Continuing on the trend of my past several articles, it remains critically important for dividend growth investors to emphasize in their investing approach investing in high-quality stocks that sell vital goods and/or services to their customers.

A prime example of a stock that fits the above mold is that of the utility company WEC Energy Group (WEC).

Today, I’ll be revisiting WEC Energy Group’s dividend safety and growth profile for the first time since I initiated coverage in the stock in June 2019. I will also be covering WEC Energy Group’s operating fundamentals and discussing its risk profile, as well as examining WEC Energy Group’s stock price relative to my estimated fair value of the stock using a couple valuation metrics and a valuation model.

My coverage of the above factors has once again led me to reiterate my neutral rating on shares of WEC Energy Group at this time, although I believe with the upcoming dividend increase in January, WEC Energy Group is a minor correction away from a buy rating.

WEC Energy Group’s Dividend Remains Safe With Mid-Single Digit Annual Growth Potential

Even though WEC Energy Group’s 2.63% yield is within a reasonable range of the S&P 500’s current 1.65% yield and this itself suggests the dividend is in no immediate danger of being cut, I will be using WEC Energy Group’s updated forecast for diluted EPS this fiscal year and measuring that against the dividends slated to be paid out this year to assess the safety and growth potential of WEC Energy Group’s dividend going forward.

While I usually provide an examination of a stock’s FCF payout ratios, I am opting to not do so in the case of WEC Energy Group for the same reason that I didn’t include an FCF payout ratio analysis for American Electric Power (NASDAQ:AEP) last week, which is due to the fact that utilities are constantly investing capital to expand their rate base (and accompanying revenue and earnings potential).

As long as a utility is able to obtain allowed rates of return that are greater than their weighted cost of capital through share issuances and debt issuances, shareholder wealth will be created and the utility’s FCF payout ratio will be rendered meaningless.

Image Source: WEC Energy Group November 2020 Investor Update Presentation

With that aside, weighing the midpoint of WEC Energy Group’s diluted EPS forecast of $3.74-$3.76 for this fiscal year against the dividends/share of $2.53 that have been or are scheduled to be paid this year, WEC Energy Group’s diluted EPS payout ratio of 67.5% falls precisely within the middle of its 65-70% target payout ratio.

Given that WEC Energy Group’s diluted EPS payout ratio is right around the sweet spot for a utility in my opinion, shares of WEC Energy Group are positioned to deliver annual dividend growth in line with whatever long-term earnings growth the company is able to generate.

Since Yahoo Finance is forecasting that WEC Energy Group will produce 6.2% annual earnings growth over the next 5 years, I believe that an annual dividend growth rate of 6.75% over the long-term is a reasonable expectation for shares of WEC Energy Group moving forward.

WEC Energy Group Is Delivering In A Tough Operating Environment

Image Source: Page 4 of WEC Energy Group’s Q3 2020 Earnings Press Release

What makes WEC Energy Group’s operating results through the first 9 months of this year so amazing, is that even in a “normal” year, WEC Energy Group’s operating results would be considered to be quite solid.

As this community is aware, this has been far from a normal year, specifically as it pertains to the COVID-19 pandemic and its accompanying interruptions to business operations and everyday life around the world.

Despite these interruptions to business operations and everyday life, WEC Energy Group’s resilient business model as a utility ensured that the company’s revenue increased 2.7% YoY from $1.608 billion in Q3 2019 to $1.651 billion in Q3 2020 (according to the above image).

As a result of WEC Energy Group’s strong revenue growth, and a slight reduction in operating expenses (from $1.297 billion in Q3 2019 to $1.281 billion in Q3 2020 as illustrated above), WEC Energy Group posted an astonishing 13.5% YoY increase in its diluted EPS from $0.74 in Q3 2019 to $0.84 in Q3 2020 as indicated by Executive Chairman Gale Klappa’s opening remarks during WEC Energy Group’s Q3 2020 earnings call.

