Before its rebound, the S&P 500 was briefly in correction territory late this month. Despite the return of volatility to equity markets to begin 2022, I have been undeterred in my commitment to dollar-cost averaging into high-quality dividend growth stocks. Why is that?
Well, I have found that dividend growth stocks help me to sleep well at night during market uncertainty. That’s because said stocks have such reliable and well-run business models that they can raise their payouts to shareholders regardless of the operating environment.
Today, I’ll be revisiting a favorite of my portfolio for the first time since last October. That stock is the electric and natural gas utility WEC Energy Group (WEC). Let’s look at a few reasons why I like WEC Energy Group and also go over the risks facing the company.
A Proven Dividend Grower With Growth Left In The Tank
Since steadily rising dividend income is what helps me navigate wild market activity, I must buy stocks with a high probability of future dividend growth.
I believe it’s helpful to compare the yield of a dividend stock to that of its industry to get an idea of whether the dividend is unsustainable. Given that WEC Energy Group’s 3.03% dividend yield is moderately lower than the 3.34% yield of the utilities – regulated electric industry average, the dividend appears to be well-protected.
But do WEC Energy Group’s diluted EPS payout ratios back this assertion up?
WEC Energy Group anticipates that it will generate $4.06 in midpoint diluted EPS for 2021 ($4.06 is the midpoint of $4.05 to $4.07 from page 2 of WEC Energy Group’s Q3 2021 earnings press release). Against the $2.71 in dividends per share that were paid in 2021, this would equate to a diluted EPS payout ratio of 66.7%. For context, this is situated near the middle of WEC Energy Group’s 65% to 70% target dividend payout ratio.
Looking to the current year, WEC Energy Group will pay $2.91 in dividends per share. Stacked up against the $4.30 in diluted EPS that analysts are forecasting for this year, WEC Energy Group’s diluted EPS payout ratio would be 67.7%.
Considering that WEC Energy Group’s payout ratio will likely remain unchanged in the long term, I believe dividend growth will be in line with earnings growth. With analysts anticipating 7% annual earnings growth over the medium term, I believe dividend growth will also be 7% in the long term.
A Utility Firing On All Cylinders
WEC Energy Group has delivered healthy operating results through the first three quarters of 2021.
First off, WEC Energy Group’s year-to-date revenue surged 15.2% higher to $6.11 billion (data sourced from page 5 of Q3 2021 earnings press release). A recovery in demand for WEC Energy Group’s natural gas and electricity services, as well as continued customer growth, led to considerably higher revenue. According to COO Scott Lauber’s opening remarks during the company’s recent earnings call, WEC’s electric customer base grew by 8,000 year-over-year while its natural gas customer base advanced 15,000 over the year-ago period.
Net margin decreased 50 basis points to 17.6% year-to-date, which was the result of higher operating expenses. This partially offset the much higher revenue base, which explains how the company’s year-to-date diluted EPS grew 11.8% year-over-year to $3.40 (all data points according to page 5 of Q3 2021 earnings press release).
WEC raised its midpoint diluted EPS slightly from $4.04 to $4.06 (per page 2 of Q3 2021 earnings press release). Over the $3.79 2020 diluted EPS base (2020 diluted EPS according to page 4 of Q4 2020 earnings press release), the latter would represent a respectable 7.1% growth rate.
WEC Energy Group is a consistently growing utility. But aside from this strength, the company also enjoys firmly investment-grade credit ratings from S&P and Moody’s.
WEC’s interest coverage ratio rose from 4.1 in the nine months ended 2020 to 4.5 in the nine months ended 2021 (data for calculations from page 5 of Q3 2021 earnings press release). Given the promising growth prospects and high interest coverage ratio for a utility, it’s not hard to understand why rating agencies are confident in the creditworthiness of the stock. After all, WEC’s earnings before interest and taxes would need to plunge more than 75% before the company would be unable to cover its interest costs.
Put WEC Energy Group’s operating fundamentals and financial health together and it becomes clear that the stock could be an excellent long-term investment if purchased at the right price.
Risks To Consider
WEC is taking steps toward producing another great year of operating results for its shareholders. But even with that being the case, investors need to know the company’s key risks. That’s why I’ll be using its most recent 10-K to go over the company’s risk profile.
The first risk facing WEC is regulatory, which is that the company spends significant resources to comply with environmental laws and regulations (pages 22-23 of the most recent 10-K).
