valuation

Introduction

In part 1 of this series on utilities published on July 26, 2012, we looked at the utility sector with a broad brush. In this part 2, we will focus on utilities located in the western part of the United States. The series was inspired because of the apparent general impression that utility stocks are overvalued.

This impression stems from the fact that utilities have been the best performing sector over the past year.  Therefore, people automatically assume that because an asset class has risen in price, that it must also be overvalued. However, if they have risen from previously undervaluation levels, this may not be the case. The following comparison of the performance of US ETF’s by sector first reported in part 1 on July 26, 2012, illustrates their recent outperformance.

On the other hand, with all the volatility there is today, it’s amazing the difference just a few days can make.  Here is an update of the above graph through July 30, 2012, just five days later.  Here we discover that utilities’ performance over the past year has still been exceptional.  However, they have now moved into second place behind consumer staples but just ahead of technology, which is making a homestretch charge.

Western Utilities – A Review Of Valuation

The following table compares the valuations of the major Western utility stocks utilizing the FAST Graphs™ portfolio review tool.  The first two columns compare each company’s current PE ratio to the PE ratio that the market has historically applied to each stock. Based on this cursory analysis, the Western utility group appears fully valued, but not necessarily overvalued.

Based on this analysis, 3 of the 15 companies covered could technically be called moderately overvalued.  However, we would not call any of them dangerously so.  Another 5 of the 15, we would classify as sitting on the upper end of fair value, and the remainder we would call fairly valued. On the other hand, we did not see any that we would be willing to call undervalued companies in this Western region of the utility sector.

There are several issues regarding investing in utilities stocks that are important to consider. As a general rule, the utility industry has been a low growth industry due to the regulated nature of the majority of its business. Many utilities are attempting to diversify their businesses away from the regulated side. The third column of the table below lists the historical past 15 years earnings growth.  As a review of the table shows, only El Paso Electric Co. (EE), Portland General (POR) and Sempra Energy (SRE) display any acceptable historical growth.

However, the reviewer might also notice by the estimated EPS column, that estimated growth for most companies is more optimistic. Many of the utilities in the Western region are currently involved in regulatory activity, which is nothing new for utilities in this region.  Then there is the issue of capital expenditures requiring cost of capital filings. Consequently, a large part of the future growth prospects of utility stocks are at the mercy of their various regulatory commissions.

In addition to the uncertainties mentioned above, utilities are facing issues in Washington DC.  In addition to proposed increases in dividend tax rates, tax credits for certain alternative energy investments are also scheduled to expire.  Add it all up and there’s a lot of uncertainty regarding future earnings and dividends for this essential sector.

The typical utility stock attracts investor interest primarily with their yields; Western utility stocks are no different.  However, their long-term dividend records are spotty at best. Below when we showcase individual examples, we will elaborate more on the dividend records of several Western utility companies.

Evaluating Western Utilities – A More Specific Approach

As we reviewed the individual earnings and price correlated graphs on Western utilities, we were struck by the lack of consistency in their operating histories.  Consequently, our general view of the utility sector as a conservative income generating equity asset class was challenged.  Although there are exceptions, the variability of earnings within the Western utility sector is a concern.

What follows is a look at specific examples of Western utilities based on valuation.  What we found as we examined utilities from the Western geographic region was a rather vague determination of value.  Although many in this group could be considered reasonably or fairly priced, we found none that we would consider compelling. On the other hand, we saw none that we would call ridiculously or dangerously overvalued either.

(For the readers convenience, follow this link to free sample live FAST Graphson the six Western utilities featured in this article)

Overvalued Examples

Black Hills Corp (NYSE:BKH)

Directly from the company’s website:

“Black Hills Corp (NYSE:BKH) is a strong, diversified energy company with a vision to be the energy partner of choice. Our utility operations include Black Hills Power – an electric utility and our legacy business that provides service to approximately 68,000 customers in the Black Hills region and sells surplus power in wholesale markets – and Cheyenne Light Fuel & Power, serving 39,300 electric customers and 34,500 natural gas customers in the greater Cheyenne, Wyo., area.

Additionally, our recently acquired Black Hills Energy utility operations provide electric services to approximately 94,000 customers in southeastern Colorado and natural gas utility services to approximately 527,000 customers in Colorado, Iowa, Kansas and Nebraska.

Our energy portfolio also includes non-utility businesses; Black Hills Exploration & Production produces oil and natural gas in New Mexico, Wyoming and Colorado. The Wyodak coal mine in Wyoming’s Powder River Basin supports the Company’s low-cost, mine-mouth power generation. Black Hills also has a fleet of power generation facilities in Colorado, Wyoming and South Dakota that produce more than 1,000 MW of energy annually for our own utility customers as well as others.”

Black Hills Corp. represents a classic example of the Western utility with inconsistent historical operating results.  In addition to earnings generally growing very slowly, we discover more than one instance of earnings collapsing and/or even disappearing altogether.

The current higher than average blended PE ratio of 20.3 can be attributed to weak fiscal 2011 earnings. Therefore, overvaluation in this case is more a function of sagging earnings than high stock price.

When you analyze Black Hills Corp.’s performance since 1998, you discover a reasonably steady record of consistent dividend payments with moderate growth.  Moreover, notice how dividend growth has slowed down in recent years consistent with recent inconsistent earnings performance.

Consensus estimates for future earnings growth for 2012 look for a 5% per annum average growth rate. Given the company’s history, I find it hard to accept a consistent record of future growth.  However, if it were to happen, this stock would not really be as overvalued based on future earnings, as it looks now based on current earnings.

 

Moderate Overvaluation Examples

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