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Westar Energy: A Progressive Utility With A 3.5% Yield

Summary Westar Energy harnesses wind in Kansas for cheap power. Westar Energy retiring three old coal and gas plants. Westar implemented a $78 million rate increase in October. Westar Energy (NYSE: WR ) is a progressive utility company that is aggressively moving to clean power. Westar Energy plans to nearly double its clean power while reducing fossil fuel energy by 7%. In my previous article about Westar Energy, I told investors to buy this stock around $37 per share as the company adds cheap wind power while reducing coal. Kansas has some of the strongest winds in the country. Westar is prepared for tougher environmental regulations from the Clean Power Plan. The Clean Power Plan establishes state-by-state targets for carbon emissions reductions, and it offers a flexible framework under which states may meet those targets. The final version of the rule would reduce national electricity sector emissions by an estimated 32% below 2005 levels by 2030. Westar Energy has sufficient capacity right now to meet demand. But on a conference call with investors, Mark Ruelle, president and chief executive officer, said the investment in wind is primarily because it’s so inexpensive with the tax credits. The move also is a bit of a hedge on what form the Clean Power Plan takes in Kansas. Ruelle said wind energy is a bargain right now. (click to enlarge) Ruelle said Westar Energy has sent out requests for proposals to add another 500 megawatts of power. Right now 9% of Westar’s generation is from renewable resources, but that number will grow to 17% of generation in 2016. Nearly all of this energy will be from wind. Westar Energy’s energy generation mix includes 700 megawatts from wind energy, with commitments to add another 600 megawatts under development for a total of 1,300 megawatts. In addition, Westar is now considering adding another 500 megawatts on top of the 1,300. “We’re continuing to evaluate, but right now it looks like it makes more sense for our customers if we own all of our sizable portion of the incremental renewables,” Ruelle said. “Today our renewables portfolio is heavily imbalanced for PPA (Purchase Power Agreement) vs. ownership and if we don’t re-balance it a bit that might set us and our customers up for problems down the road when the PPAs expire, plus customer economics favor ownership,” Ruelle said. Westar Energy recently announced plans to close three small units at Lawrence, Tecumseh and Hutchinson by the end of the year. These are the first major unit that Westar has closed in the past few decades. The Lawrence and Tecumseh units burn coal, and the Hutchinson one uses natural gas. “It’s been good for our customers to hold on to these small old units as long as we reasonably could, but for a number of reasons, now is the right time to let them go,” Ruelle said. “They have lasted decades longer than anyone ever imagined, some of them are older than me, but given the clean power plan, their age, size and our need to manage expenses, it just doesn’t make sense to pour more money into them. They reflect two small 50s and early 60s vintage COLI units and a 60s vintage gas steamer. Together they are just 350 megawatts and less than 1% of plant investment.” Third quarter Westar Energy’s third quarter was sluggish. Cool-to-mild temperatures in August hurt demand for electricity. Westar Energy posted 3Q15 earnings of $138.2 million or $0.97 per share, compared with $146.9 million or $1.13 per share in 3Q14. Earnings for the nine-month period ended Sept. 30, 2015, were $253.4 million or $1.84 per share, compared with $270.3 million or $2.08 per share for the same period in 2014. The company has narrowed its 2015 earnings guidance range to $2.18-$2.25 per share from $2.18-$2.33. The company issued preliminary 2016 earnings guidance of $2.38-$2.53 per share. The company has strong financial strength. The company’s debt is investment grade. Total long-term debt was $2.941 billion at the end of 3Q15, compared to $3.224 billion at the end of 2014. The stock trades around 18.8 times earnings, which is a slight premium to its peers. Westar will see earnings improve in the fourth quarter and in 2016 due to implementation of a $78 million rate increase, approved by the Kansas Corporation Commission. Risks Utilities are sensitive to interest rates. When the Federal Reserve begins raising interest rates, these stocks are likely to take a hit. Utilities had a nice run up in 2014, but haven’t performed well in 2015. The Utilities Select Sector SPDR Fund (NYSEARCA: XLU ) is down -9.47% YTD. Westar stock has held up fairly well in 2015, down only -1.14% YTD. Ruelle said one large chemical producer had reduced consumption of electricity due in part to the low prices for oil. I believe we are near a bottom in oil but the price recovery will be slow and arduous. Weather is always a factor with utilities. Westar benefits from extremely hot temperatures in the summer and really cold temperatures in the winter. 2015 was mild to moderate most of the year in Kansas. Conclusion If Westar falls into the high $30s again, investors may want to consider buying the stock. Westar is a well-run utility with strong financials and steady income. The stock offers a yield of 3.5% with potential for modest appreciation. I bought WR at $37.03 on Aug. 27, 2015. The stock recently traded at $41.32 per share, a gain of 11.58% plus the gain from the $0.36 dividend for a total gain of 12.55%. I’m holding o nto the stock. Long-term investors will get the dividend and likely modest appreciation with a 12-month target price of $44.

