2023-05-17 13:31:01 ET
Summary
- Ten years of downward pressure on gas and coal prices was interrupted in early 2022 with Russia's invasion of Ukraine.
- Low gas and coal prices allowed MGEE to invest heavily in regulated assets on which it earns a regulated return, while at the same time keeping rates to customers low.
- Despite gas and coal prices falling in 2023, MGEE tariffs for gas and electricity in Q1 2023 are still above Q1 2022.
- If rate increases through new capital investment are no longer able to be absorbed by lower gas and coal prices, regulators may take a tougher stance towards such investments.
- Any curtailment of MGEE's regulated asset investment program will directly curtail MGEE's earnings growth.
Investment Thesis:
In an article dated Feb. 22, 2023, " MGE Energy: Average Yearly Growth - Customers +1.3%, Net Income +9.5 %," I expressed concern at the disparity between the growth in number of MGE Energy, Inc. ( MGEE ) customers and net income growth. Interestingly, in a 8-K filed May 2023, MGEE included a graph showing affordability of electricity billed to customers over the 10-year period - 2011 to 2021.
Figure 1 - MGEE Graph
I checked US Census statistics and found Wisconsin Median household income for 2021 was $67,080 and for 2011 $52,058. That's an average yearly increase of 2.6% over the 10 years. I then compiled Table A below, to determine the rate of increase in MGEE regulated revenues over the same period.
Table A
Table A shows MGEE regulated revenues grew at a slightly lower rate than growth in customer numbers over the 10 years 2011 to 2021. This suggests prices for electricity and gas remained fairly constant or declined slightly over the 10 years, which supports the Fig. 1 graph showing electricity affordability improvement as median incomes rose by 2.6% per year. Despite prices to customers remaining flat, or declining, Table A shows MGEE net income grew by an average 5.7% per year over the 10 years 2011 to 2021. In my previous article I surmised growth in capital investment was driving earnings growth. Table B below supports that assumption.
Table B
Excerpted from MGEE's FY 2022 10-K,
Rate regulation is based on providing an opportunity to recover costs that have been reasonably incurred and the ability to earn a reasonable rate of return on invested capital. However, we have no assurance that our regulators will consider all of our costs to have been reasonably incurred. In addition, our rate proceedings may not always result in rates that fully recover our costs or provide a reasonable return on equity.
For regulated utilities, for the most part, whether operating and maintenance costs go up or down, they're recoverable and there's no profit to be made. Over the 10-year period 2011 to 2021, input costs for energy were kept down, as per this excerpt from an IEA publication:
The shale revolution in the United States unleashed a formidable competitor to coal - natural gas. Low gas prices have squeezed US coal demand more than any other factor. In 2009, coal's share in the US power mix was 45%, with gas at 23%. By 2019, coal's share had fallen to 24%, while gas now accounted for 38% of power generation. LNG exports have spread the effects of the shale revolution beyond the United States, driving down international gas prices. The combination of lower gas prices and carbon pricing in Europe resulted in a similar decline for coal there.
The source of regulated utilities earnings is regulated returns on invested capital. It follows the main driver of earnings growth is growth in invested capital. Table B shows MGEE grew regulated assets at an average rate of 6.7% per year for the 10 years 2011 to 2021. Over the same period MGEE grew regulated energy net income by 8.1% per year, and total net income by a lower 5.7% per year, due impact of nonregulated operations. It appears they were able to achieve this without increasing average customer billings due to lower coal and oil prices.
Outlook post 2021 -
The Russian war on Ukraine reversed the position over the last 10 years, almost overnight. Between 2011 and 2021 MGEE invested heavily in regulated assets and showed strong earnings growth. Despite this regulated revenue grew by only 1.1% per year, less than the 1.5% growth rate for regulated energy customer numbers. In 2022 regulated energy customer numbers grew by 1.8% for the year, but revenue grew by 17.8%. MGEE are projecting continuing capital investment per Fig. 2 slide below from May 2023 8-K filing.
