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Summary Reliance on aging coal-fired power generation is a risk. Capital expenditures and dividend payments exceed operational cash flow. Dividend yield is solid but has not grown and is unlikely to grow meaningfully in the future. ALLETE, Inc. (NYSE: ALE ) primarily operates as a regulated utility, providing services for customers in Wisconsin, Michigan, Minnesota, and Illinois. By comparison to some utilities, ALLETE’s largest customers are primarily industrial in nature, with these large customers (mining and paper industries primarily) drawing 54% of KWH generated. Because of this, ALLETE profit is tied directly to the health of these industries. Luckily, Minnesota mining production has continued at full-speed even in the face of a global rout in commodities that have deeply impacted the iron and steel industries. Investors who own ALLETE should focus more of their attention on the health of ALLETE industrial customers rather than traditional utility research, such as demographic trends and unemployment growth in the service areas that primarily affect residential consumers. Aging Infrastructure And Management’s Plan The vast majority of energy production for ALLETE comes from coal-fired power generation. At the end of 2014, 64% (1,277 MW) of energy production was coal-fired. The majority of these coal-fired plants are getting quite old — while units 3 and 4 at the Cohasset, MN facility are the newest (producing 75% of generation at this massive facility), these were still originally constructed in 1973 and 1980. Like a large swath of US coal-fired plants, obsolesce may soon be around the corner. The average lifespan of a coal-fired plant is forty years, according the National Association of Regulatory Utility Commissioners . While the Cohasset facility has seen many updates over the years, facts remain that the bones of the facility have aged. Those that follow my work on utilities know that I’m a big fan of natural gas and other renewable power regeneration. This isn’t driven by my own personal feelings on the environmental impact. Regardless of your thoughts on environmental regulation, investors should nonetheless be aware of the fact that the Environmental Protection Agency has begun taking a harder stance on coal and that course is unlikely to change. Regulations on pollutant emission will likely only continue to strengthen and so will the cost burden on utilities to maintain necessary updates on these aging coal-fired plants. As a recent example of the cost impact, ALLETE is nearing completion of an environmental upgrade at one of its plants; total cost will run $260M to bring the plant into compliance with the Mercury Emissions Reduction Act. While this is cost recovery eligible through rate increases on the retail customer and if approved these customers will have no alternative but to bear the cost, industrial customers (which if we remember constitute the majority of revenue) do have the option to pursue other providers with approval from the state or can generate their own electricity on-site. This is why it is imperative that investors who remain long on ALLETE as a company pay close attention to the strides the company is making in renewables and natural gas. The company is targeting a production goal of thirds — one-third of energy production with coal, one-third with renewables, and one-third with natural gas. This was most likely driven in part by the Minnesota Next Generation Energy Act of 2007, which requires 25% of retail energy sales to be from renewables by 2025, with hurdles of 17% in 2016 and 20% in 2020. These hurdles are around the corner, but luckily ALLETE does have a foundation to work off of. There is some minimal existing hydroelectric production (105 MW) spread throughout Minnesota, but the likely new crown jewel for ALLETE is its Bison Wind Energy Center in North Dakota, which produced 497 MW of energy at the end of 2014. Further bolstering renewables production is the agreement reached to purchase hundreds of megawatts of production from AES Corporation (NYSE: AES ) early on in 2015. I’m long AES Corporation, and I see this as a win/win for both companies. AES has spread itself way too thin around the globe and these asset sales make sense to let the company gain focus on more core facilities. ALLETE in return gains solid wind production facilities that will likely be immediately accretive to earnings per share. As another related victory for ALLETE in the renewables space, the deal for ALLETE to construct a wind farm for Montana-Dakota Utilities, a division of MDU Resources Group (NYSE: MDU ) shows that the company has an industry reputation for knowing what it is doing when it comes to wind construction. Operating Results (click to enlarge) Total revenue has grown at a 5.81% over the past five-year period and this trend is set to continue with revenue projected at 1.2B for 2015. Fuel expenses have fallen as coal prices have taken a nosedive, a benefit that many utilities have enjoyed in recent years. This input cost windfall has resulted in expanding operating margins. Net income growth would have been stronger if not for a burgeoning debt load; total debt now stands at nearly $1.4B, almost double the $773M the company held in 2014. This is due to the fact that capital expenditures have massively outstripped operational cash flow over the past five years. Operational cash flow totaled $1.2B in the 2010-2014 period; capital expenditures totaled $1.8B. This out-of-balance is before factoring in dividends, which totaled another $350M. This is not what you want to see from a utility. By comparison, Calpine Corporation (NYSE: CPN ), which I own, has seen nearly $3.8B in operational cash flow versus $2.8B in capital expenditures over the same timeframe. This falls back to the cost of running and maintaining coal-fired plants. Calpine primarily operates extremely new, high-technology natural gas plants, the direct opposite of ALLETE’s current portfolio. Management is guiding these costs to fall over the next five years, capital expenditures are guided to average $250M/year versus the prior five-year average of $360M. Even with those decreases, ALLETE may continue to run into a situation where they must raise more debt to fund all their obligations. Conclusion While investors might be tempted by the 4% dividend yield, investors should keep in mind the five-year average dividend growth rate has only been 2.2% and this is unlikely to change. No large catalysts exist for substantial earnings per share and dividend expansion in my opinion. Total shareholder returns are likely to lag a broader utility index and investors would likely be better off in other names with more opportunity. Larger peers like American Electric Power (NYSE: AEP ) or prior-mentioned name AES Corporation present more compelling stories for stable dividend growth. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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. Scalper1 News
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