As a dividend growth investor, I tend to balance the past with a forward-looking focus. The past can’t tell an investor everything, but it could be a decent place to start.
In the case of 3M (MMM) which I alluded to in a recent article about Automatic Data Processing (ADP), there were signs the former’s payout was going to be slashed.
Through 2023, the company’s earnings fell in four out of five years. They are expected to fall by another 8% in 2024 to $7.11 per FAST Graphs. Add mounting litigation against the company to the mix, and it was only a matter of time until a dividend cut.
The past several years of results were a good indicator that something was amiss at 3M. Digging deeper into the company’s fundamentals as Dividend Sensei did last October would have further confirmed this suspicion to be correct.
On the opposite end of the spectrum, it is usually quite obvious when a company is on the path to becoming a Dividend Aristocrat. Just invert what happened to 3M, and this is what allows a business to join that illustrious class.
Today, I’ll be revisiting one of my favorite utilities, WEC Energy Group (NYSE:WEC). The electric and gas utility comprises 0.8% of my portfolio, which makes it my second-largest utility holding behind American Electric Power (AEP). When I last maintained my buy rating in February, there were several characteristics that I liked about WEC:
- The company has delivered earnings growth in all of the last 20 years. At the time, the analyst consensus looking out through 2026 anticipated another three years of healthy dividend growth.
- The utility enjoyed an A- credit rating from S&P on a stable outlook.
- WEC Energy had a track record of 21 consecutive years of dividend growth.
- Shares looked to be significantly undervalued.
Briefly, the first-quarter results for March 31 that were shared on May 1 were respectable. Revenue missed the analyst consensus for an understandable reason, but diluted EPS topped expectations and climbed higher. The company’s growth prospects and financial health both remain intact. Lastly, WEC’s shares still look to be discounted by a double-digit percentage versus my fair value estimate.
A Solid Start To 2024
In my view, WEC had a decent start to 2024. The company’s operating revenue decreased by 7.2% year-over-year to nearly $2.7 billion during the first quarter. This came in $260 million below the analyst consensus per Seeking Alpha.
Why would I be satisfied with this seemingly sizable operating revenue miss? Readers who follow my utility coverage on Seeking Alpha or who are familiar with utilities probably already know what’s up.
For those who don’t, there is a reasonable explanation for this topline decline. As an electric and gas utility, WEC’s biggest expense item is “cost of sales.” The expense item mostly consists of commodities that are used to supply customers with electric and natural gas services.
Since natural gas prices were down over the year-ago period, the cost of sales was as well in the first quarter. As a regulated utility, the lower cost of sales for WEC translates into lower bills that are charged to its customers. This is what caused the dip in operating revenue.
On the flip side, these much lower costs more than compensated for the downside to operating revenue. The company’s diluted EPS climbed 22.4% higher year-over-year to $1.97, which was $0.06 ahead of the analyst consensus according to Seeking Alpha. Led by a plunge in the cost of sales, WEC’s total operating expenses dropped by 15.9% to ~$1.9 billion over the year-ago period for the first quarter.
This helped the utility’s net profit margin to expand by over 560 basis points to 23.2% during the first quarter. Along with an unchanged weighted average diluted share count, that is how WEC’s diluted EPS soared higher as operating revenue moved lower in the quarter.
For 2024, WEC reaffirmed its guidance of between $4.80 and $4.90 in diluted EPS. At the top end of the company’s guidance, this would represent a 5.8% year-over-year growth rate versus the $4.63 in 2023 diluted EPS. My confidence that WEC will hit the top end of its guidance or even exceed is supported by a few factors.
For one, it is the only utility that has beat guidance every year for 20 consecutive years. This speaks to the consistency of WEC to deliver on its promises, which is very impressive to me.
Secondly, as I noted in my previous article, the company has a record $23.7 five-year investment plan in progress. WEC’s Executive Chairman, Gale Klappa, noted in his opening remarks during the Q1 2024 Earnings Call that he believes this plan includes projects that are “low risk and highly executable.”
Finally, it isn’t hard to understand why Klappa believes this to be the case. WEC operates primarily in Wisconsin, which is a constructive regulatory environment. For context, approximately 70.8% of the company’s $8.7 billion in 2023 operating revenue was derived from the company’s regulated electric and natural gas operations in the state (page 30 of 199 of WEC’s 10-K filing).
Looking out beyond this year, the FAST Graphs analyst consensus is that diluted EPS will rise by 7.6% from the 2024 consensus to $5.24 in 2025. Another 6.7% diluted EPS growth to $5.59 is expected in 2026.
For 2025 and 2026, WEC recently filed applications with Wisconsin’s Public Service Commission for proposed revenue increases for electric and natural gas. These ranged from the mid-single-digits to 10%.
