After the Market’s Fall: The Fantastic Four

This summer has been a white-line nightmare for the average investor, where equities markets gyrated wildly as they became detached from the gravitational pull of their fundamentals. The S&P 500 and Dow Jones Industrial Average traded up, down and sideways after Federal Reserve Chief Ben Bernanke’s comments in late May showed the central bank was considering how to taper its $85 billion per month stimulus program. And the subsequent speculation, innuendo and rumor about when this will happen caused investors to sell in fear of a sharp market correction or other Fed surprises.

In late June while in the midst of this volatility, we identified four utilities whose fundamental value proposition was so well grounded that we believed they could withstand the forces wreaking havoc with securities markets. Now we take a closer look at these four companies to see which ones preserved value the best and why, as well as whether they’ll be able to do so again under tougher market dynamics. Additionally, we investigate what best practices were common to all, and how we might use that information to identify other valuable utility players that offer both income and growth.

In late May, the S&P 500 traded at a high of 1663.50, and then by June 24 fell to a low of 1573.09, a nearly 6 percent drop in less than 30 days following Bernanke’s initial comments. During July, the indices rallied as the Fed softened its stance, culminating in a high of 1706.87 at the beginning of August. But the S&P 500 steadily declined during the month to 1663.50 on Aug. 23, a nearly 3 percent drop.

Similarly, in late May, the Dow stood at the 15,303.10 level, and by June 24, it had dropped 4 percent, to a low of 14, 659.56. The Dow rallied for most of July, hitting a high of 15628.02 on Aug. 1. But like the S&P, the Dow has steadily declined for most of the month. By Aug. 23, the Dow had declined 4 percent from its previous high, trading at 15010.51 at the market’s close that day.

Over that same period, NextEra Energy Inc (NYSE: NEE), NRG Energy Inc (NYSE: NRG), DTE Energy Co (NYSE: DTE) and CMS Energy Corp (NYSE: CMS), have either equaled or surpassed the S&P on a total-return return basis over the trailing 12-month period. NextEra is the standout here: It outperformed both indices on a year-to-date basis, while NRG, DTE and CMS fell just shy of the indices’ returns.

Chart A: The Fantastic Four–Utilities Beating the Market on an Annual Basis

Created with YCharts

 

And when looking at the last three months, when markets were most volatile, NextEra alone continued to add value. Meanwhile, DTE lost less than the Dow, but lagged the S&P, while CMS and NRG outperformed both indices, losing between 1 percent and 3 percent versus declines of 3 percent and 4 percent for the S&P and Dow, respectively.

 

Chart B: NextEra Added Value Under Heightened Summer Volatility

Created with YCharts

 

NextEra Energy: Why It Leads When Other Utilities Follow

In any group, there has to be a leader. Of the four utilities, NextEra has made some shrewd decisions in how it plays the energy game. And it’s also benefiting from some excellent growth dynamics in its service territory, which has made the firm the envy of the utilities industry.

First, NextEra has located its energy systems around the US, strategically positioning them to always have the competitive advantage. Whereas other utilities that have base-load nuclear have had their margins impacted by low-priced natural gas or renewable energy, NextEra’s Florida Power & Light (FP&L) subsidiary’s baseload plants–whether nuclear or natural gas–are located in its regulated monopoly service territory, where margins are preserved.

Similarly, the utility has become an expert in renewable energy. With the largest fleet of wind and solar, as well as a hydro plant, NextEra has become deft at earning steady returns from various state renewable portfolio standards throughout the country.

Second, unlike some other utilities that have regulated service territories, but play heavily in unregulated markets and, therefore, seem to divert nearly all net income to new projects or operations, NextEra has remained faithful to its equity investors. The firm has delivered a steady $4 to $5 in earnings per share since 2010, on a diluted, twelve-month trailing basis.

NextEra’s service territory is blessed with significant population growth trends and steadily improving economic and power-demand dynamics. According to a Texas A&M study that forecasts energy consumption through 2050, population growth will be the greatest factor in determining long-term trends in energy demand. The model projects an overall national population increase of almost 38 percent from 2010 to 2050. The states with the largest growth rates included Arizona, Nevada, Florida, and Texas.

As such, it’s no surprise that NextEra’s second-quarter numbers held firm against their comparable period. NexEra generated net income of $610 million, or $1.44 per share, compared to $607 million, or $1.45 per share, in the second quarter of 2012.

“While we do not expect the second half of the year to be quite as strong as the first half, based on our performance year to date we think it is reasonable to expect our full-year adjusted EPS to be in the upper half of the $4.70 to $5.00 range that we have previously communicated,” management noted in the company’s earnings release.

