There are selective opportunities within the electrical utilities sector that have potential inflection points to reward the consilient investor. The issue is, these opportunities are fiendishly hard to find.
There are two major issues that make uncovering the gems difficult. One, there are no consumer advantages or cost differentiation benefits, nor are there any cost leadership opportunities. Electricity pricing is dictated by the market, and, all suppliers are selling electricity and offering nothing different. Two, investment + reinvestment requirements are high to maintain its competitive position (even more so with the pivot to renewables) without the growth to show for it.
On careful examination, these two headwinds are relevant in the investment debate for MGE Energy, Inc. (NASDAQ:MGEE) in my informed opinion. MGEE is a diversified company with several subsidiaries operating across 5 different business segments. These include regulated operations for both electric and gas utilities, as well as nonregulated energy operations aimed at meeting energy needs of customers. Additionally, the company has transmission investments through its equity stake in ATC and ATC Holdco.
MGEE’s investment proposition is marred by flat returns on capital, and heavy asset/reinvestment requirements to maintain its competitive position. The company mentions this itself in its latest filings:
“MGE continues to face the challenge of providing its customers with reliable power at competitive prices. MGE works on meeting this challenge by investing in more efficient generation projects, including renewable energy sources.”
This report will unpack all of the moving parts in the MGEE investment debate, linking it back to the broad hold thesis. Net-net, I rate MGEE a hold for the reasons raised here today.
Critical investment factors underpinning the hold thesis
1. Q2 FY’23 insights
In Q2 MGEE put up operating revenues of $148mm, down ~$2.5mm YoY, on operating income of $38.4mm, a 50% growth rate on last year. It reported earnings of $22.2mm on this, up ~58.5%. MGEE also got permission from The Public Service Commission of Wisconsin (“PSCW”) to increase retail electric rates by around 9.01%. This generated $10.2mm in extra revenue from its retail markets over the year. However, gas retail sales were lower in H1 ’23, mainly due to the warmer weather, resulting in a sales decrease of ~12%. Additionally, heating degree days (a critical weather-related factor to MGEE’s unit economics) declined by ~14% during the firsts half as well. Pre-tax margins have decompressed by ~10 points from Q2 last year, as seen in Figure 2, alongside the split of electricity sales in kWh. For the quarter, it sold a total of 822,202 kWh to the market.
In the first half of ’23, MGEE invested $107.7mm in CapEx, a growth of $41.7mm YoY. This was due to the acquisition of 25 MW of West Riverside and the purchase of the Red Barn wind farm.
Moving forward, MGEE plans to allocate more than 40% of its total CapEx from 2023—2027 toward renewable generation projects. On the list already includes:
- Red Barn—Wind; 9.16 MW),
- Badger Hollow II—Solar; 50 MW),
- Paris—Solar and battery; 20 MW/11 MW),
- Darien—Solar and battery; 25 MW/7.5 MW), plus
- The PSCW solar project, Koshkonong—Solar and battery; 30 MW/16.5 MW.
2. Economic value analysis
As mentioned earlier, electric utilities, more often than not, are a case of intense capital requirements with slow growth to show for it. We see this for MGEE in a number of ways.
For starters, the firm’s cash conversion cycle (“CCC”) nearly doubled from Q2 ’22—’23, lifting from 32 days to 60 days, as seen in Figure 2. This, despite DSO tracking lower to 39 days. Whilst these are still good numbers, it shows the rate of cash collection has slowed for the company, which means more cash is tied up in NWC and less available for shareholders.
MGEE had deployed ~$2.1Bn of cash into capital at risk in the business as of Q2, ~$58/share. The $58/share produced $3.60/share in trailing NOPAT last period, above 2020 levels, but still just 6.2% return on investment. The culprits behind this are clear, and relate to points raised in the introduction:
- Post-tax margins are relatively low at ~18–20% on average, bringing in $0.18–$0.2 per $1 of investment. This shows the lack of consumer advantage, and lack of cost differentiation—it is a price taker in this regard.
