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Black Hills Corporation Is Still A Growth Story

Summary The company has increased dividends every year for more than 40 years. This is one of the few utility stocks to show significant capital gains in its history besides times when interest rates decrease. Even with the acquisition, the company’s financial outlook remains reasonable. The company continues to invest for future growth. The company has several ways to participate in the recovery of the oil and gas industry when the recovery arrives. The company is well diversified among several states which should increase the stability of the dividend and the return to shareholders. Black Hills Corporation (NYSE: BKH ) has been around a long time and boasts one of the best dividend records out there. The company has not only paid a dividend it also increases that dividend. However, the capital gains picture has not been kind to the company for the last ten years, which is roughly from the time of 2006 and includes the last very significant recession. The price of the stock has been relatively stagnant as the chart below shows. Nonetheless, the company has some good fundamentals and is probably worth a good look by the serious investor looking for a relatively safe and consistent return. The dividend yield is becoming significant, even generous for a company with a large utility component, but also an unregulated component that will provide future growth. The combination of future earnings growth and dividend yield is worth looking at here to see if it suits the risk averse investor. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 So the question remains as to whether or not the company has lost its touch. Currently its most visible customers, the oil and gas companies are laying off employees and decreasing activity. Some are going bankrupt. The company itself has an oil and gas division that is showing enough losses to eliminate reported profits. Normally an investor would run the other way. But this company has such a consistent history prior to now that it would be wise to see if investing contrarian style could be a winning strategy. Plus it announced an acquisition, the latest of many prior successful acquisitions. At one point, in its history the company not only had attractive dividends but also showed significant appreciation. The chart above shows a return of 9.2% for twenty years which is very attractive for such a low risk stock that pays a significant and secure dividend. The last ten years, however, the rate of return is only 3.7% which may not even cover the dividend return for that period of time depending upon when the stock was purchased. Now admittedly, the economy was in far better shape in the earlier part of the twenty year period than it has been in the last ten years, and there are plenty of companies with far worse returns because the economy took a very significant dive around 2008. Still it is worth looking into to see what the company is doing now. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 From a dividend perspective , it is still growing and that is a very large indication that the company is on the right track and has not lost its touch. The current dividend yield is nearing a four percent yield and based upon past history, an investor can expect about a 1.5% increase in that dividend each year in the future. There is an occasional larger jump. A look at the earnings picture may well modify this stance. It’s even more significant that the company retains nearly 60% of its adjusted earnings for reinvestment in the business and potential diversification. Many utilities pay out far more earnings, and hence the dividend growth rate is lower or there is no growth rate. Some of this retention will be explained below where it is shown that the electrical and gas use is growing, so investment is needed to keep up with the growth in demand. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 When the earnings picture is reviewed, it’s clear that dividends may increase at a faster rate in the future. Earnings have grown at a 15% compounded rate for the last five years, but dividends have only grown at 2%. That earnings growth rate is far faster than the typical utility, although some of that growth could be a recovery from the 2008 downturn. For the last few years this company has been located in some of the hottest oil and gas plays in the country. This utility services Montana (which has part of the Bakken play), Colorado, and Wyoming. All of these areas have major shale oil plays, and with the production growing rapidly, there is a need for employees who with their employers use electricity and gas (until the current downturn). The company has also made acquisitions at an average of one a year or so, and obviously those acquisitions have helped the profit picture. The company has also integrated itself more fully, mining coal to provide coal for its power plants, and drilling for gas to provide gas for its power plants and customers. It also has a wholesale electric company. So this company has several ways to grow. It can grow by integrating new acquisitions and implementing new efficiency measures, by the growth of the non-regulated business, and by growing its regulated business as allowed by law (although this is by far the slowest of the three possibilities). The first two avenues of growth are not usually available to utility investors. The company emphasizes the non-gap results because the oil and gas division is currently negating all the corporate earnings because of the ceiling calculation writedowns. Those writedowns confirm that money spent a few years ago was not profitably spent, and therefore is now officially a loss. They are known as a sunk cost. In the current low price oil and gas environment, those expenditures will not be recovered. But those charges do not affect current cash flow, future earnings growth, or really change the outlook of the company. When removing those non-cash charges, the company is still showing impressive growth in the other divisions. That growth will show on the income statement as soon as the ceiling cost adjustment ceases to be a factor in reported earnings. More importantly, the oil and gas business has been profitable for the company in the past, and it has reported gains (for example) on the sale of some of the properties in that division so there is reason to hope for profitability of this division in the future. The division was small enough