am able to determine revenues for each. Over the last 5-6 years non-residential retail revenues have declined by (0.6)% while residential revenues have grown by 2.1%. This increasingly favorable sales mix would have contributed to the rate of net income growth.
Increased Renewables - MGEE has been investing heavily in solar and wind renewable energy. In 2016 electric energy delivery requirements were met in part by 10.8% from renewable sources, of which 8.0 percentage points was purchased. In 2016 the Wisconsin Energy Efficiency and Renewables Act requires that 10% of the state's electricity be generated from renewable sources. The costs to comply with the Act and its accompanying regulations are recoverable in rates. In 2015, MGE announced its Energy 2030 framework that continues steps to reduce CO 2 emissions. Subject to regulatory approvals and other conditions, MGE aimed to increase renewable energy to 25% of retail electric sales by 2025 and to 30% by 2030 (see 2016 SEC 10-K ). In 2021, 16.6% of MGEE electricity was generated from renewable sources, but the proportion of purchased renewables was not disclosed. It might be that renewables, with the major cost component capital costs, and low ongoing operation and maintenance costs and no fossil fuel purchases, might allow greater margins to be achieved by MGEE, in compliance with regulations, without inflating tariffs.
Return on equity - Excerpted from the company's 2021 10-K filing , "The return on common stock equity for 2022 and 2023 is 9.8% based on a capital structure consisting of 55.6% common equity." This same return rate has applied since 2017, with 10.2% applying in 2016. MGEE has been spending capital on coal to gas conversions as well as on renewables. It might be this is generating additional return on equity for MGEE without increasing tariffs due to offsets from lower ongoing operating costs for renewables and more efficient operation of gas fired generation versus coal.
Summary and conclusions -
MGEE has a current dividend yield a little over 2% and 46 years of uninterrupted dividend growth. A continuation of that performance far into the future appears highly likely. Based on the range of analysts' EPS estimates for 2023, and assuming the P/E ratio remains at the current level of 24.47, double digit returns are indicated for buying now and holding to end of 2023. There is a downside risk of multiples shrinking. A decrease in the multiple to around 20.0 would likely result in low to negative returns in the short term through end of 2023. This would not affect the continued payment of dividends, and ongoing earnings growth would likely result in positive returns for a longer term hold beyond 2023. MGEE remains a hold for existing shareholders. Prospective investors in the stock, might like to hold off for a possible dip in the share price, while monitoring the relationship between growth in customer numbers and net income.
Looking for share market mispricing of stocks
What I'm primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the "E" in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.
Table 1 - Detailed Financial History And Projections
SA Premium
Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2024 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note - while estimates are shown for analysts' EPS estimates out to 2023, 2024 and 2025 where available, estimates do tend to become less reliable, the further out the estimates go. These estimates are generally only considered sufficiently reliable if there are at least three analysts' contributing estimates for the year in question). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7.5% per year through the end of 2023 (see line 12), based on buying at the Feb. 21, 2023, closing share price level. As noted above, estimates become less reliable in the later years. In the case of MGE Energy, I have decided to input a target return based on 2023 year, which has EPS estimates from only two analysts, due to lack of additional analyst coverage. The table shows to achieve the 7.5% return, the required average yearly share price growth rate from Feb. 21, 2023, through Dec. 31, 2023, is 5.09% (line 50). Dividends, including estimated dividend increases, account for the balance of the target 7.5% total return.
MGE Energy's Projected Returns Based On Selected Historical P/E Ratios Through End Of 2023
Table 2 below provides scenarios projecting potential returns based on select historical P/E ratios and analysts' consensus, low, and high EPS estimates per Seeking Alpha Premium through the end of 2023.
Table 2 - Summary of relevant projections MGE Energy
SA Premium
Table 2 provides comparative data for buying at closing share price on Feb. 21, 2023, and holding through the end of 2023. There's a total of nine valuation scenarios for the year, comprised of three EPS estimates (SA Premium analysts' consensus, low, and high) across three different P/E ratio estimates, based on historical data. MGE Energy's P/E ratio is presently 24.47. For many companies, their current P/E ratios are distorted by the impact of COVID-19. For MGE Energy, the present P/E ratio is within the range of historical P/E ratios. Table 3 shows potential returns from an investment in shares of the company at a range of historical level P/E ratios. This analysis, from hereon, assumes an investor buying MGE Energy shares today would be prepared to hold through end of 2023, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2023 column follow.
Consensus, low, and high EPS estimates
All EPS estimates are based on analysts' consensus, low, and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely to high based on analysts' assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as MGE Energy. I believe the "low" estimates should be considered important. It's prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.
Alternative P/E ratios utilized in scenarios
- The actual P/E ratios at share buy date based on actual non-GAAP EPS for FYE 2021.