Figure 2
Figure 2 shows MGEE investments of $1.015 billion over the last five years and projections for investment of $1.076 billion over the next five years. If the projections were achieved that should continue to drive net income growth at similar rates to the last five years. However, as noted further above, there's no assurance regulators will approve rate increases to the extent expected by the company. Bear in mind, over the past 10 years it appears MGEE regulated energy revenue has lagged customer number growth, indicating a decrease in rates charged to customers. In such an environment there would be less pressure on regulators to bear down on rates of return on equity and increased investment in assets. In a future environment where rates are higher, the attitude of regulators to new investment that would further increase rates is likely to be far less accommodating. Despite lower gas and coal prices in 2023, MGEE electricity rates charged to customers continued to increase per Table C below.
Table C
It might be that hedging is contributing to continuing high rates despite falls in gas and coal prices, and we will eventually see rates to customers decline. This is something to monitor because I see continuing high rates causing concern to regulators who might look to limiting new asset investment to limit rate increases. If MGEE earnings growth becomes limited in this way, the current relatively high P/E multiple is likely to also come under pressure. For these reasons, despite the prospect for solid returns if past performance is repeated, I cannot currently rate MGEE better than a hold for DGI investors. A more detailed financial analysis follows below.
A More Detailed Financial Analysis
Just because the operations of a listed business perform well does not mean buying shares in that business at any given point in time will result in that investment performing well. My main aim in this more detailed financial analysis is to analyze financial data with regard to...
Total Return, Dividends, and Share Price
The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.
Changes in Share Price
From a purely mathematical/statistical point of view, changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock specific.
"Equity Bucket"
Earnings are tipped into the "Equity Bucket" for the benefit of shareholders. It's prudent to check whether distributions out of and other reductions in the "Equity Bucket" balance are benefiting shareholders.
Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing financial data with the foregoing in mind.
Table 1 - Detailed Financial History And Projections
Table 1 analyses historical data from 2016 to 2022, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. For the six years 2016 to 2022, MGEE has grown EPS at an average yearly rate of 5.87%. Average yearly share price growth of 1.26% is lower than the EPS growth rate of 5.87% due to P/E multiple contraction from 29.95 at end of 2016 to 22.93 at end of 2022.
The table also includes estimates out to 2025 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 through 2026 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 2024 (see line 12), based on buying at the May 12, 2023, closing share price level. As noted above, estimates become less reliable in the later years. In the case of MGEE, I have decided to input a target return based on 2024 year, which has EPS estimates from two analysts. I have not based on 2025, as there's only one analyst providing EPS estimate for that year. The table shows that to achieve the 7.5% return, the required average yearly share price growth rate from May 12, 2023, through December 31, 2024, is 5.56% (line 51). Dividends, including estimated dividend increases, account for the balance of the target 7.5% total return.
MGEE's Projected Returns Based On Selected Historical P/E Ratios Through End Of 2024
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 2024.
Table 2 - Summary of relevant projections MGEE
Table 2 provides comparative data for buying at the closing share price on May 12, 2023, and holding through the end of 2024. There's a total of 12 valuation scenarios for the year, comprised of three EPS estimates. SA Premium analysts' consensus, low, and high. MGEE's P/E ratio is presently 26.13, based on TTM Q1 2023 non-GAAP EPS. For MGEE, the present P/E ratio is almost the same as the modified average of historical P/E ratios over the last six years of 26.07. Table 2 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 MGEE shares today would be prepared to hold through end of 2024, if necessary, to achieve their return objectives. Comments on contents of Table 2, for the period to 2024 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 MGEE. 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 current P/E ratio . This scenario provides a range of potential returns if the P/E ratio remained at the current level through end of 2024.
- A modified average P/E ratio based on 26 quarter-end P/E ratios from Q4 2016 to Q1 2023 plus the current P/E ratio in Q2 2023. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result. The present P/E ratio is close to the average so in this instance, this scenario shows indicative returns similar to if the multiple stayed around current levels through the end of 2024.