WEC Energy Group’s strong results in the third quarter due to the above developments and increased service area economic activity/warmer summer temperatures helped the company’s revenue through the 9 months ended this fiscal year only decline 4.8% YoY from $5.576 billion to $5.308 billion (as shown by the above image).

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Moreover, WEC Energy Group’s diluted EPS surged 8.2% YoY from $2.81 through the 9 months ended 2019 to $3.04 through the 9 months ended this fiscal year.

Image Source: WEC Energy Group November 2020 Investor Update Presentation

Moving to WEC Energy Group’s capital plan for the next 5 years, the future has never been brighter for the company.

As Executive Chairman Gale Klappa noted in WEC Energy Group’s Q3 2020 earnings call, WEC Energy Group’s $16.1 billion in planned investments over the next 5 years represents a $1.1 billion or 7.3% increase over the previous 5 year plan, which is the largest 5 year capital plan in the company’s history.

Overall, WEC Energy Group anticipates that about 64% or $10.4 billion of its total projected capital spending will be allocated to renewable energy (~40% of Sustainability category spending or $4.1 billion) and grid and fleet upgrades to improve reliability (the remaining ~60% of Sustainability category spending or $6.3 billion).

Moving to Growth spending, which accounts for 19% or $3.0 billion of WEC Energy Group’s total projected capital spending, WEC Energy Group anticipates that the majority of that, or $1.6 billion will be allocated to gas distribution projects while the remaining $1.4 billion will be spent on Electric projects.

The remaining 17% or $2.7 billion of capital spending will be allocated to technology ($1.0 billion) and grid and fleet modernization ($1.7 billion).

As a result of WEC Energy Group’s strong commitment to growing its rate base at a 7% CAGR through 2025 (as indicated on slide 11 of WEC Energy Group’s November 2020 Investor Update Presentation), WEC Energy Group anticipates that it will be able to deliver 5-7% annual EPS growth over the next 5 years with minimal impact to customer rates (per slide 22 of WEC Energy Group’s November 2020 Investor Update Presentation).

Image Source: WEC Energy Group November 2020 Investor Update Presentation

Closing out my discussion of WEC Energy Group from a fundamentals standpoint, is WEC Energy Group’s balance sheet.

As illustrated by the slide above, WEC Energy Group boasts a stronger funds from operations to debt ratio at a forecasted range of 16-18% going forward than AEP, which was 12.8% over the past 12 months according to methodology from Moody’s.

Moving to WEC Energy Group’s interest coverage ratio, the company maintained a very respectable interest coverage ratio of just over 3 (as per data sourced from page 4 of WEC Energy Group’s Q3 2020 earnings press release), which was stronger than AEP’s at ~2.

As a result of WEC Energy Group’s balance sheet metrics, WEC Energy Group enjoys a firmly investment grade balance sheet and the lower overall cost of capital that comes along with it (which is very important given that WEC Energy Group expects that it will entirely rely on retained earnings/debt issuance rather than equity issuance over the next 5 years according to slide 22 of WEC Energy Group’s November 2020 Investor Update Presentation).

When I take into consideration WEC Energy Group’s solid YTD operating results, WEC Energy Group’s significant capital plans over the next 5 years, and WEC Energy Group’s strong balance sheet, I believe that the company is capable of delivering great long-term total returns if shares are acquired at or below fair value.

Risks To Consider

While WEC Energy Group is a high-quality business, it is of utmost importance that prospective and current shareholders occasionally monitor the company’s risk profile to ensure that the investment thesis remains intact. It is for this reason that I will be discussing a few key risks facing WEC Energy Group using the company’s previous 10-K and most recent 10-Q.

The first set of risks to WEC Energy Group are a result of the COVID-19 pandemic, which include current and/or future restrictive orders aimed at curbing the spread of COVID-19 leading to reduced future energy demand, the inability of customers to pay for service, and potential supply chain interruptions, similar to the risks discussed in last week’s article on AEP (pages 75-76 of WEC Energy Group’s most recent 10-Q).