- A modified average P/E ratio based on 26 quarter-end P/E ratios from Q4 2016 to Q4 2022 plus current P/E ratio in Q1 2023. The average of these P/E ratios has been modified to exclude the five highest and five lowest P/E ratios to remove outliers that might otherwise distort the result.
- A median P/E ratio calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded. In the case of MGEE, I have chosen to use an assumed P/E ratio of 24.47, based on the current multiple, in place of MGEE's historical median of 26.40. I have done this to provide an idea of the impact on returns if the multiple remained at the current level through the end of 2023.
- The actual P/E ratio at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before the distortion of P/E ratios by the impact of the coronavirus pandemic. In the case of MGE Energy, the P/E ratio at Feb. 21, 2020, appears anomalous at 32.33. I have found it preferable to include an assumption of a P/E ratio of 20.00 which is around the low end of its historical P/E ratios. This might be considered a worst case scenario as far as P/E ratios are concerned.
Projected returns (lines 18 to 39)
Lines 25, 32 and 39 show if MGE Energy's P/E multiple were to contract from the present level of 24.47 to around 20.00, and consensus EPS estimates were achieved, a negative return of ~(3.7)% could be expected through end of 2023. The analysts low EPS estimates coupled with the 20.00 P/E ratio would produce a possibly worst case indicative return of -9.4%. Only at the analysts' high EPS estimates would a positive return of 1.7% be achievable. On the other hand, if the multiple remained around the current level of 24.47, returns of 10.5% to 24.1% are indicated, with consensus 17.5%. Higher returns again are indicated should the P/E multiple revert to its historical average of 26.08.
Checking MGE Energy's "Equity Bucket"
Table 3.1 MGE Energy Balance Sheet - Summary Format
SA Premium and SEC filings
Table 3.1 shows MGE Energy has increased net assets used in operations by $705 million over the last 5.75 years. The increase was funded by $351 million in equity and $269 million in net debt. Net debt as a percentage of net debt plus equity increased from 28.7% to 37.5%, over the 5.75-year period. Outstanding shares increased by 1.5 million from 34.7 million to 36.2 million, over the period. The $351 million increase in shareholders' equity over the last 5.75 years is analyzed in Table 3.2 below.
Table 3.2 MGE Energy Balance Sheet - Equity Section
SA Premium and SEC filings
I often find companies report earnings that should flow into and increase shareholders' equity. But often the increase in shareholders' equity does not materialize. Also, there can be distributions out of equity that do not benefit shareholders. Hence, the term "leaky equity bucket." I can assure readers there are no leaks in MGE Energy's equity bucket. There are no stock compensation share issuances for staff, and there are no share repurchases. That is not to say there is necessarily anything wrong with stock compensation and buybacks, just that they provide an avenue for abuse at times. In the case of MGE Energy, the only distributions are in the form of dividends to shareholders.
Explanatory comments on Table 3.2 for the period from end FY-2016 to end Q1-2022.
- Reported net income (non-GAAP) over the 5.75-year period totals $557 million, equivalent to diluted net income per share of $15.76.
- MGE Energy reports purely on the basis of GAAP results, with none of the non-GAAP adjustments seen with other companies, which almost invariably increase headline reported profits.
- Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund - these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact the value of shareholders' equity at any point in time. For MGE Energy, these items totaled to nil over the 5.75 years.
- There were no share issues to employees, and there were no share repurchases. There are bonuses for staff based on equity but these are not material and are settled in cash.
- For most companies, by the time we take the above-mentioned items into account, we find the headline reported non-GAAP net income has considerably reduced, providing less funds from operations available for distribution to shareholders. For MGE Energy we find the reported net income of $557 million for the 5.75-year period is all available for distribution to shareholders.
- Dividends of $287 million were adequately covered by the $557 million generated from operations, leaving $270 million increase in equity. This $270 million from operations, plus $81 million from shares issued to raise additional capital, resulted in the increase of $351 million in shareholders' funds per Table 3.1 above.
Summary and Conclusions
MGE Energy stock is a "sleep well at night" investment. It can be seen from the analysis above, while there is downside risk for returns, upside is potentially quite good. The dividend for this dividend king is very well covered by earnings. There is no reason to think the 46 years of unbroken dividend growth will not continue into the foreseeable future. I am generally in agreement with SA Quant ratings but note MGEE is currently rated as a Sell, per Figure 1 below.
Figure 1
SA Premium
I believe most investors in MGEE are likely to be dividend growth investors seeking reliable, growing dividends in the long-term, rather than seeking shorter term trading gains. As discussed in my recent article, "Allete: The Qualitative And The Quantitative", decisions to Buy, Hold or Sell can be influenced by the investment objectives of each individual investor.
I rate MGE Energy a hold for existing investors and a potential buy on any further dip in the share price, for investors seeking security of investment and dividends, and prepared to accept modest returns or even share price falls in the short term, with potential for upside in the longer term.
For further details see:
MGE Energy: Average Yearly Growth - Customers +1.3%, Net Income +9.5%