As a regulated utility, the company is still at the mercy of regulators and consumer advocacy groups for approval of these proposed revenue increases. However, WEC’s typical residential bills clock in below the national average and are in line with utilities throughout Wisconsin and the Midwest.
My best guess is that consumer advocacy groups will get the amount of these rate increases lowered a bit, but WEC will mostly get what it wants. This way, everybody will come out with a win.
Regulators and advocacy groups can point out that they’re looking out for consumers’ interests. WEC can come away with more revenue. This will also support continued investment in infrastructure to keep providing quality service to customers.
The utility’s financial positioning remained healthy to kick off 2024 as well. WEC’s interest coverage ratio was 4.7 in the first quarter, which was up incrementally over the 4.4 interest coverage ratio from the year-ago period. For the reliability that comes with being a great regulated utility, this suggests WEC is financially robust. That is why it enjoys an A- credit rating from S&P on a stable outlook (unless otherwise sourced, all details were according to WEC’s Q1 2024 Earnings Press Release and WEC’s April 2024 Investor Presentation).
Shares Could Be Worth The Mid-$90s
On top of its encouraging fundamentals, WEC arguably still has a compelling value proposition. As there are more income alternatives to utilities with higher interest rates in recent years, this has weighed on demand and sentiment.
That is why WEC’s shares are priced at a current-year P/E ratio of 17. Relative to the 10-year average of 20.8, this would be a substantial discount. The macro environment probably won’t justify a return to quite as high of a valuation multiple. Interest rates are likely not going back to zero anytime soon, if ever.
But as interest rates are lowered by 150 or 200 basis points, the appeal of utilities like WEC to income investors should return. The nearly 7% compound annual earnings growth rate forecast through 2026 is also just above the 10-year average. For these reasons, I think a reversion to a more middling valuation multiple of around 19 is on the table.
WEC’s pending rate cases and capital spending plans to keep growing the rate base bode well for future growth. That’s why I think the FAST Graphs diluted EPS inputs of $4.87 and $5.24 for 2025 and 2025, respectively, are reasonable.
Weighing for the 65% of 2024 that remains and 35% of 2025 ahead in the next 12 months, I get a weighted average earnings input of $5. Plugging in a 19.2 valuation multiple, my 12-month forward fair value is $96 a share. Compared to the $83 share price (as of May 3, 2024), that would represent a 14% discount to fair value.
If WEC can grow at least as anticipated (as it has done for 20 years and counting) and return to such a multiple, 40%+ cumulative total returns could be justified through 2026.
Four Years Away From Dividend Aristocracy
WEC’s 4% forward dividend yield is in line with the utility sector median of 4%. That explains the C+ grade for forward dividend yield from Seeking Alpha’s Quant System.
The company’s 21-year dividend growth streak is more than double the utility sector median of 9.7 years per Seeking Alpha. This is likely why WEC earns an A+ grade for consistency from the Quant System.
Boasting a 7.8% compound annual growth rate in the dividend in the last 10 years, WEC’s dividend growth rate is much higher than the sector median of 5%. This is probably why the utility has a B- mark from dividend growth from the Quant System.
The dividend also should keep growing by around 7% annually in the years to come. This is because WEC’s 68% EPS payout ratio is below the 75% that rating agencies desire from the industry. The company’s 54% debt-to-capital ratio also implies that the balance sheet won’t get in the way of this dividend growth, either.
WEC is slated to pay $3.34 in dividends per share in 2024. Against the $4.90 top-end diluted EPS guidance, that would be a 68.2% payout ratio. This is within the 65% to 70% payout ratio that the company targets. That’s why I’m quite optimistic WEC will extend its 21-year dividend growth streak to 25 years in 2028. Thus, making it a newly minted Dividend Aristocrat.
Risks To Consider
WEC is a tremendous business, but it has risks that merit a discussion.
The company’s significant concentration in Wisconsin is a two-fold risk. First off, this makes the company more vulnerable to regulatory risks. That includes the potential that the state’s Public Service Commission could issue unfavorable outcomes on WEC’s pending rate cases. If this did happen, it could have an outsized and negative impact on the company’s future growth.
Additionally, operating risk could be elevated with this geographic concentration of the business mix. Natural disasters like wildfires or windstorms could damage WEC’s infrastructure beyond the amounts covered by its commercial insurance. Operations could also be interrupted, which would affect results.
If WEC was found liable for any property damage or loss of life in surrounding areas, that could hurt the company through litigation, too.
Summary: A Quality Dividend Growth Stock On Sale
WEC is an all-around great business. Few companies can match the reliability of their earnings growth. The A-rated balance sheet is keeping the cost of capital low. The dividend is well-covered and has room to keep growing for many more years. Finally, the stock’s valuation looks to be discounted. These reasons are the foundation of why I’m reasserting my buy rating.