While COVID-19 shelter-in-place orders in WEC Energy Group’s service areas have largely expired, there are various other orders that were since enacted and interfere with economic activity, which could continue to weigh on demand for energy, especially among WEC Energy Group’s commercial customers.

It is also worth noting that any additional COVID-19 restrictions that are enacted in the future would further exacerbate WEC Energy Group’s near-term risk profile due to the increased likelihood of reduced near-term energy demand and the inability of customers to pay for their service.

Rounding out my discussion of COVID-19 related risks, additional restrictions could also limit WEC Energy Group’s ability to secure the raw materials that are necessary to power its plants, which could potentially impact WEC Energy Group’s ability to meet the demand for utility services that it provides to its customers.

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It goes without saying that any developments that lead to the above risks manifesting themselves would adversely harm WEC Energy Group’s operating and financial results in at least the near-term.

The first key risk to WEC Energy Group is from an operational standpoint, which is the possibility of key capital projects encountering cost overruns or in-service delays (pages 25-26 of WEC Energy Group’s previous 10-K).

Given that the construction of electric generating facilities and so forth requires a significant amount of capital, raw materials and labor, and involves a great degree of other complex factors like the legal aspect of such a massive undertaking, there is no guarantee that WEC Energy Group won’t encounter snags along the way with the construction of its projects, whether legal, operational, or otherwise.

Should WEC Energy Group encounter setbacks on major capital projects, this could result in a significant impact on the company’s future operating and financial results at any time.

Like AEP, WEC Energy Group is dependent on capital markets to fund the bulk of its capital projects due to the fact that the majority of its earnings are paid out to shareholders in the form of dividends (pages 28-29 of WEC Energy Group’s previous 10-K).

One distinct advantage over many of its utility peers is that WEC Energy Group indicated on page 22 of its November 2020 Investor Update Presentation that it doesn’t expect it will need to issue additional equity through its 2021-2025 forecast period to fund its $16.1 billion in capital projects.

While WEC Energy Group’s stock price would likely lead to accretive share issuances, the benefit to WEC Energy Group’s current position is that by not needing to rely on equity issuances for capital project funding, the company isn’t subject to the whims of the market where its stock price may be up 30% one year and down 30% the next.

The caveat to WEC Energy Group’s positioning, however, is that the company will still heavily rely on debt issuances to fund the lion’s share of its capital projects over the next 5 years.

If the company isn’t able to continue to access debt at reasonable terms in the years ahead, a monkey wrench could be thrown into its growth plans unless there are other viable alternatives to fund capital projects at that time.

Even though I have discussed several key risks associated with an investment in WEC Energy Group, the above shouldn’t be interpreted as a complete discussion of WEC Energy Group’s risk profile. For a more comprehensive discussion of WEC Energy Group’s risks, I would refer interested readers to pages 21-31 of WEC Energy’s previous 10-K, pages 75-76 of WEC Energy Group’s most recent 10-Q, and my prior article on the stock.

WEC Energy Group Is A Wonderful, But Overpriced Business

Although WEC Energy Group has proven itself to be an above-average quality company over the duration of its corporate history, it is important for prospective or current shareholders to avoid overpaying for shares of the stock to minimize the risks of a lower starting yield, valuation multiple contraction, and lower annual total return potential.

In order to establish a fair value for shares of WEC Energy Group, I will be using a couple valuation metrics and a valuation model.

The first valuation metric that I’ll be utilizing to arrive at a fair value for WEC Energy Group’s shares is the TTM dividend yield to 13 year median TTM dividend yield.

According to Gurufocus, WEC Energy Group’s TTM dividend yield of 2.63% is well below its 13 year median TTM yield of 3.01%.

Factoring in a reversion to its 13 year median TTM yield of 3.01% and a fair value of $84.05 a share (which I believe fairly takes into account WEC Energy Group’s risks), shares of WEC Energy Group are trading at a 14.3% premium to fair value and pose 12.5% downside from the current price of $96.10 a share (as of November 22, 2020).

