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Applying Graham’s Stock Selection Criteria To Dow Jones Utilities

Summary Ben Graham’s stock selection criteria are tried and true for the defensive investor. Public utilities, represented by the Dow Jones Utility Average (DJUA), are no longer sound investments for the defensive investor today. Great variations are found among the 15 DJUA components, allowing an enterprising investor to select stocks higher in both quality and quantity than the average. In a previous article , we revisited Benjamin Graham’s stock selection criteria, applied them to the thirty issues in the Dow Jones Industrial Average (DJIA), and found the DJIA unsatisfactory, mostly failing the valuation criteria. Below are Graham’s 7 stock selection criteria for the defensive investor: Quality 1. Adequate Size of the Enterprise . Graham suggested at least $100 million of annual sales for an industrial company, and at least $50 million of assets for a public utility. These 1973 figures can be adjusted for inflation to roughly $500 million of annual sales and $250 million of assets today (2014). Market capitalization, used by many as a proxy for size, confuses market valuation with business fundamentals. While the two are very much correlated, they may widely diverge at times, and paying exorbitant price for a small business is the exact opposite of defensive investing. 2. A Sufficiently Strong Financial Condition . Current ratio should be at least 2:1 for industrial companies; debt to equity should be no more than 2:1 for public utilities. 3. Earnings Stability . Some earnings in each of past ten years. 4. Dividend Record . Uninterrupted payments for at least the past 20 years. 5. Earnings Growth . A minimum of at least one-third in per-share earnings in the past ten years using three year averages at the beginning and the end. Multi-year average earnings smooth out cyclical earning variations and better reflect a company’s true earning potential. This corresponds to 2.9% compound annual growth, a relatively low hurdle. Quantity 6. Moderate Price/Earnings Ratio . Current price should be no more than 15 times average earnings of the past three years. Again, ignore single year earnings. P/E calculated using trailing twelve month earnings or predicted earnings for the next 12 months are unreliable. 7. Moderate Ratio of Price to Assets . Current price should be no more than 1.5 times the book value last reported. Alternatively, the product of P/E and P/B should not exceed 22.5. A stock meeting this alternative criteria may be considered as fulfilling both quantity criteria and admitted for investment. Application of Graham’s Criteria to the DJUA in 2014 We will now turn our attention to the public utilities, specifically the 15 prominent issues in the Dow Jones Utility Average (DJUA), to see how many, if any, meet these stringent criteria for the defensive investor. As a frame of reference, when Graham did his analysis for the DJUA in 1971, he found all fifteen issues meeting the criteria. In his own words: In comparison with prominent industrial companies as represented by the DJIA, [the DJUA] offered almost as good a record of past growth, plus smaller fluctuations in the annual figures–both at a lower price in relation to earnings and assets. Can the same be said regarding the DJUA today? The table below lists the 15 DJUA stocks with the Graham criteria (red means it failed; green means it passed). These data are obtainable from SEC filings here . Stock Ticker Price Assets Debt/equity Earnings stability? Yrs of Uninterrupted Dividends 2002-2004 Avg Earnings 2011-2013 Avg Earnings Earnings Growth Price to Earnings Book value Price to Book (P/E)*(P/B) # Criteria Met Duke Energy DUK 80.62 119656 1.00 Yes 29 0.43 3.55 725.58% 22.71 58.57 1.38 31.26 6 Exelon EXC 35.48 85264 0.95 Yes 34 2.13 2.39 12.21% 14.85 27.45 1.29 19.19 6 Southern SO 47.76 67654 1.19 Yes 32 1.98 2.36 19.19% 20.24 22.07 2.16 43.79 4 American Electric Power AEP 57.83 57925 1.15 Yes 44 0.49 3.22 557.14% 17.96 34.48 1.68 30.12 5 PG&E PCG 51.94 57884 0.93 Yes 10 3.11 1.95 -37.30% 26.64 33.25 1.56 41.61 3 NextEra Energy NEE 101.08 53383 1.54 Yes 31 0.05 4.54 8980.00% 22.26 43.10 2.35 52.22 5 Dominion Resources D 71.79 52279 2.15 Yes 30 3.20 2.69 -15.94% 26.69 19.82 3.62 96.67 3 FirstEnergy FE 37.19 51224 1.70 Yes 16 1.98 1.66 -16.16% 22.40 30.19 1.23 27.60 4 Edison International EIX 63.18 49475 1.14 No 11 2.85 0.70 -75.44% 90.26 32.95 1.92 173.06 2 Consolidated Edison ED 64.14 40667 0.99 Yes 44 2.59 3.68 42.08% 17.43 43.39 1.48 25.76 6 AES AES 12.79 38983 2.76 No 2 (2.23) (0.33) NM NM 6.14 2.08 NM 1 Public Service Enterprise PEG 40.46 34147 0.74 Yes 107 1.09 2.62 140.37% 15.44 23.89 1.69 26.15 5 NiSource NI 39.10 23710 1.62 Yes 28 1.24 1.37 10.48% 28.54 19.04 2.05 58.61 4 CenterPoint Energy CNP 21.71 22048 1.92 No 44 (4.70) 1.62 NM 13.40 10.41 2.09 27.95 4 Amertican Water Works AWK 51.42 15716 1.20 No 6 1.10 1.94 76.36% 26.51 27.44 1.87 49.67 3 DJUA 51334 1.40 Yes 31 19.19% 26.09 1.90 50.26 4 Unfortunately, the DJUA has changed for the worse since 1971. Not even one of the 15 issues meet all 7 criteria today. It is poorer in both quality and quantity compared to 1971, when utility stocks were inviting to the defensive investor. Salient Aspects of the DJUA Today 1. Size is adequate , with all fifteen issues easily surpassing the minimum $250 million of assets stipulated. 