to not cripple the company when something like these writedowns occurred, but big enough to provide significant gains to shareholders in the past and hopefully the future. The company has a solution for the future of those writedowns in the form of cost of service gas support. The interesting thing is that the company has to be better than average (in selling gas to its utilities from the exploration company) for it to be allowed to earn an extra 1% on its ROE, and it has a customer base for its gas that is long term and possibly less demanding than many other companies that are not regulated. Right now, this is just a proposal, and has not yet made it through all the regulatory hurdles (nor is there any way near enough significant operating history on this proposal), but if approved (and if it works as management thinks it will), would be a way to avoid the cost ceiling writedowns that has concerned the company and the whole exploration industry. The company would avoid future charges by locking in long term supply contracts to retail customers at a fixed price and avoid the spot market swings. Furthermore, that solution is unique to this company because it has a an oil and gas subsidiary (that is mostly gas) as well as utilities to sell its production to. As a conglomerate, more so than a utility, this company continually finds ways to make the sum of its parts more than each part separately, and this is just one example of what the company has accomplished. To prepare for the implementation of the proposal, the company has decreased its capital spending to accommodate the current low commodity prices. It has also decreased the well costs and increased well productivity considerably. So it is working hard to make that subsidiary above average and meet the regulation requirements needed for the cost of service gas support program. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 Despite the cyclical nature of both the oil and gas business and the coal mining business this company is succeeding in steadily growing its non-regulated business over time as shown by the growth in the non-regulated operating earnings. There are going to be hiccups, such as the oil and gas ceiling cost writedowns, and they definitely hurt. But the company has found a formula to consistently increase cash flow, operating earnings, and maintain that dividend (even grow it) through the disappointments. For the risk averse investor that wants consistency, this accomplishment is worth noting. The company has also noted that it has acquired 19 utilities in about the same number of years and integrated them. That is a fair amount of practice leading up to a larger acquisition. A strategy of making periodic small acquisitions (and an occasional large one) usually pays off better for shareholders than making one giant acquisition (with no previous acquisition experience), and here is a case in point. The current proposal for a large acquisition, the SourceGas acquisition has a far better than average chance to add to earnings within the first year. There is enough history of acquisitions to add credibility to that statement even though this acquisition is larger than the typical ones the company has made in the past. Also an investor would expect the combined company to maintain its investment grade rating. Therefore the investor should expect the growth in earnings, cash flow, and operating earnings to continue. That growth might even temporarily accelerate from the acquisition. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 The significance of this particular slide is that the company is investing in its future to grow. Notice the continual investment that exceeds the depreciation charges. Plus the company noted that its customer base does increase around one percent or so a year. Because many of its service areas (all of them in fact) are located outside of major cities, the plant size tends to be smaller, and with the company’s diversification, it is not dependent on really any one area (more than the others) for much of its revenue. In short the company has a lot of small power plants, rather than a few big ones (like some of the big city setups). So when the government decided it was time to reduce emissions, this company is having an easier time replacing its coal plants with natural gas fired plants (and reducing emissions of the remaining plants until the proper replacement time). Its new power plants, because of their size often are completed within budget and on time. With the diversification of the company, replacing one power plant, is not the strain it would be on a company that is not so diversified and dependent on a few large plants. The government may want to speed up the replacement process and that would put a strain on the company finances, although the regulatory process would allow for cost reimbursement. Still the company has an investment grade rating, and that rating is unlikely to change because of the current emphasis on emission reduction. Although the current ratings outlook is reflecting the current uncertainty of the merger. For the time being, the coal fired plants and the issues surrounding them are not a drag on discretionary cash flow to the point where future dividend growth would slow. Even in a worst case scenario, the company is well diversified that an emphasis to change from coal to gas or otherwise reduce emissions would be mitigated by the company’s diversification. The company has many small rate increases because of its extensive diversification. One unfavorable rate increase ruling is unlikely to derail the company’s growth plan. Plus should one state become utility business hostile, the company is in a position to spin off that division and emphasize the more growth or rate of return friendly areas. Once the merger details are known, the negative outlook by the ratings agencies should be quickly revised. Otherwise, the company’s finances currently appear to be able to handle whatever capital investments and debt financing are needed for the future as the debt markets are definitely open for this company. The company also appears to be receiving a return on its investment and diversification in the form of higher adjusted earnings, operating earnings, cash flow, and the ability to increase dividends. Admittedly the oil and gas division is an exception, but after a year or so that exception will be gone. The company has a history of profitability in its non-regulated subsidiaries (it has ten years of experience in the oil and gas business and experience in the coal mining business also), it has even sold pieces of these subsidiaries for gains and spun at least one of the subsidiaries off to shareholders in the past. In short there is a history of both experience and success with non-regulated subsidiaries that should be expected to continue and add to profitability in the future. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 The company numbers among its customers some very large growing companies. Interestingly, it lists a Microsoft (NASDAQ: MSFT ) location as a major customer. That kind of diversification is not really well advertised but does exist in its service area (see slide below). It is known for having a lot of oil and gas companies as its customers. That customer diversification in the service areas is the reason that the company is showing growth through the oil and gas downturn. Should profitable times return to the oil patch, this company can be expected to participate in the growth of those firms by selling them more electricity and all the related businesses. Plus it has non-regulated subsidiaries that will participate in the recovery. In the meantime, showing any growth at all in this downturn is a major accomplishment. The company does note that its service area includes some of the lowest unemployment areas in the country and that certainly helps. As a result, the expected decrease in earnings from the more visible oil and gas industry in the company’s operating areas has not materialized. The advantages of the diversification of the company are being demonstrated yet again. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 As discussed above and referenced from the company presentations , the merger still has a few hurdles to clear, but the experience of the company making acquisitions is shown by this slide. There are a large number of service overlaps and adjacent areas that open themselves up to economies of scale after the acquisition, and could provide several years of profitable utility growth to the combined company. Notice that no one service area is so dominant that the company relies solely on that area for its profits. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 In reviewing the company’s goals, I take some comfort in all the oversight through regulation of the company’s financial health. It must maintain in most cases (through each subsidiary) a minimum amount of equity of 40% vs. long term debt. Overall the company maintains an equity level (vs. long term debt) usually in the 48% level and has room for things such as the writedown of oil and gas properties due to the ceiling calculation. That writedown will not affect the equity at the utility subsidiary level which is required by each state. The utility subsidiaries can still pay dividends to the parent company so that the parent company can pay dividends to the shareholders. The writedown does affect the overall company results, and the oil and gas subsidiary. However, with the company reporting operating income of roughly $275 million this year, the loss caused by the oil and gas ceiling calculation of more than $100 million will be easily replaced. The writedowns will not cripple the parent company. With the healthy state of the other divisions, that total company equity to long term debt ratio will recover once the writedowns stop. To its credit management has come up with a proposal to avoid those writedowns in the future, a sign of good management. Conclusion The goals themselves really are more of the same of what has made the company successful in the past. Maybe, the stock got a little ahead of itself (or maybe the recession really did slow the growth rate for a few years) and that is the reason for the sub-par returns for about five years. However, the latest five year period returns are superior and based upon the capital budgets, the proposed acquisition, and operating earnings, as well as customer growth, the key basics look to be in place for a rewarding future. The company looks to be back on track, especially when the investor reviews the returns of the latest five years in comparison to the returns of the latest ten year period. The oil and gas industry downturn has not slowed customer growth, usage growth, cash flow, and earnings growth. Those current ceiling cost charges reflect investments made in previous years that are not currently profitable. They don’t affect current operations. Therefore this company should continue to grow earnings in the seven to ten percent range for the foreseeable future. When this is combined with the nearly four percent dividend, the total return from an investment at the current price of the stock ( approximately $46 lately)looks to be a very attractive eleven to fourteen percent for the future. The price-earnings ratio appears to be about twelve without the oil and gas writedowns. That is a very reasonable price to pay for these returns. (click to enlarge) Source: Black Hills Corporation Analyst Day Presentation October 8 Raising guidance is usually reserved for well run companies , and I believe that is the case here. The company has also provided some fairly detailed assumptions that look fairly reasonable. The major acquisition is not expected to close until next year, and the company has even set a public goal to complete the acquisition and have it add to earnings the first year. This is a reflection of the certainty of management in the acquisition as well as the practice of having made so many acquisitions in the past. Plus any efficiencies earned from the upcoming acquisition will provide the shareholder with significant upside potential. Clearly this company is looking forward to more profitable growth and shareholders can look to profitable returns that will probably be superior to what was achieved in the last ten years when the economy took a nose dive. There are risks to any acquisition, and with a large acquisition there are large risks. However, those risks are mitigated by the number of successful acquisitions this company has made in the past. While the debt rating agencies are a little skittish and will remain so until all the details of the acquisition are known, the company has a history of maintaining an investment grade rating, and can be expected to do so in the foreseeable future. Disclaimer: I am not an investment advisor and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents, and press releases to see if the company fits their own investment qualifications.

