A major benefit to dividend growth investing is that collecting a rising stream of dividend income from your portfolio helps you to maintain or grow your purchasing power over time.
With inflation reaching a 40-year high last month, building a portfolio of inflation-resilient stocks is more crucial now than ever. One stock that looks capable of keeping up with inflation is the electric and natural gas utility Xcel Energy (XEL).
For the first time since last October, I’ll go over Xcel Energy’s fundamentals and the risks to keep in mind before buying the stock.
Xcel Energy Offers A Safe Dividend With Room To Grow
True to my goal of picking dividend stocks that can keep their dividend growth going well into the future, I look at a couple of factors to determine the safety of a stock’s dividend.
Comparing a stock’s dividend yield to that of its industry average yield is a surface-level indicator of whether the dividend is safe. Xcel Energy’s 2.78% dividend yield is moderately lower than the electric – regulated utilities industry average of 3.40%. This suggests that the dividend is quite sustainable going forward.
A more in-depth sign that a stock’s dividend will continue to grow is looking at its dividend payout ratios.
Xcel Energy generated $2.96 in diluted EPS in 2021 against $1.83 in dividends per share that were paid during that time. This works out to a diluted EPS payout ratio of 61.8%, which is feasible for the long haul.
Looking at the current year, Xcel Energy is anticipating midpoint diluted EPS of $3.15 ($3.10 to $3.20). Factoring in a 6.6% increase in annualized dividends per share to $1.95, this would be a diluted EPS payout ratio of 61.9%.
Xcel Energy could expand its diluted EPS payout ratio slightly without any meaningful impact on its growth prospects or dividend safety. Couple that with the analyst annual earnings growth forecast of 6.9% over the next five years and I am comfortable maintaining my 6.75% annual dividend growth rate over the long run.
The Utility’s Fundamentals Are Healthy
Xcel Energy delivered a robust 2021 for its shareholders, which was evidenced by its operating revenue and diluted EPS growth.
Xcel Energy reported $13.43 billion in total operating revenue during the year, which was a 16.5% growth rate over the year-ago period. This was the result of low-single-digit growth in the company’s electric and natural gas customer base for one. The other factor that led Xcel Energy’s operating revenue much higher was the economic recovery that occurred last year, which was due to the declining adverse impact of COVID-19 (all info sourced from pages 3 and 7 of Xcel Energy’s Q4 2021 Earnings Press Release).
Xcel Energy’s diluted EPS increased 6.1% year-over-year to $2.96 last year. Xcel Energy’s increased electric and natural gas margins were partially offset by increased depreciation and amortization, which explains how the company was able to log such solid earnings growth (all details according to slide 8 of Xcel Energy’s 2021 Year End Earnings Report Investor Presentation).
For the current year, Xcel Energy is expecting even stronger earnings growth. The company’s $3.15 diluted EPS midpoint for this year would represent 6.4% growth over last year (calculations made from data on page 1 of Xcel Energy’s Q4 2021 Earnings Press Release).
In addition to Xcel Energy’s admirable operating results last year and an encouraging outlook for this year, the company is financially well.
Xcel Energy’s interest coverage ratio improved from 2.7 in 2020 to 2.8 last year (data sourced from page 3 of Xcel Energy’s Q4 2021 Earnings Press Release). Since utilities hold up well in essentially every economic environment, the probability of Xcel Energy being unable to service its debt is low. As a result, Xcel Energy enjoys investment-grade Baa1, BBB+, and BBB+ ratings from Moody’s, S&P, and Fitch, respectively (info according to slide 24 of Xcel Energy’s 2021 Year End Earnings Report Investor Presentation).
Due to its fundamentals, Xcel Energy could be a great long-term investment if shares are acquired at a sensible valuation.
Risks To Consider:
While Xcel Energy had another decent year for earnings growth, there are risks that investors should be comfortable with before pulling the buy trigger or while owning the stock. Therefore, I’ll be going over a few key risks from the company’s most recent 10-K.
The first risk to Xcel Energy is one that all utilities must address, which is the potential for a material increase in fuel costs (page 18 of Xcel Energy’s recent 10-K).
Even though there are fuel cost recovery mechanisms in most states, Xcel Energy could still be adversely impacted. Assuming that the company can recover its costs, it could be delayed and harm cash flows and liquidity in the near term. Xcel Energy could also face the possibility of being unable to secure enough fuel to provide services to its customers, which would weigh on its financial results and could also lead to regulatory fines.