Because there is no guarantee that WEC will be approved by regulators to recover these costs from customers, the company’s operating and financial results could be adversely impacted by this at any time. And even if these costs are allowed to be collected from customers over time, this could result in lower demand for natural gas and electricity. This could also harm WEC’s operating and financial results.
The next risk is operational, which is the potential for natural disasters or failure of equipment to interfere with operations (page 26 of the most recent 10-K). If WEC were to experience such events on a large enough scale, its operating results could be hurt.
The final risk to WEC Energy Group is from an economic aspect, which is the potential that the company will be unable to secure the capital needed from markets to fund its capital projects (page 30 of the most recent 10-K).
WEC retains approximately one-third of its earnings to put back into the business. But the capital spending that it can’t cover with retained earnings comes from debt markets. If the company isn’t able to access the funds that it needs to finance all of its projects, it may not be able to meet growth targets. This could result in slowed dividend growth.
While I have gone over several major risks facing WEC, this wasn’t an exhaustive discussion of the stock’s risks. For a more complete discussion of its risk profile, I would refer interested readers to pages 22-23 of the most recent 10-K and my past articles on the company.
A Decent Entry Point
Despite WEC Energy Group’s quality, investors must avoid grossly overpaying to do well over the long haul. Thus, I will be using two valuation models to estimate the fair value of shares.
The first valuation model that I’ll employ to gauge the fair value of WEC shares is the dividend discount model or DDM, which is comprised of three inputs.
The first input into the DDM is the expected dividend per share, which is the annualized dividend per share. Following the 7.4% dividend raise, WEC Energy Group’s current annualized dividend per share is $2.91.
The next input for the DDM is the cost of capital equity, which refers to the annual total return rate that an investor requires from their investments. Although this is often different from one investor to the next, I require 10% annual total returns. I find such return levels to be a decent reward for my efforts that go into investment research and keeping up with my portfolio.
The final input into the DDM is the DGR or long term annual dividend growth rate.
The first two inputs for the DDM require data retrieval to find the annualized dividend per share and subjectivity to arrive at an acceptable annual total return rate. However, correctly predicting the annual dividend growth rate over the long term requires an investor to weigh multiple factors. These include a stock’s payout ratios (and whether those payout ratios are poised to expand, contract, or remain the same over time), annual earnings growth potential, the strength of a stock’s balance sheet, and industry fundamentals.
As I already noted, I’ll be using a 7% annual DGR for WEC.
Plugging the inputs above into the DDM, I get a fair value output of $97.00 a share. This indicates that WEC’s shares are trading at a 1.2% discount to fair value and offer a 1.2% upside from the current price of $95.84 a share (as of January 28, 2022).
The second valuation model that I will utilize to approximate the fair value of shares of WEC is the discounted cash flows model, which also includes three inputs.
The first input for the DCF model is a stock’s prior twelve months of earnings, which is $4.16 in diluted EPS in the case of WEC.
The next input into the DCF model is growth assumptions.
I’m modeling a 6.25% annual diluted EPS growth rate over the next five years, which is a bit below analysts’ 7% annual earnings growth projection. I’m also assuming a deceleration to 5.25% in the years thereafter to reflect the law of large numbers.
The final input for the DCF model is the discount rate, which is the annual total return rate that an investor requires. Just as I did above, I will use 10% for this input.
Using the above inputs for the DCF model, I am left with a fair value of $96.27 a share. This suggests that WEC’s shares are priced at a 0.4% discount to fair value and can provide 0.4% capital appreciation from the current share price.
Averaging the two fair values together, I compute a fair value of $96.64 a share. This means that shares of WEC are trading at a 0.8% discount to fair value and offer a 0.8% upside from the current share price.
Summary: Attractive Yield And Growth Potential At A Fair Price
WEC Energy Group has raised its dividend for 19 straight years, which puts it on track to become a Dividend Aristocrat in 2028. The most recent 7.4% dividend increase and WEC’s safe payout ratios are what led me to believe the dividend growth is just getting started.
WEC’s sales and earnings both grew in the double-digits year-to-date, which suggests the company’s operating fundamentals are robust. And WEC Energy Group’s interest coverage ratio increased from 4.1 in the year-ago period to 4.5 year-to-date.
Fortunately, WEC is trading at a slight discount. Income investors looking for solid growth as well should consider buying the stock at this time.