Market Lab Report – Premarket Pulse 10/20/15

Major averages rose yesterday on lower volume with the NASDAQ Composite a kiss away from its 200-day moving average. Expect a continuation of the tug-o-war between signs of economic strength which determine the future of quantitative easing (QE) and rate hikes: Key variables that can push the market higher: 1) QE 2) Global economic strength – if it is believed this is a sign of a sustainable recovery, the onset of higher rates will be considered a bullish event 3) U.S. economic strength – if it is believed this is a sign of a sustainable recovery, the onset of higher rates will be considered a bullish event Key variables that can push the market lower: 1) Global economic strength – if it is believed this is not sustainable, the onset of higher rates will be considered a bearish event 2) US economic strength – if it is believed this is not sustainable, the onset of higher rates will be considered a bearish event We have been at inflection points on a number of variables this year which accounts for much of the market’s trendless, sideways action. The global economic slowdown, especially in China, created the first correction exceeding -10% that the U.S. market has seen on the S&P 500, since 2011. But such economic slowdowns have central banks fueling markets with additional QE, further kicking the can down the road, and the road is a long one having started in late 2008. But this year’s trendless market action in the U.S. and downtrends in global markets shows QE has a limited lifespan. As always, keep a close eye on your stocks and watch lists. Despite this year’s trendlessness, profit opportunities in stocks have been present as can be seen in this year’s Pocket Pivot and Buyable Gap-Up reports. Of course, a deft hand of taking profits when you have them in context with the stock’s chart relative to itself and to the general market have also been key. Telecom infrastructure company Dycom (DY) had a pocket pivot. Earnings are skyrocketing, sales are accelerating, group rank 7. Supply chain management software company Manhattan Associates (MANH) had a pocket pivot at near breakout point. Pretax margin 28%, ROE 48.5%, consistent and robust earnings and sales, group rank 23.

Building A Bulletproof Portfolio Of Lower Beta Stocks

Summary An investor can “bulletproof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start by narrowing down your universe of stocks. We explore the second method here. The stock we start with are ones with lower betas. Although CAPM predicts lower beta stocks will have lower returns, evidence suggests the opposite is the case. Since lower beta stocks are not without risk, owning them within a hedged portfolio can make sense. We recap the hedged portfolio method, show how you can build a hedged portfolio of lower beta stocks yourself, and provide a sample portfolio. Seeking Beta The traditional view of lower beta stocks, encapsulated in the Capital Asset Pricing Model ( CAPM ), is that they offer lower risk than higher beta stocks, but also lower returns. Seeking Alpha contributor and hedge fund manager Dr. Eric Falkenstein is one of the researchers who has challenged that, presenting evidence that lower beta stocks actually generate higher returns than higher beta stocks. In a 2012 Seeking Alpha article (“Is Low Vol A Beta Phenomenon”), Falkestein included the chart below, showing that, among the top 1500 stocks by market cap (excluding financials), stocks with lower beta (average beta of 0.85 versus 1 for the market) had outperformed both the market and high beta stocks since 1990. The Risks of Investing in Lower Beta Stocks As with any style of stock investing, when investing in lower beta stocks, you face two kinds of risks: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. By definition, the market risk of lower beta stocks should be less than that of the market (assuming the lower beta stocks you buy remain lower beta, which isn’t always the case, as Seeking Alpha contributor Matti Suominen has noted ), but the idiosyncratic, or stock-specific risk of lower beta stocks may come as a surprise to some investors. Six months ago, for example, how many investors in Wal-Mart (NYSE: WMT ) (beta: 0.82) would have thought they would be down nearly 25% on the stock by mid-October, as the chart below shows? (click to enlarge) Two Ways of Limiting Stock-Specific Risk One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article (“How to Limit Your Market Risk”), we discussed ways to limit market risk for a diversified portfolio. In this post, we’ll look at how to “bulletproof” a concentrated portfolio of lower beta stocks using the hedged portfolio method . In that method, you limit both stock-specific and market risk via hedging. Below, we’ll show how to use that method to construct a “bulletproof”, or