2. Financial condition is adequate in the aggregate, with an average debt to equity ratio of 1.4 for the DJUA, and 13 out of 15 issues meeting the criteria of debt to equity less than 2:1. 3. Earning stability is satisfactory in the aggregate , but 4 out of these 15 issues failed this criteria, a worse showing compared to the DJIA, where only 1 out of 30 issues failed. This is both surprising and alarming, suggesting that utilities are no longer as stable or defensive as they once were. 4. Most of the issues have at least 20 year history of uninterrupted dividends , with an average of 31 for the DJUA. Although satisfactory, the dividend history for the DJUA pales compared to the DJIA, which boasts an average of 67 years of uninterrupted dividends. 5. Earnings growth is very poor . The median earnings for the DJUA is only 19% over the past decade, or 1.77% compounded annually, which does not even keep up with inflation. Only 6, or fewer than half, out of 15 issues met the threshold of at least one-third of per-share earnings over ten years. 6. Ratio of price to three-year average earnings was 26.31 for the DJUA today, which is 75% greater than the maximum 15 required. The DJUA today is not only significantly more amply valued compared to its past, but even more overvalued than the DJIA today, which has a ratio of price to three-year average earnings around 20. 7. Ratio of price to net asset value was 1.91 for the DJUA today, which is 27% greater than the maximum 1.5 required. This is significantly more expensive compared to a ratio of 1.21 for the DJUA in 1971, but more favorable compared to the corresponding figure of 4.38 for the DJIA today. That DJIA commands a higher price relative to asset than the DJUA is by no means surprising, since the industrials tend to have more intangible assets such as brand name, patents, franchises, and trade secrets, which we generally do not find in public utilities. Not all 15 DJUA Issues Are Created Equal It is important to note that although none of the 15 DJUA issues met criteria, significant variations in quality and quantity are detected among the issues. Duke Energy, American Electric Power, NextEra Energy, Consolidated Edison, and Public Service Enterprise Group are five high quality issues meeting all five quality criteria, but failing one or both of the quantity criteria. These would be good stocks to buy after a correction. Stock Ticker Price D/E P/E Book value P/B (P/E)*(P/B) ROE Yield Duke Energy DUK 80.62 1.00 22.71 58.57 1.38 31.26 6.06% 3.94% American Electric Power AEP 57.83 1.15 14.96 34.48 1.68 25.09 11.21% 3.67% NextEra Energy NEE 101.08 1.54 22.26 43.10 2.35 52.21 10.54% 2.87% Consolidated Edison ED 64.14 0.99 17.43 43.39 1.48 25.77 8.48% 3.93% Public Service Enterprise PEG 40.46 0.74 15.44 23.89 1.69 26.15 10.97% 3.66% Average 1.08 18.56 40.69 1.71 32.09 9.45% 3.61% Interestingly, despite these five issues possessing better quality than the composite DJUA, they sell at lower prices relative to earnings and assets compared to the DJUA, with P/E only 71% and P/B only 90% of the composite index. Debt to equity is only 1.08, which is only 77% of the DJUA. Enterprising investors do not have to “pay up” for quality in this peculiar case, and can obtain higher quality utility stocks with lower risk at better prices relative to earnings and assets. Return on equity for this group is 9.45%, not bad given the regulatory environment of public utilities. Exelon also stands out, meeting both quantity criteria and 4 out of 5 quality criteria, failing only the earning growth criterion. The enterprising investor may considering buying if he deems the recent low earnings temporary and trusts the company to turn around eventually, while getting paid a 3.5% dividend to wait it out. On the other hand, AES is demonstrably an inferior issue compared to the average DJUA stock. It has significantly higher debt, multiple years of earnings deficits within the past decade, but nevertheless selling at higher price in relation to its net asset value. Edison International and American Water Works are also inferior issues to be avoided for similar reasons. Conclusion As we have seen, utility stocks, as represented by the DJUA, are unattractive investment options for the defensive investor today. Compared to 1971, utility companies have become somewhat more aggressive, but in vain, evidenced by poorer ten year earnings growth. The moat once enjoyed by regulated public utilities appears to have eroded. Despite the poor showing, the market amply values utility stocks today, much more so compared to 1971, and, in terms of price in relation to earnings. even more so than the DJIA today. This overvaluation is likely the result of the multi-decade low interest rate environment we are in today, since public utilities, with their higher dividend yields and generally higher debt on the balance sheet, are more bond-like compared to industrial issues. At the current extremely low levels, interest rate have nowhere to go but up, which will not hurt bonds, as I wrote in a previous article , but also bond-like investments like public utilities. The defensive investor is well advised to avoid the DJUA for now and wait for a more favorable entry point when interest rates revert to the mean.

