I always look for additions to my dividend growth portfolio. One sector that I have limited exposure to is the utilities sector. While I am, in general, a fan of the business model, a regulated utility, I understand that it contains significant growth limit that comes with the relative safety. Therefore, it is very hard to find a fast-growing utility company.
A good friend of mine asked me to look again at Xcel Energy (XEL) after I analyzed it twice in the last five years. The last analysis was before COVID-19 fully hit the American economy, and as the company is focused in Texas that was hit hard by COVID-19, I believe it is a good time to take another look at the company. In my previous analysis, I didn’t find the company worthy of addition to my dividend growth portfolio.
As always, I will use the following graph to analyze the company. I always use this graph for analyzing companies since it’s crucial to have a consistent methodology that allows me later to compare the investment options. I am going to analyze the fundamentals, valuation, opportunities, and risks of Xcel Energy.
(Graph made by author)
According to Seeking Alpha company profile, Xcel Energy engages primarily in the generation, purchase, transmission, distribution, and sale of electricity in the United States. It operates through Regulated Electric Utility, Regulated Natural Gas Utility, and All Other segments. The company generates electricity through coal, nuclear, natural gas, hydroelectric, solar, biomass, oil, wood/refuse, and wind energy sources. It also purchases, transports, distributes, and sells natural gas.
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Over the past decade, the company has managed to achieve top-line growth of less than 1% annually. While the figure is extremely low, it isn’t very different when compared to its peers. Due to the nature of the business, the ability to raise prices is very limited, and value is driven by the ability to bring new projects online and increase efficiency, and this is where Xcel Energy excels.
The bottom line is very impressive, especially when we take into account the low top-line growth. This 6% annual growth is expected to continue according to analysts in the medium term. This growth is achieved by cost cutting and improved efficiency as well as new acquisitions that grow the company’s customer base. In 2020, the company acquired a wind farm from NextEra (NEE) and increased its exposure to green energy while increasing the number of customers.
The company is offering an extremely safe dividend with a payout ratio lower than 60%. It is a low payout for utilities, and in my opinion, the risk of a dividend cut is slim to none. However, with the low payout comes low yield, and when compared to its peers, XEL offers a relatively low entry yield. On the other hand, it offers higher dividend growth, as the dividend grew at around 6% annually. The company offers a safe dividend with medium growth rate trajectory, but the price you must pay for it is relatively low yield.
The number of shares outstanding is growing over the past decade. The reason for that is that the company is constantly raising cash by issuing stocks and bonds to fund its growth project and acquisitions. I am not a fan of share issuance as it dilutes the current shareholders and requires more funds to pay the same dividend and, therefore, requires highly efficient capital allocation.
The valuation today is more attractive when I compare it to the last time I analyzed the company. Back then, the forward price to earnings ratio was above 25, and now, it’s 23.65. I still believe that the valuation is too high, and you can see that, while the S&P 500 rose almost 50% since I analyzed XEL, the share price of XEL stayed the same, and I believe that, with the current valuation, this trend of significant underperformance is here to stay.
The graph below from Fastgraphs.com is also implying the company is overvalued. The average P/E ratio for XEL is a little bit less than 16. Right now, the P/E is 23.65, and it is hard to justify with the current growth rate such rich valuation. I believe that the dividend is safe, but investors will see very low total return if they buy the shares at the current price.
To conclude, Xcel Energy offers its investors very decent fundamentals when compared to its peers. Strong earnings growth, together with safe dividend that grows much faster than inflation. However, the valuation is very rich, and while the fundamentals are strong, they are not strong enough to justify such valuation.
The company is having a good regulatory environment in most of the states the company operates in. The main example is Texas which has a very pro-business attitude. Even in other states where the environment is not as pro-business, the fact the company is focusing on becoming “greener” and more focused on renewables allows it to maintain good relationship with the regulator. Renewable energy is a major investment for XEL, and it suits the needs of its customer base.
Another opportunity is the great execution and capital allocation. The company managed to achieve higher earnings growth despite low top-line growth. I credit the management that achieves its growth goals by allocating capital to new projects and mergers and acquisitions in a manner that allows it to achieve higher than average growth.
Moreover, the company shows high profitability with high return on equity and operating margins. The return on equity is constantly at 10% or above, and during the past three years, it is stable at 11%. At the same time, the operating margin is close to 20% which shows that the company is efficient when compared to other utilities. I believe that the margin should exceed 15%, and XEL is doing it very well.
The company is a regulated monopoly. While, for some companies, it can be an advantage, for Xcel Energy, it’s a disadvantage. The limitations of the regulations come with the ability to be a monopoly. Companies which are poorly run may enjoy it, but companies like XEL with its great capital allocation suffer more from the limitations. The gains from being a monopoly are limited as I believe that the management could have achieved higher returns if it wasn’t so tightly regulated.
Another risk is the negative free cash flow. In the last decade, the company showed negative free cash flow every year. This happened due to massive investment, acquisitions, and mergers. However, this has come with price, higher debt level, and dilution of shareholders. As long as the capital allocation is efficient, the price is worth it, but it is still a risk in case the company invests in bad projects and has to deal with its high leverage.
I am also concerned by the fact that the company doesn’t offer investors decent margin of safety. The company is priced for more than perfection. Even if the company maintains its great track record of EPS growth, it will take the company almost a decade to get back to its average valuation. During that time, investors may find themselves lagging the S&P 500 significantly, and for an insufficient compensation.
Xcel Energy is probably one of the best companies in the utilities sector. It offers good capital allocation that is translated to strong earnings growth which in turn is translated to strong dividend growth. In addition, it is my opinion that the opportunities outweigh the risks for investors. However, the valuation, while more attractive than it was a year ago, is still unjustifiable.
Due to the high valuation, there is no margin of safety, and while the company is roughly at the same price it was in March, any case of lower expectations or lower earnings might initiate a massive sell-off. Therefore, at this price, I will not be initiating a position in the company. I would reconsider when the forward P/E is closer to 18.
Disclosure: I am/we are long NEE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.