hedged portfolio for an investor who is unwilling to risk a drawdown of more than 16%, and has $250,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 26% decline will have a chance at higher potential returns than one who is only willing to risk a 6% drawdown. In our example, we’ll be splitting the difference and using a 16% threshold. Constructing A Hedged Portfolio We’ll outline the process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising lower beta stocks Most brokerage websites offer screeners that let you screen for lower beta stocks. Since you’re going to hedge your stocks, you’ll want to limit your screen to stocks that are optionable. Next, you’ll need to calculate potential returns for your lower-beta, optionable stocks. One way to do that is to look up the consensus price targets for each stock, and derive potential returns in percentage terms from them. We offered an example of doing that for Novo Nordisk (NYSE: NVO ) in a recent article (“Building A Hedged Portfolio Around A Position In Novo Nordisk”). In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-16% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs, but, in any case, you’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return 7% declines, they all had positive net potential returns when hedged against > 16% declines. Nevertheless, the site rejected GOOGL. Why? Because of its share price ($695.32) relative to the size of the portfolio ($250k). For a portfolio of this size, the site attempts to allocate equal dollar amounts to 4 primary securities. Since a quarter of the portfolio would be $62,500, and a round lot of GOOGL would have cost more than that ($69,532), the site eliminated GOOGL from consideration for this portfolio. As it allocated cash to each of the stocks we entered, it rounded down the dollar amounts to get round lots of each stock. In its fine-tuning step, Portfolio Armor added Tesla Motors (NASDAQ: TSLA ) as a cash substitute, to replace most of the cash leftover from the rounding down process. TSLA happens to be a higher beta stock, but the site doesn’t take beta into account when adding cash substitutes; instead, it looks at which securities (whether stocks or exchange traded products) have the highest net potential returns when hedged as a cash substitute. Let’s turn our attention now to the portfolio level summary. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 14.33%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.19%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 13.77% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets its potential return (since three of these positions are uncapped, it’s theoretically possible that the portfolio could return more than 13.77% if each of the uncapped stocks exceeds its potential return). A More Likely Scenario The portfolio level expected return of 5.52% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. By way of comparison, the average 6 month return for the SPDR S&P 500 ETF (NYSEARCA: SPY ) over the last 10 years was 3.84%. Each Security Is Hedged Note that each of the above securities is hedged. TSLA, the cash substitute, is hedged with an optimal collar with its cap set at 1%, HRL is hedged with an optimal collar, with its cap set at its potential return, and the other 3 primary securities are hedged with optimal puts, which are uncapped. In our series of 25,412 backtests conducted over an 11-year period, the average actual return of a security hedged with an optimal put was 1.93x that of one hedged with an optimal collar, so the site aims to hedge primary securities with optimal puts unless their net potential returns, when hedged with collars, are > 1.93x higher. That was the case with HRL, which is why it’s hedged with an optimal collar. That wasn’t the case for the other three primary securities, which is why they’re hedged with optimal puts. Here’s a closer look at the optimal put hedge on MO: The cap field above is blank, as this is an optimal put, which is uncapped. As you can at the bottom of the image above, the cost of the put protection on MO was $840, or 2.04% as a percentage of position value.[i] Note that, although the cost of this hedge was positive, the overall cost of hedging the portfolio was negative . Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging Tesla. [i] To be conservative, Portfolio Armor calculated the hedging cost using the ask price of the puts; in practice an investor can often buy puts for less (for some price between the bid and the ask). The other hedges in the portfolio were calculated in a similarly conservative manner, with the puts priced at the ask, and the calls priced at the bids, so the actual cost of hedging this portfolio would likely have been lower than shown (i.e., an investor would have collected more than $465, on net, after opening the hedges).