Wisconsin Energy Continues To Be A Great Dividend Pick For The Long Term

Summary Developments have predominantly been positive since my previous article over a year ago. Specifically, positive developments like its merger with Integrys and a management that continues to be conservative yet practical outweighs negative ones such as effects of weather and the government. Although prices have increased since then, a DCF valuation on the company still indicates that there is still a margin of safety if investors buy shares today. It has been more than a year ago since I written about Wisconsin Energy (NYSE: WEC ), and subsequently added the company to my portfolio of dividend stocks. Since then, we have seen a 23% increase in stock price, its dividend increase twice to a level 24% above what it was then, and some remarkable evidence of its nature as a rock-solid high growth dividend stock. For those who are new to the company, here is some short background information: Wisconsin Energy was founded in 1981, and the company generates and also distributes electric energy. It generates electricity from coal, natural gas, wind, biomass and also from hydro-electrical sources; and then it provides electric utility services to a variety of industries, including the mining, food products and the retail industry. It also generates and sells steam. It is also the largest electric and gas utility company in Wisconsin, with 1.1 Million electric customers and another 1.1 Million natural gas customers. Besides all these, the company also invests in and develops real estate, like business parks and commercial real estate projects. Snapshot Price (12.12.2014) $50.38 Market Cap $11.36B TTM Income $611.20M (P/E: 18.8) TTM Sales $4.95B (P/S: 2.30) Book Value per Share $19.50 (P/B: 2.58) Return on Equity (ROE) 14.10% Debt/Equity Ratio 1.16 EPS Growth Past 5 Years 10.80% Dividend $1.69 (3.35%) Payout Ratio 57.3% Buy Thesis Do refer to my previous article for the main structure of the buy thesis. A substantial part of the buy thesis has largely remained the same. In this follow-up article, I will be focusing on the key changes between then and now. As the company has evolved since then, there has been both good and bad developments in the company’s prospects. Positive Developments Dividend Growth One plus point that has been evident over the past year is the company’s accelerating dividend growth. The company grew dividends by 20.4% from 2012 to 2013, and has increased dividends by further 8% this year. Besides this, the company has also recently announced that dividends would be grown by a further 8.3% to $1.69 annualised, which represents a yield of 3.4% on the last closing price. This is in line with management’s promises in 2012 to increase payout ratios to the 65%-70% range, which is near the industry average for utility stocks. In light of a forward payout ratio of 63% (drawing closer to management targets), I expect dividend growth to slow down slightly (nearer to the growth rates of earnings) going forward. A chart showing Wisconsin Energy’s dividend payments over the past 10 years can be found below: (click to enlarge) Conservative Management – Beating Earnings Estimates In addition, Wisconsin Energy management has continued their multi-year streak of earnings beats. As shown in the chart below, all of Wisconsin Energy’s earnings reports over the past 4 years has beaten EPS estimates. This shows that the Wisconsin Energy management team is very conservative in laying out their plans and estimates each quarter. This quality of under-promising and over-delivering is an outstanding one that will ensure both the company’s continued success in the industry and the satisfaction of shareholders. An earnings beat can also mean an increase in stock price, especially if it is significant. Hence, this can also bring some possible short-term price appreciation for shareholders Courtesy of zacks.com Acquisition of Integrys Energy In June 2014, Wisconsin Energy announced that it would purchase Integrys Energy for $9.1B. This deal, which is expected to bring a considerable amount of positive synergies for Wisconsin Energy (which will change its name to WEC Energy after the acquisition), will be completed next year. Courtesy of wisconsinenergy.com First and foremost, the acquisition will expand the area that Wisconsin Energy will be supplying, and increase the company’s power generating capacity from its current 6020MW to over 8700MW with the addition of Integrys’ power generators. The acquisition will also allow the company to operate 7 regulated electric and utility companies, making the combined company a leading electric and gas utility and the Midwest and also the 8th largest natural gas distribution company in the USA. In addition, the acquisition will also increase Wisconsin Energy’s stake in the American Transmission Company (NYSEMKT: ATC ) from around 20% to 60% . This will make the combined company the majority shareholder in the