- A modified historical low P/E ratio calculated using the same data set used for calculating the modified average P/E ratio, with the three highest and lowest P/E ratios excluded.
- A selected P/E ratio to provide an alternative P/E scenario to take into account other factors that might be relevant to assessing potential returns. For example, if analysts' forward estimates reflected EPS growth rates significantly higher or lower than historical EPS growth rates. In such cases the forward P/E ratio might be expected to trend higher or lower than the historical average. In the case of MGEE, I have selected a P/E ratio of 19.80. Use of the 19.80 P/E ratio is designed as a form of stress test, to provide an idea of the effect on MGEE returns of the P/E ratio falling to a level more in line with its Electric Utilities peers. Fig. 3 below from SA Premium statistical data shows MGEE multiples in comparison to Sector Median,
Figure 3
Reliability of EPS estimates (line 18)
Line 18 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are only two analysts covering MGEE through the end of 2024. In my experience, a range of 5.3 percentage points difference in EPS growth estimates between two analysts is not getting on the high side, suggesting a degree of uncertainty, and thus lesser reliability.
Projected returns per Table 2 above (lines 20 to 45)
Lines 25, 35 and 45 show if MGEE's P/E multiple were to fall to the selected low P/E ratio of 19.80, returns of negative (5.4)% to negative (0.1)% could be expected through end of 2024, based on the range of analysts' EPS estimates. The negative (5.4)% is based on analysts' low estimates and the negative (0.1)% on their high estimates, with consensus negative (2.6)%. At the historical average of 26.07, similar to the current level of 26.13, returns of 10.3% to 16.5% are indicated, with consensus 13.6%. If the P/E ratio should decrease to the level of the historical low P/E ratio of 22.38, returns of 1.3% to 7.0% are indicated, with consensus 4.3%.
Checking MGE Energy's "Equity Bucket"
Table 3.1 MGE Energy Balance Sheet - Summary Format
Table 3.1 shows MGE Energy has increased net assets used in operations by $789 million over the last 6.25 years. The increase was funded by $374 million in equity and $415 million in net debt. Net debt as a percentage of net debt plus equity increased from 28.7% to 39.1%, over the 6.25-year period. Outstanding shares increased by 1.5 million from 34.7 million to 36.2 million, over the period. The $374 million increase in shareholders' equity over the last 6.25 years is analyzed in Table 3.2 below.
Table 3.2 MGE Energy Balance Sheet - Equity Section
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 Q1-2023.
- Reported net income (non-GAAP) over the 6.25-year period totals $609 million, equivalent to diluted net income per share of $17.20.
- 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 6.25 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 $609 million for the 6.25-year period is all available for distribution to shareholders.
- Dividends of $316 million were adequately covered by the $609 million generated from operations, leaving $293 million increase in equity. This $293 million from operations, plus $81 million from shares issued to raise additional capital, resulted in the increase of $374 million in shareholders' funds per Table 3.1 above.
Summary and Conclusions
It can be seen from the analysis above, while there's downside risk for returns, upside is potentially quite good. The dividend for this dividend king is very well covered by earnings. There's 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 and note MGEE Quant rating has moved from Sell at the time of my previous article to Hold, per Figure 4 below.
Figure 4
SA Premium
Decisions to Buy, Hold or Sell can be influenced by the investment objectives of each individual investor. I believe most investors in MGEE are likely to be dividend growth investors seeking reliable, growing dividends in the long term, rather than focusing on share price gains.
I believe MGEE is fully priced at present and the impact of inflation places a cloud over MGEE's ability to grow future earnings at the same rate as in the past ten years.
I continue to rate MGE Energy a hold for existing investors, subject to monitoring regulatory attitude to MGEE's additional investment in regulated investments flowing through to higher rates charged to customers.
For further details see:
MGE Energy: Inflation Might Bring A Tougher Regulatory Environment