(Published Nov. 30 by Bob Ciura)
FirstEnergy (FE, Financial) stock has a tantalizing 4.4% dividend yield. With interest rates still very low, the yield looks appealing as an income investment.
But FirstEnergy has a checkered past.
The company committed the cardinal sin in dividend investing: It cut its payout (by 34.5%) in 2014.
Sure Dividend typically focuses on high quality dividend growth stocks, businesses that have both the ability and willingness to increase their dividends year after year. A good example of these types of stocks is the Dividend Aristocrats list – a group of 50 stocks with 25-plus years of dividend increases.
With its dividend reduction in 2014, FirstEnergy has a long way to go before income investors forget the cut.
With that being said, FirstEnergy’s fundamentals are improving. The company is successfully turning itself around.
Going forward, the current dividend rate appears sustainable over the long term.
Business overview
FirstEnergy is in the utility sector. It may be surprising to read of a dividend cut coming from a utility. These stocks have historically been among the most stable in the entire market.
Utilities are known for their relative stability because their businesses see steady demand, regardless of the economic climate. This keeps profits and shareholder dividends rolling in each year.
FirstEnergy generates and transmits energy, which is an important distinction that explains its dividend cut. Prior to the dividend cut, the company sold electricity primarily in non-regulated markets where prices are set by supply and demand.
FirstEnergy sells electricity generated by predominantly coal and nuclear energy.
Source: Investor relations
The company was undercut by the boom in U.S. natural gas production that caused prices to collapse. This has resulted in a shift in demand from industrial customers to natural gas.
In order to remain competitive, the company has had to invest significantly in shifting its generation toward natural gas. In addition, FirstEnergy has invested considerable amounts to modernize its transmission assets.
Consequently, net income fell from $771 million in 2012, to just $299 million in 2014.
The good news is that FirstEnergy’s investments are laying the groundwork for a better future.
Its turnaround took an important step last year. Net income soared 93% to $578 million. FirstEnergy’s net income has made up roughly half the ground it lost between 2012 and 2014.
Growth prospects
Going forward, a key part of the turnaround will be to grow its regulated business and stabilize its unregulated business.
Source: 2016 JPMorgan Energy Equity Investor Conference, page 5
FirstEnergy is focusing more on the regulated side of the business, because it is much more stable. Regulated utilities receive virtually guaranteed growth each year from regular rate increase.
Source: EEI 51st Financial Conference, page 4
Last year, six of the company’s regulated utilities received rate hike approvals. Overall rate cases approved last year amounted to $321 million in revenue growth.
Next it plans to invest to improve its infrastructure. The company expects to spend $4.2 billion from 2014 to 2017 to modernize its transmission system.
It is also steering its portfolio to evolve along with demand. The company is steadily increasing its exposure to natural gas, relative to coal and nuclear.
By 2017, the company expects shale gas will account for 1,100 megawatts of new generation. That is enough capacity to power 1 million homes.
Approximately 50% of FirstEnergy’s industrial demand growth will come from natural gas by 2019.
These initiatives should return the company to earnings growth.
The company expects earnings per share to recover to $2.47 to $2.77 next year, once its various charges are off the books. By then, the unregulated businesses will have a much smaller impact.
Source: EEI 51st Financial Conference, page 15
2016 is likely to be another difficult year; FirstEnergy expects to lose about $1.10 per share at the midpoint of its forecast for this year. However, the company is projected to return to profitability next year.
Earnings per share are expected to exceed its $1.44 per share annual dividend.
Dividend analysis
A recovery is great news for the dividend. Not only did FirstEnergy cut its payout, it also has not raised its dividend since the cut.
The quarterly dividend rate has remained at 36 cents per share since the cut.
Fortunately, FirstEnergy has put itself on firmer financial ground. The cut has at least right-sized the dividend payout in terms of earnings potential.
The company expects to become solidly profitable next year, driven in part by cost cuts. By next year, FirstEnergy expects to reduce expenses by $240 million annually.
These actions will propel earnings per share to a sustainable level. If all goes as planned, the dividend is likely to represent just 52% to 58% of 2017 forecasted earnings per share.
This is actually a modest payout ratio. It could leave room for dividend growth next year and beyond.
Valuation and expected total return
FirstEnergy stock trades for a price-earnings (P/E) ratio of 17. This is slightly above its 14.5 average P/E ratio since 2000. Its relative premium means investors may not generate returns from expansion of the valuation multiple.
To see FirstEnergy stock trading above its average level is surprising, given its fundamental challenges in recent years. It could be that investors are willing to forgive and forget FirstEnergy’s difficulties and instead focus on its high dividend yield.
With interest rates where they are, one can hardly blame investors for giving FirstEnergy the benefit of the doubt in return for a 4.4% dividend yield.
Indeed, FirstEnergy’s dividend will be a significant driver of future returns. A breakdown of expected returns could be as follows:
- 3% to 5% earnings growth.
- 4% dividend.
FirstEnergy’s earnings per share next year should return to pre-turnaround levels. From there, however, growth is likely to be modest.
Utilities typically do not generate high earnings growth. Earnings growth is usually around GDP growth plus a percentage point or two in growth from cost cuts.
This is why dividends are such an important contributor to utilities’ shareholder returns.
Investors could earn 7% to 9% annual returns going forward.
Final thoughts
FirstEnergy has taken investors on a bumpy ride over the past few years. The company doesn’t have the kind of dividend history investors will find with Dividend Aristocrats or Dividend Achievers. But the company may be back on track.
The higher levels of spending that reduced the company’s earnings and caused the painful dividend cut should diminish going forward.
FirstEnergy has a high dividend yield, and its successful turnaround should put it back in the good graces of income investors. The company makes an interesting investment choice in the utility sector, as it has a bit better growth prospects than some of the most stable utilities.
Disclosure: I'm not long the stock mentioned in this article.
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