ATC. The ATC was founded in 2001 as the first multi-state, transmission-only utility in the USA, focusing only on the transmission of electric power from the generator to the areas where it is needed. This will give the new, combined company more flexibility in the transmission of electricity, and also an extra income source as a toll road if other utility companies are using it to transmit electricity. With all these benefits, the company’s management is expecting a long-term EPS growth rate of between 5% and 7% and for dividend growth to continue accelerating towards their target of a payout ratio between 65% and 70%. Undertaking Practical Projects For Safety In addition, Wisconsin Energy’s management has been (and will be) undertaking more practical projects for the safety of their infrastructure, instead of focusing on other projects for more ambitious projects such as expansion. As shown in the slide below, one of Wisconsin Energy’s points of focus over the next few years will be to upgrade their old, outdated infrastructure that might possibly compromise safety and efficiency. This shows how the management team knows their priorities, without neglecting the maintenance of their old infrastructure. It is no wonder, with such qualities, why Wisconsin Energy clinched the award for being the most reliable utility company in the USA for 2013. (click to enlarge) Negative Developments Mild Weather After the USA in general experienced an especially chilling winter in 2013, with phrases such as “polar vortex” commonly seen, weather this year has been considerably milder. The summer of 2014 was not as warm as usual, with articles stating that this year’s summer was just an extension of spring . This has decreased the electricity usage of American households, which has taken a toll on the earnings of Wisconsin Energy. For instance, Wisconsin Energy’s EPS in Q3 2014 declined from a year-ago $0.60 to an adjusted $0.57, which was due, in part to a 2% decrease in revenues to $1.03B year-on-year. The earnings release can be accessed here . Additionally, this mild weather is expected to continue this winter and also into next year. As shown in this National Geographic article , temperatures this winter in the Midwest (the region which Wisconsin is in) are forecast to be 16% warmer than in the 2013-2014 winter. This factor, with better than expected replenishment of fuel stocks, means that the average household will spend as much as 27% less this winter. Although this is great news for people, this will also bring decreased profits for utilities like Wisconsin Energy going forward, especially after experiencing a great boost in earnings from the harsh winter last year. In fact, analysts have already reflected such a trend in their estimates, with sales expected to decline 13% in Q4 2014 (year-on-year) and to decline by 2% in Q1 2015 (year-on-year). EPS figures are also expected to decline by around 10% year-on-year for each of the two quarters mentioned above. Such slower growth may take a toll on capital appreciation and the growth rates of dividends over the short term. But, I believe that this, in no way, impacts the company’s favourable future prospects. Government Regulations The government has been placing many regulations on utilities such as Wisconsin Energy of late, as part of a movement to reduce pollution to make the USA more environmentally-friendly. For example, the government has set targets for the company to meet in terms of the amount of energy to be powered by cleaner forms of energy such as natural gas (instead of coal) within a limited amount of time. Additionally, as shown in this news article , one of We energies’ power plants was converted from a coal-fired plant to a natural gas-burning plant instead. The change was needed since the plant previously lacked pollution regulations imposed by the government. More recently, the Environmental Protection Agency (EPA) proposed a regulation that would reduce carbon dioxide emissions from coal plants by up to 30% by 2030 as compared with 2005 levels, as shown here . With the regulation expected to come into effect in the near future, the company can expect to divest more funds towards projects to reduce emissions of harmful pollutants, and towards cleaner forms of energy or even renewable energy sources. All these regulations will cause higher expenditures, resulting in lower earnings and margins, which will not in the best interests of the company. Valuations I will be using the conventional DCF valuation method to value Wisconsin Energy. First and foremost, I will be calculating the discount rate (weighted average cost of capital) for both the current time period and the terminal time period (11 years later). I will be using the WACC formula in the image below. Courtesy of Investopedia.com With the risk-free rate (10 Year Treasury Bonds) at 2.08%, the Equity Risk Premium taken to be 6%, and Wisconsin Energy’s beta at 0.38, the company has a cost of equity of 