Investing In Central Utility Stocks: Do Today’s Valuations Make Sense?
Chuck Carnevale | Aug 07, 2012 01:00AM ET
This is the third in my series on investing in utility stocks based on the sector’s current valuation levels. The series was initially inspired by concerns that utility stocks may be overvalued because they had recently performed very well. When the series first started with ITC Holdings Corp: Only Investor-Owned Transmission Utility
ITC Holdings Corp. (NYSE: ITC) is the nation's largest independent electric transmission company. Based in Novi, Michigan, ITC invests in the electric transmission grid to improve reliability, expand access to markets, lower the overall cost of delivered energy and allow new generating resources to interconnect to its transmission systems. ITC's regulated operating subsidiaries include ITCTransmission, Michigan Electric Transmission Company, ITC Midwest and ITC Great Plains.
Through these subsidiaries, ITC owns and operates high-voltage transmission facilities in Michigan, Iowa, Minnesota, Illinois, Missouri, Kansas and Oklahoma, serving a combined peak load exceeding 26,000 megawatts along 15,000 circuit miles of transmission line. Through ITC Grid Development and its subsidiaries, the company also focuses on expansion in areas where significant transmission system improvements are needed.
Electric transmission is getting more focus and attention as a concept of an electronic grid analogous to the Internet. Currently there is only one investor-owned utility that is solely invested in transmission; ITC Holdings.
The company was formed in 2002 when it acquired the transmission assets of DTE Energy. The company continues to buy the transmission assets from other utilities and is also building its own projects. ITC went public in July of 2005.
I look at this company separately because not only is it unique within the electric utility industry, but the investment dynamics underpinning this company are unique as well. However, notice that the 60.8% earnings growth rate is skewed due to anomalous earnings growth from 2004 to 2005.
This is a classic example of how statistics can be misleading. Moreover, we further see an example of where the normal PE ratio is more meaningful than the orange earnings justified valuation line, again, due to the skewed growth rate.
Therefore, in order to get a more reasonable and accurate picture of ITC Holding Corp.’s growth, I have re-drawn the graph from 2006 to current in order to exclude the aberrant number. With this shorter graph we discover that ITC Holdings Corp. has grown earnings substantially faster than the average regulated utility. To get an even clearer picture of this, the reader can examine the Chg/Yr column at the bottom of the graph.
When you examine the performance associated with the above earnings and price correlated graph, you find returns that correlate with earnings growth. Consequently, ITC Holdings Corp. looks and performs more like a growth stock than a conservative utility.
MGE Energy Inc (MGEE): Overvalued Example
MGE Energy is a public utility holding company. Its principal subsidiary, Madison Gas and Electric generates and distributes electricity to 139,000 customers in Dane County, Wis., and purchases and distributes natural gas to 144,000 customers in seven south-central and western Wisconsin counties. MGE's roots in the Madison area date back more than 150 years.
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MGE Energy Inc. appears to be a classic example of what you would expect a regulated utility to look like. The company’s average earnings growth rate has been slightly higher than 4% per annum. However, a closer examination of the company’s Chg/Yr illustrates more inconsistencies than the picture implies. But most importantly, MGE Energy Inc. is clearly overvalued relative to historical norms.
From a performance perspective, MGE Energy Inc. (MGEE) has generated returns consistent with its operating record. Capital appreciation has closely approximated earnings growth at a slight premium due to current overvaluation. Although the company has consistently increased its dividend, the growth rate of their dividend has been rather anemic.
When you look at earnings forecasts, you discover that only one analyst is reporting on this company. A cross-check with Zacks also shows only one analyst. This in itself is a red flag; however, the 4% estimated growth rate is at least in line with the company’s historical achievement.
Vectren Corp. (VVC)
Vectren Corporation (NYSE: VVC) is an energy holding company headquartered in Evansville, Ind. Vectren's energy delivery subsidiaries provide gas and/or electricity to more than 1 million customers in adjoining service territories that cover nearly two-thirds of Indiana and west central Ohio. Vectren's nonutility subsidiaries and affiliates currently offer energy-related products and services to customers throughout the U.S. These include infrastructure services, energy services, coal mining and energy marketing.
Vectren Corp provides yet another example of a low growth utility stock. The reader should notice that stock price has been relatively flat (see annual highs and lows highlighted in yellow) and has followed earnings since 1998. Clearly, and as we will soon see, investing in Vectren Corp is all about the dividend, as capital appreciation is extremely low.
Moreover, the company is clearly fully valued as it currently sits at its historically normal PE ratio. Consequently, an argument could be made that the company is too expensive to invest in it at this time, even though it is not excessively overvalued.
When we more closely examine Vectren Corp’s performance, we discover exactly what we might expect. Capital appreciation is closely correlated with earnings growth, and the dividend growth rate is low but consistent. Clearly, this is a utility that you buy for the dividends, but you should be very careful what price you pay to buy it at.
Alliant Energy (LNT)
Alliant Energy Corporation is an energy holding company. Providing Midwest utility customers with safe and reliable electric and natural gas services is our top priority.
Our corporate headquarters are located in Madison, Wisconsin. General offices are located in Cedar Rapids and Dubuque, Iowa; utility operation facilities are located in communities throughout our utility service territory in Iowa, Minnesota and Wisconsin.
Alliant Energy shows an almost perfect example of the earnings and price relationship. Although the company’s earnings have been moderately cyclical, the company’s stock price tracks the earnings very closely. But more importantly, we see that the company’s fair value calculated PE ratio of 15 almost perfectly correlates with its historical normal PE of 14.9. Therefore, a rather straightforward argument that the company is overvalued at its current PE ratio is vividly portrayed.
When we calculate performance associated with the above graph on Alliant Energy (LNT) we discover that capital appreciation correlates almost perfectly to earnings growth. Also, note that the company was slightly overvalued both at the beginning of this time period as well as currently. But perhaps the most important piece of information on this performance graph is the 50% dividend cut in 2003.
Summary and Conclusions
As we continue our examination of the utility sector, it is becoming eminently clear that the majority of utility stocks are currently fully valued. Although this is not to say that they are excessively overvalued, we must not forget that the concept of valuation is exaggerated when considering utilities. Because of very low growth rates that most of them possess, even slight overvaluation can relegate returns to below optimal levels.
Therefore, we suggest that prospective investors proceed with caution and carefully examine each company that they may be contemplating. In general, utility stocks are not high risk, and are known for high yields. However, they are not known for high growth of either capital or dividends. Once again, we strongly suggest caveat emptor.
Disclosure: No positions at the time of writing.
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