- At the same time, capital turnover is also low, at ~0.3x on average the last 2.5 years. This relates to the pricing mechanisms MGEE must accept, in that it can’t offer supply to the market at below industry rates. But more critically, it shows the firm doesn’t enjoy any production advantages or efficiencies that could drive this number higher.
Instead, the reinvestment requirements are high, but the earnings recycled on this are statistically low.
I treat companies as investors/stewards of capital. Business investment decisions are measured as the rate of return on capital deployed. This is akin to our return on investment by outlaying capital to any kind of asset. If a company is going to compound capital, you’d expect it to be doing so at higher rates than market averages to create economic value (12% here) and to be worth more in intrinsic value. The market is a fairly accurate judge of fair value over time, so it will tend to recognize these facts as well.
A 6.2% rate of return on capital is behind long-term market averages and thus misses our 12% hurdle rate imposed here. Figure 5 depicts what MGEE needed to produce in order to hit this mark since 2020. For example, it needed to throw off $252mm in NOPAT last period, but did $130mm (TTM values) and thus produced a $121mm economic loss equating to negative $3.36/share. In 2020, it was a $114mm economic loss and negative $3.14/share. This doesn’t represent value to me, and capital is likely more valuable in our hands.
3. Expectations and forecasts at steady-state of operations
The critical value drivers of MGEE’s operations for the past 3 years are seen in Figure 6. Sales have grown at a 3% rate on stable operating margins averaging 22.7%.
Critically, each new $1 in sales growth has required $1.70 of reinvestment for MGEE over this time to maintain its competitive position. So each new $1 in sales the firm had to increase its fixed assets by $1.45 and commitments to NWC by $0.25. This hammers in what I’ve been rhapsodizing about here today—the reinvestment requirements are high, without the growth to show for it.
These steady-state numbers are reasonable expectations to carry forward in my view. Figure 7 shows 1) the expected sales and profit numbers, 2) the capital/investment requirements, and 3) the rates of return on capital at these stipulations.
If it were to continue growing at ~3% each period, it’s likely MGEE would need to invest ~27–28% of NOPAT each period, around $37–$43mm (~$120–$170mm annualized) of capital investment. I’d still see ~6–7% returns on capital moving forward, meaning it could compound its intrinsic value at ~3% each period going forward.
4. Technical factors for consideration
The stock has broken key technical levels and now trades with a pessimistic trend in my view.
On the daily cloud chart in Figure 8, both price and lagging lines cross beneath the cloud in August. You’d need a break above $76.00 to cross into bullish territory again based on this chart. The daily chart looks out to the coming weeks, so I am neutral on MGEE over this time frame at least.
The weekly chart, looking to the coming months, reveals similar findings. The stock is now testing critical levels at the cloud top having been rejected at this level last week. The lagging line (in blue) has crossed beneath the cloud and doesn’t support a bullish reversal at this point. Based on this setup, I am also neutral on the company over the coming months as well.
Finally, we have downsides to $65/share on the point and figure studies below. You can see the P&F studies have eyed the price action well in the past. It caught the $74/share range off the top which is where MGEE trades as I write. The $65 level could be one to look out for in my view, further supporting a neutral stance.
Valuation and conclusion
The stock sells at 23x forward earnings and 22.8x forward EBIT, and these are pricey in my view. For one, you’re paying ~30% and 23.5% premium to the sector, respectively. Secondly, to pay $23 for every future $1 in EBIT/earnings you’d expect the growth profile to support this. Either that, or to see profits growing off a stable, and small, capital base.
This isn’t the case here. In fact, the market has priced it at just 1.6x invested capital, showing it expects flat earnings power off these investments going forward. My estimates imply any future business upside may be well reflected at its current market values.
Carrying the steady-state numbers in Figure 7 out to FY’28, then compounding its intrinsic value at the function of ROIC and its reinvestment rates, this gets you to an implied intrinsic value of $71/share, in line with where MGEE trades today. This also supports a neutral view.