Why You Should Own Utility Westar Energy

As regulated assets increase with reduced debt and equity needs, the incremental earnings should improve overall ROIC. With the decline in share price since peaking in January, Westar offers an acceptable yield and low payout ratio of around 64%. Kansas has a neutral regulatory environment, but growth is pegged to FERC-regulated transmission assets. Westar Energy (NYSE: WR ) is a mid-sized regulated electric utility in the heart of the Midwest. The company service 700,000 electric customers in central and northeast Kansas. WR also has a relatively high 6,200 miles of transmission lines and seven power plants with generating capacity of 7,160MW. There is a lot to like about WR from a longer-view perspective. Over the past 5 years, stock price performance has kept up with the Dow Jones Utility Index (DJU) and outperformed the S&P Utility Index (NYSEARCA: XLU ). However, over the last 6 months, WR has performed worse than these indexes by losing around 12% vs. 5% for the overall peer index. Morningstar reports 1-yr total return at -1.0% vs. its regulated electric utility peers at 3.1%, 3-yr total return at 9.3% vs. 11.3% respectively, 5-yr return of 14.1% vs. 11.3% respectively, and 10-yr total return at 7.6% vs. 8.3% respectively. Below are 5-yr and 6-month price only charts: 5-yr 6-month Westar’s Equity Quality rating by S&P Capital IQ for 10-yr consistency in earnings and dividend growth is A-. This falls within the top 25% of all publicly traded utilities with 10 firms rated A+ or A, and 15 firms rated A-. WR has an average credit rating at BBB+. Westar has been investing in its regulated asset base for the past several years. While WR has one of the largest capital expansion programs of a utility its size, free cash flow has remained almost neutral over the previous 2 ½ years. Previous expansion of WR regulated assets is driving the current growth in operating cash flow. For example, in 2011 and 2012, WR invested a combined $1.5 billion but had operating cash flow of just a bit over $1.0 billion, generating a free cash flow deficit of $500 million. However, in 2013 and 2014 combined, WR invested $1.6 billion and its operating cash flow increased to $1.5 billion, reducing the free cash flow deficit to $100 million. Over the trailing 12 months, WR has invested $821 million while generating operating cash flow of $800 million, for a deficit of only $21 million. Morningstar’s analysis of this asset driven aspect for Westar: Between 2006 and 2013, Westar increased its asset base from $5.5 billion to $9.6 billion, and we expect that it could top $11 billion by 2017. Its equity base has doubled since 2007 with its investments in new power plants, environmental upgrades, wind farms, and large transmission lines. With cash flow tight, investors have had to settle for pedestrian 3% annual dividend growth. But as Westar’s investment pace slows and rate increases flow in, dividend growth should accelerate. In addition, as Westar’s investment mix shifts to higher-return transmission projects, earned returns and cash flow should grow. Westar is waiting on a decision on a rate case that could increase rates by an average of 7.0% to 7.9%, and would represent the first rate increase since 2012. Included in the rate request will be approval of $600 million in upgrades to coal plants for environmental investments and to its nuclear plant to expend its useful life. While the company is requesting a $152 million rate increase, it is likely the PUC will approve around $135 million. In dealing with the issue of distributed generation, WR’s rate request include higher fixed charges with the monthly fee increasing for $12 to $15 in year one and to $27 by year four. If approved, the rate plans would shift a greater percentage of Westar’s revenues to fixed monthly fees, which better reflects the utility’s cost to serve its customers. Kansas is considered by S&P Credit to be a neutral regulatory environment. The anticipated allowed ROE for its state-regulated assets will be set at 10.0% with the resolution of the pending rate case. About 18% of WRs asset base are federally regulated transmission assets with a higher allowed ROE of 11.3%, and some projects in central Kansas carry an allowed ROE of 12.3%. However, the Kansas utility commission has filed an appeal to the FERC to reduce transmission ROE to just below 10%. Westar has a growing transmission profile as transmission investments will be about a third of the firm’s total cap ex budget. Currently, transco assets account of about 18% of its total regulated rate base at $1.1 billion. The company is expected to almost double the transco base over the next four years by investing $225 million a year in this business. Westar’s service area is