The firm attributed part of this performance to an improving economy in Florida, where it added 35,000 new customers, thanks to a 67 percent jump in housing starts and a 1.7 percent drop in the state’s unemployment rate, to 7.1 percent. New investments and plant modernization programs at FP&L and new contracts for solar and wind at the renewable subsidiary were the driving factors in the quarter.

With a dividend currently yielding 3.2 percent, a low payout ratio of 61 percent, and a return on equity of 10.7 percent, this utility would seemingly be a must in any income portfolio. But with a price-to-earnings-growth ratio over 2, this stock presently appears overvalued, and we would have to see a few more quarters of the same growth performance to agree that the firm deserves its lofty valuation , though we’re impressed so far.

NRG Produces High Yield

Over the last year, Princeton, N.J.-based NRG Energy managed to beat both the S&P and the Dow, with a 26.4 percent gain versus 18.4 percent for the Dow and 20.5 percent for the S&P. Despite the stock’s performance, as the largest independent power producer in the US, some income investors might shy away from the company, given the volatility in its earnings and the fact that the firm pays a modest dividend (recently yielding 1.8 percent).

And the high risk of ownership was reflected in NRG’s latest numbers. Though the firm posted second-quarter earnings per share of 39 cents, which beat Wall Street estimates, these results were significantly down from year-ago earnings per share of $1.09. The decline was primarily due to lower demand from a cooler summer in its service territories.

Although NRG’s total operating revenue grew 35.2 percent from a year ago, to $2.9 billion, this was more than offset by a 48.9 percent rise in total operating expenses, to $2.6 billion, due to the higher cost of operations, depreciation charges, and selling, general and administrative expenses. The significant jump in expenses also affected the company’s operating margins, which came in at 10 percent, down nearly 830 basis points, or 8.3 percentage points, from a year ago.

NRG’s stock has been largely driven by its story as a revolutionary energy firm that is implementing new renewable distributed technologies that may one day undercut monopoly utilities. The company boasts a merchant-energy fleet in 18 states around the country. Furthermore, its presence in competitive retail markets, such as Texas, where forecasts indicate high growth in future demand also have been positives for the stock.

So why did the stock still outperform after such a lousy quarter? NRG figured out that its robust portfolio of contracted assets (as opposed to its merchant operations) would be highly attractive to a whole new asset class of income investors. The stock may have been buoyed by its spin-off of NRG Yield Inc (NYSE: NYLD), in which the firm holds a majority stake.

NYLD is a shell vehicle whose payout is funded from renewable and conventional generation and thermal infrastructure assets, which are ultimately owned by NRG. NYLD’s annualized dividend is expected to be 6 percent, with 20 percent growth in the payout by the end of 2014.

Crash and Burn in Michigan

Michigan-based DTE and CMS have been riding high on the apparent resurgence of the automobile industry, which may have contributed to the stocks’ resilience during the summer’s volatility. But second-quarter results for both firms missed consensus estimates. The reasons were varied, but it appears growth in industrial demand from automobile manufacturing was not enough to offset an unusually cool summer that lowered demand for electricity.

CMS Energy’s earnings dropped 27.5 percent from a year ago, while DTE’s earnings from its electric utility fell 30 percent.

Although profits from DTE’s gas utility segment doubled, the energy company’s overall margins weakened, and it posted a $2 million loss at its energy-trading segment. The variance is primarily due to lower earnings at DTE Electric Company, as a result of abnormally hot weather in 2012.

Of course, CMS also suggested Michigan’s economy has not completely recovered from the downturn, though the utility was optimistic. “CMS Energy and Consumers believe that economic conditions in Michigan are improving. Consumers expects its electric sales to increase annually by about 0.5 percent to 1 percent on average through 2017, driven largely by the continued rise in industrial production,” the firm stated.

Similarly, DTE’s management says its utilities’ growth will be driven by mandated environmental and renewable investments, in addition to base-infrastructure investments. DTE Electric’s capital investments over the 2013-2017 period are estimated at $5 billion for base infrastructure, $900 million for mandated environmental compliance requirements, and $500 million for renewable energy and energy efficiency expenditures.

CMS Energy affirmed its guidance for full-year 2013 adjusted earnings in the range of $1.63 to $1.66 per share. This is consistent with the company’s long-term plan of 5 percent to 7 percent annual earnings growth.

DTE Energy also reiterated its 2013 operating earnings guidance of $3.90 to $4.20 per diluted share.

Though one bad quarter is not definitive of a company’s value, the recent performance of these two utilities is evidence that the US economic recovery is still quite fragile, and investors should be cautious of irrational exuberance. While we believe the fundamentals that underpin these companies are quite good, investors will have to be patient, as the road to value creation may have some windy turns, and many hills and valleys.