Another risk to Xcel Energy comes via its two nuclear power plants in Minnesota (page 18 of Xcel Energy’s recent 10-K).
While nuclear power plant accidents are exceedingly rare, the costs of a major incident could be well beyond the scope of what is covered by insurance. This could lead to massive liabilities if an accident were to occur. The more likely risk associated with nuclear power plants is that it costs several hundred million dollars to safely decommission or close them.
One more risk to Xcel Energy is that the company’s operations are dependent on complex information technology systems (page 20 of Xcel Energy’s recent 10-K).
Xcel Energy is constantly taking steps to protect its IT systems from being breached. But that doesn’t guarantee that a major breach won’t occur.
If a breach happened, the company’s operations could be disrupted and the information of its customers could be compromised. If significant enough, this could break Xcel Energy’s investment thesis.
Although I have gone over several major risks facing Xcel Energy, this was by no means a complete discussion of its risk profile. I would urge readers to check out pages 16-22 of Xcel Energy’s recent 10-K and my prior articles on the stock for a more all-encompassing discussion of its risks.
Xcel Energy Is Reasonably Priced
Xcel Energy is a dividend stock that’s worthy of a place in dividend growth stock portfolios. But investors need to avoid grossly overpaying for shares of the stock to position themselves for success. How does an investor not significantly overpay for a stock?
Well, they need to first know the stock’s fair value. I’ll be utilizing two valuation models to determine the fair value of shares of Xcel Energy.
The first valuation model that I will use to approximate the fair value of Xcel Energy’s shares is the dividend discount model or DDM, which is made up of three inputs.
The first input into the DDM is the expected dividend per share, which is the annualized dividend per share for a stock. With what I anticipate will be a 6.6% increase in the stock’s annualized dividend per share just days away, I will use $1.95 for this input.
The next input for the DDM is the cost of capital equity, which is the annual total return rate that an investor requires. I use 10% as my annual total return rate because I believe that’s ample return for my time and energy.
The last input into the DDM is the long-term annual dividend growth rate or DGR.
While the first two inputs into the DDM require little contemplation from an investor, correctly prognosticating the long-term DGR requires an investor to consider numerous components: These include a stock’s payout ratios (and whether those payout ratios will contract, expand, or remain unchanged in the future), annual earnings growth potential, the health of a stock’s balance sheet, and industry fundamentals.
As I noted earlier in the piece, I’ll use a 6.75% annual DGR for this input.
Taking these inputs into consideration, I come out at a fair value of $60.00 a share. This suggests that shares of Xcel Energy are trading at a 9.6% premium to fair value and pose an 8.8% downside from the current price of $65.77 a share (as of February 19, 2022).
The second valuation model that I’ll apply to value Xcel Energy’s shares is the discounted cash flows or DCF model, which involves three inputs.
The first input for the DCF model is diluted EPS. Xcel Energy’s diluted EPS over the past 12 months is $2.96, so that’s what I will use for this input.
The second input into the DCF model is growth assumptions. Earnings growth must be accurately forecasted for the DCF model to be helpful to an investor.
Xcel Energy’s 6.9% annual earnings growth estimates over the next five years make a 6.25% annual earnings growth rate doable. I’ll further assume a drop to a 5.5% annual earnings growth rate in the years that follow.
The third input for the DCF model is the discount rate, which is the required annual total return rate. I will use 10% for this as well.
Using these inputs, I arrive at a fair value of $71.70 a share. This would mean that shares of Xcel Energy are priced at an 8.3% discount to fair value and offer 9% capital appreciation from the current share price.
Upon averaging these two fair values together, I compute a fair value of $65.85 a share. This implies that Xcel Energy’s shares are trading at a 0.1% discount to fair value and offer a 0.1% upside from the current share price.
Summary: A Steadily Growing Utility With Decent Total Return Potential
When Xcel Energy raises its dividend in a few days, it will have been the stock’s 19th consecutive dividend increase. This comfortably makes it a Dividend Contender. But better yet, this dividend growth streak looks like just the beginning for the stock.
For one, Xcel Energy’s diluted EPS payout ratio will remain in the low-60% range this year. Second, Xcel Energy’s annual earnings growth is expected to be nearly 7% through the next five years. Finally, Xcel Energy appears to be a financially healthy business when looking at its interest coverage ratio.
Overall, Xcel Energy’s mix of a soon-to-be 3% dividend yield and 6-7% annual earnings growth potential should produce 9-10% annual total returns for the foreseeable future.