4.36% Cost Of Equity=2.08%+(0.38*6%) Cost Of Equity=4.36% Since Wisconsin Energy’s interest expense this year of $252M has been generated from $5.26B in debt, we get a cost of debt of 4.80%. After tax of 36% (average tax for WEC over the past 5 years), the company’s cost of debt is 3.07%. The company had $5.243B in debt and $4.263 in equity as of fiscal year 2013. Weighting the cost of debt and the cost of equity by these two figures, we generate an initial WACC of 3.65%. WACC=4.36%(4263/4263+5243)+3.07%(5243/4263+5243) WACC=3.65% Following this, we calculate the final (terminal) WACC for Wisconsin Energy. For the cost of equity, we will assume that the risk-free rate in the USA stays at 2.08%, the equity risk premium stays at 5%, and the that the company’s beta remains constant at 0.38. This yields a cost of equity of 4.36% once again. For the cost of debt, we will assume that Wisconsin Energy has a debt/equity ratio of 85.35%, the industry average for the electric utility industry. In addition, we will also assume that the company’s cost of debt decreases from its current 4.80% to 4.09%, which is 2% above the risk-free rate- more typical of companies experiencing stable growth. Applying the same formula, we generate a final WACC of 3.56%, slightly lower than the initial WACC. Now, we will estimate the revenue, EBIT and FCF growth Wisconsin Energy will experience over the next 10 years. Here are some assumptions I made during the valuation process: Revenue Growth Forecast: With analysts expecting revenue growth rates of 2.8% next year (2015) due to expected mild weather, I will be conservative and will assume that revenues grow at 2.80% over the next 5 years, before slowing down from Year 6 to Year 10 at a constant rate to reach 1.46% in the terminal year. Since a general rule of thumb is for the terminal growth rate to not exceed the risk-free rate, the terminal growth rate in this valuation is set at 70% of the current risk free rate of 2.08%. Operating Margins: Operating Margins are expected to converge towards the industry average operating margins of 17.26%. Operating margins are assumed to stay constant throughout the first 5 years of the valuation, before declining at a constant pace from Year 6 to the terminal year. Tax Rate: The effective tax rate for Wisconsin Energy is at 36% this year, even though the average effective tax rate for the electric utility industry is 31.82%. Hence I assumed that the company’s tax rate would decline from 36% to 31.82% at a constant rate between Year 1 and the terminal year. Reinvestment (Initial Years) : Reinvestment refers to the amount the company will spend to grow itself in one fiscal year. It is the sum of Capital Expenditures and the change in Non-Cash Working Capital. I will assume that the company has a Sales/Capital ratio of 0.545 (average for electric utilities industry). Hence, the reinvestment figures you will see in the image of the excel spreadsheet below will adhere to this figure for the first 10 years of the valuation. Reinvestment (Terminal Year): The reinvestment rate in the terminal year will be computed by taking the terminal growth rate, divided by the final WACC calculated earlier in the valuation. With the above assumptions, we get the following numbers: (click to enlarge) All values in Millions By adding the Present Discounted Value of the FCFF values over the next 10 years, we get a value of $4.261B. The terminal value will be calculated by the formula below, and then discounted to give a present value of $13.798B. Terminal Value=Terminal Year Cash Flow/(Final WACC- Terminal Growth Rate) Terminal Value=$411.34M/(3.56%-1.46%) Terminal Value=$19.549B Present Value of Terminal value= Terminal value/(Final WACC)^10 Present Value of Terminal value= $19.549B/ (1.0356)^10 Present Value of Terminal value= $13.774B By adding the two present values up (PV of Terminal value at $13.774B and PV of FCF values of $4.258B), we get a total present value of $18.059B. Adding the company’s current cash holding and subtracting off its current debt holding, the final value of equity is $12.841B. Dividing by its current 225.52M shares outstanding, wits per-share value is $56.94. This is a 13% premium to the last closing price is $50.38. Takeaway In conclusion, even though Wisconsin Energy faces some challenges in the near future such as stricter government regulations and milder weather, the company’s buy thesis and dividend policies are still very attractive to me. Besides this, it is also worthy to mention that many of the projects that the company is undertaking will be beneficial to it over the long term, whereas many of the challenges (such as mild weather) are shorter-term in nature. Furthermore, a DCF valuation of the company indicates that there is a margin of safety, with 13% upside in WEC shares from current levels. Hence, I believe that Wisconsin Energy will continue to be a long term buy for new investors, and also a long term hold for my dividend portfolio.