smack in the middle of the wind-generating corridor of the Midwest with an abundance of project to connect wind farms with several grid operators to the north and south. Westar is well-versed in the transmission business and has a joint venture with American Electric Power (NYSE: AEP ) and MidAmerican Utility. On a per mile valuation comparable to ITC Holdings, the major independent publicly traded transco, Westar’s current network could be worth about $2.5 billion, or about $20 a share. With a target growth in base assets of 18% to 20% annually, not only is the regulated transmission business more profitable, but also is gaining sufficient critical mass to be considered an independent company. With the industry on the cusp of financial engineering for transmission assets, Westar is well positioned. Westar operates in a stable economic environment as described in their fourth qtr. conference call: Turning to the Kansas economy, it continues to hum along. Year-end unemployment was just over 4%, a level not seen since 2008. And it remains 150 basis points favorable to the nation. Small business formation continues at a good pace with most of that right in our service territory. Recent articles have touted our part of the world. Topeka was recently ranked America’s top ten most affordable cities by livability.com and a new report by the Brookings Institute ranked Wichita, which is our largest city that we serve, third in the nation among top 100 metro areas for concentration of jobs in advanced industries. These instances and a state report showing a 6% increase last year in the number of new businesses registered validate our outlook for our Kansas economy that has a lot of offer. Westar has historically generated above average return on invested capital ROIC. In an industry where the average ROIC is between 4% and 5%, since 2004, WR has consistently generated ROIC in the 5.5% to 6.0% level. Below is a 20-yr ROIC chart courtesy of fastgraph.com. (click to enlarge) With a weighted cost of capital of 5.2%, as calculated by ThatsWACC.com, management has barely generated sufficient returns over its cost of capital. On the brighter side, there are utilities that generate negative Net ROIC. However, as regulated assets increase with reduced debt and equity requirements, the incremental earnings should improve overall ROIC. Westar is trading at a slight discount to its peers with a forward P/E of 13.7. Below is a table from morningstar.com reflecting higher operating statistics such as 3-yr revenue and net income growth and operating margins compared to industry averages. However, these attributes is not reflected in the share price. Source: morningstar.com Fastgraph.com historic graph suggests WR is fairly valued. At the end of 2014, the yield was 3.4%, but has improved to a more historic year-end average of 4.1% yield (the downside to the yield improvement was a decline in price). Dividend growth has been a bit shy of many in the utility sector but could ramp up as earnings continue to grow at 6% a year. With the financial troubles of the early 2000s, an annual increase in the dividend goes back only 10 years, a bit light for a utility with Westar’s roots. The low payout ratio of 64% allows management to increase the dividend faster than its underlying earnings growth without jeopardizing its financials. (click to enlarge) The June investor’s presentation is one of the most through descriptions of various aspects of their business. Even current shareholders should learn something new by reviewing the information and it is recommended reading. However, Westar has a bit of a tarnished history . In 2002, then-CEO David Wittig and his Chief Strategic Officer were fired for alleged financial improprieties and the company, then known as Western Resources, almost went bankrupt. Wittig was convicted in federal court of 39 counts of financial malfeasance in 2005, but it was over turned in 2007. Amazingly, Wittig settled with Westar in 2011 to the tune of $42 million in compensation and legal fees from an unjust termination dispute while his underling negotiated a $22 million deal. In recap, Westar offers acceptable historic returns based on its peers, high quality ratings, rising operating cash flow to fund aggressive regulated asset accumulation, pending rate relief, good regulatory environment, growing regulated transmission asset base, increasing economic environment, stable ROIC and positive Net ROIC with the potential for increasing returns. With a typical current utility yield, the potential for above-average dividend growth is also attractive. What’s not to like about that? Author’s Note: Please review disclosure in Author’s profile. Disclosure: The author is long AEP. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.