The next valuation metric that I will use to approximate the fair value of WEC Energy Group’s shares is the current Shiller PE ratio to 13 year median Shiller PE ratio, which accounts for the cyclical nature of a stock’s earnings unlike the PE ratio.

As indicated by Gurufocus, WEC Energy Group’s current Shiller PE ratio of 30.61 is well above its 13 year median Shiller PE ratio of 24.06.

Assuming a reversion in WEC Energy Group’s Shiller PE ratio to just above its 13 year median Shiller PE ratio at 26.00 and a fair value of $81.64 a share, WEC Energy Group’s shares are priced at a 17.7% premium to fair value and pose 15.0% capital depreciation from the current share price.

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Image Source: Investopedia

The valuation model that I’ll be utilizing to assign a fair value to shares of WEC Energy Group is the dividend discount model or DDM, which is comprised of three inputs.

The first input into the DDM is the expected dividend/share, which is simply the annualized dividend/share. In the case of WEC Energy Group, that amount is currently $2.53 (although the dividend is likely going to be raised 6-7% in January).

The second input into the DDM is the cost of capital equity, which is the annual total return rate that an investor requires on their investments. While the required annual total return rate varies from one investor to the next, I require a 10% annual total return rate on my investments because I believe that such returns offer ample reward for the time and effort that I allocate to researching investment opportunities and occasionally monitoring my investments.

The third input into the DDM is the annual dividend growth rate over the long-term or DGR.

Unlike the first two inputs into the DDM that require no more than data retrieval to find the annualized dividend/share and subjectivity to set an annual total return requirement, accurately forecasting the annual dividend growth rate over the long-term requires an investor to consider a variety of variables, including a stock’s payout ratios (and whether those payout ratios are positioned to expand, contract, or remain the same over the long-term), annual earnings growth potential, the strength of a stock’s balance sheet, and industry fundamentals.

When I take into consideration that WEC Energy Group’s diluted EPS payout ratio is in a position to remain the same or slightly expand over the long-term and that WEC Energy Group has historically delivered 6-7% annual earnings growth, I believe that a dividend growth rate at the upper end of that range is appropriate. Ergo, I decided upon a 6.75% annual dividend growth rate over the long-term.

Upon plugging the above inputs into the DDM, I am left with a fair value of $77.85 a share, which implies that WEC Energy Group’s shares are trading at a 23.4% premium to fair value and pose 19.0% downside from the current share price.

When averaging the three fair values together, I compute an average fair value of $81.18 a share, which indicates that shares of WEC Energy Group are priced at an 18.4% premium to fair value and pose 15.5% capital depreciation from the current share price.

Summary: WEC Energy Group Is A Correction And Dividend Increase Away From A Buy Rating

WEC Energy Group has delivered 17 consecutive annual dividend increases and is positioned to deliver its 18th consecutive dividend increase in January, which is certainly an impressive feat that demonstrates the quality of WEC Energy Group as a business.

Given that WEC Group’s diluted EPS payout ratio for this year will be in the middle of the company’s long-term 65-70% diluted EPS target and that the company is set up for 6-7% annual earnings growth over the next decade, I believe that WEC Energy Group’s dividend increase streak has many years left in the tank.

From an operational standpoint, WEC Energy Group’s revenue has only declined YoY at a mid-single digit clip through the first 9 months of this fiscal year, which is admirable given the COVID-19 environment the business has contended with this year.

What’s more, diluted EPS has grown by 8.2% YoY through the first 9 months of this fiscal year.

Unfortunately, I estimate that shares of WEC Energy Group are trading at an 18% premium to fair value.

As a result of its 2.6% yield, 6.0-7.0% annual diluted EPS growth, and 1.7% annual valuation multiple contraction, shares of WEC Energy Group are positioned to fall short of my 10% annual total return requirement over the next decade.

At $85/share and my forecasted $2.70/share annualized dividend after the dividend increase, WEC Energy Group would offer a 3.2% yield and 6.0-7.0% annual earnings growth with a static valuation multiple, which I believe would make the stock a compelling long-term buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com

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