The market goes up and down, but it mostly goes up over the long haul.
That’s something I try to keep in mind while I routinely turn rotting dollars into growing and passive cash flow. There was a day, years ago, when The Coca-Cola Co. (KO, Financial)'s stock seemed expensive at $5.00. And I’ve seen that phenomenon play out in real time over a short period of time – I’ve been at this for less than six years, yet I lament not being able to buy more KO at $26.39, which was the price I paid when I initiated a position in the company back in July 2010.
So while I strongly advocate not buying overvalued stocks, keep in mind that the stock market is filled with thousands of stocks. And while some may very well be pricey at any given moment, there are likely many others that aren’t. Moreover, what might appear to be a price on the upper end of what you’d be willing to pay, that price may become cheap in hindsight when looking back on it. While inflation may be low right now, I think the opportunity cost of sitting on cash over a long period of time is as high as ever.
With that said, I recently took advantage of what I think is a really solid opportunity on a stock that’s dangling in value territory right now. While this stock isn’t necessarily of superior quality across the board compared to its nearest peers, I think the price warrants strong interest right now. It’s basically a company that operates at a similar level to many others in its space but is available for a somewhat significant discount to many others, pushing its yield well above its recent historical norm.
I purchased 65 shares of CenterPoint Energy Inc. (CNP, Financial) on Oct. 6 for $18.62 per share. I then added another 15 shares on Oct. 20 for $18.56 per share.
Overview
CenterPoint Energy Inc. is an electric and natural gas utility company. It owns a portfolio of energy-related businesses that serve customers across six states.
It operates a traditional regulated utility business by providing natural gas distribution and electric transmission and distribution services to customers primarily in the cities of Houston and Minneapolis.
However, the company differentiates itself through its 55.4% limited partner interest in Enable Midstream Partners LP (ENBL, Financial), which is a midstream pipeline master limited partnership that owns and operates over 21,000 miles of interstate, intrastate and gathering pipelines in the Mid-Continent region. The partnership also owns and operates natural gas processing and storage facilities.
Founded in 1882, CenterPoint Energy and its predecessor companies have history dating back more than 140 years.
Fundamentals
CenterPoint’s fundamentals are rather solid, though not necessarily better or worse than many other utilities in general. I view this as a stable and defensive investment that, when bought at the right price, could provide for rather attractive long-term total return.
Here is a look at revenue and profit growth over the last decade first to see what we’re working with.
Top-line growth has been challenging for the firm; revenue is roughly flat, slightly decreasing from $9.277 billion to $9.226 billion from fiscal years 2005 to 2014. This isn’t completely uncommon among larger, more mature utility companies.
Earnings per share, however, has grown nicely over this time frame. EPS is up from 75 cents to $1.42 over the last 10 fiscal years, which is a CAGR of 7.35%.
That growth seems to be largely possible through improvements in profitability, though that has its limits. For perspective, S&P Capital IQ is predicting that CenterPoint will compound its earnings at a -2% annual rate over the next three years. If realized, that would be a somewhat significant bifurcation from CenterPoint’s recent guidance: CenterPoint is guiding for 4% to 6% annual earnings per share and dividend growth through 2018.
When comparing CenterPoint to many other larger utilities, I find their growth to be pretty respectable. Where the stock diverges in terms of its attractiveness right now is its dividend.
First, the company has increased its dividend for the past 10 consecutive years, so we can see the company has a proclivity for rewarding shareholders with increasing dividends year in and year out. Not the most impressive pedigree around, but I view that as a great start, especially when combined with earnings reports that routinely specifically discuss continued dividend growth.
The 10-year dividend growth rate is also very impressive for a utility company, coming in at 9%. However, this has in part been fueled by an increasing payout ratio.
We can see the payout ratio currently stands at 81.1%, which doesn’t offer nearly as much wiggle room for dividend growth as what the company was afforded a decade ago when the payout ratio was roughly half that.
The most recent dividend increase came in at 4.2%, which is roughly in line with forward guidance. That would be my expectation for the foreseeable future.
Now, dividend growth in the mid-single digits isn’t necessarily eye-popping when looking at most stocks. But it’s pretty exciting when we consider that the stock currently offers an outstanding yield of 5.33%.
That yield, by the way, is significantly higher than the five-year average yield of 4.1% for this stock. So investors buying in today are getting a yield about 120 basis points higher than what it’s typically offered over the last five years. That’s pretty appealing, especially in a low-rate environment.
Debtwise, CenterPoint operates much the same as most utilities, which is to say in a rather leveraged manner.
The long-term debt/equity ratio is 1.76, and the interest coverage ratio is slightly under3.
In absolute terms, these numbers leave a lot to be desired. However, this level of debt isn’t all that far off from what a number of other larger utility companies operate with. Notably, though, CenterPoint is more exposed to debt than most other utility companies by the very virtue of its ownership of Enable Midstream Partners, so this is something of which to be mindful.
Profitability metrics are more than suitable. Over the last five years, the firm has averaged net margin of 6.04% and return on equity of 16.5%. Good, solid numbers here.
Qualitative aspects
I’ve long been lukewarm on utility companies. They’re heavily regulated, which limits potential growth. While they’re allowed a relatively attractive return on investment by the government, there are natural caps to that. Furthermore, they’re generally geographically limited in terms of expansion.
But in exchange for that you’re buying into what essentially amounts to localized monopolies. You have a captive audience where there is usually very limited competition, and the services that companies like CenterPoint offer are those that people literally cannot live without. Power is ubiquitous for obvious reasons, which lends its hand to generally stable results and a fairly defensive investment, all considered.
As such, I do have a small place in my portfolio for a select few companies in the Utilities sector. What really attracted me to CenterPoint is fourfold.
First, it has no electricity generation assets/capability. I view this as a positive. It doesn’t have those legacy generation assets that could require expensive conversions away from coal and toward cleaner, more renewable sources of energy.
Second, it differentiates itself through its ownership in Enable Midstream. While a headwind right now due to lower energy commodity prices, this could be a really nice growth kicker when looking out over the long haul. At the very least, it diversifies the company away from the regulated utility business. This adds risk, however.
Third, I think the valuation right now is very compelling, as I’ll go over shortly.
Fourth, its prime markets are healthy and growing. Houston and Minneapolis offer two of the more exciting and economically vigorous metro areas in the country. While Houston might be somewhat of a mixed bag over the near term due to its exposure to the oil and gas industry, all the reports I’ve come across show a pretty strong and diverse economy. And as I went over a moment ago, utilities are ubiquitous and necessary. You don’t lose your job and then cancel your electricity.
Risks
The company operates with a large amount of debt. Rising interest rates could make this more burdensome. In addition, its ownership in Enable Midstream exposes it to more debt than the average utility company.
Rising interest rates could also make the stock less attractive from an income standpoint.
Its exposure to Houston could prove to a be a short-term headwind due to recent volatility in the oil and gas industry.
Lower commodity prices serve as a headwind for Enable. This could limit distribution growth to CenterPoint, which could in turn limit earnings per share and dividend growth to CNP shareholders.
Valuation
The P/E ratio for CNP stands at 15.21 right now. That’s pretty appealing from a number of standpoints. It’s well under the broader market, though rightfully so, in my view, due to relatively limited growth prospects. But it’s also well below the P/E ratio of 20.2 the stock has averaged over the last five years. It also compares favorably to almost every other utility I’ve come across, which is made even more appealing by the potential growth offered by its exposure to the midstream space. And as mentioned earlier, the current yield is substantially higher than the five-year average. It’s also much higher than what most other utilities offer right now.
I valued shares using a dividend discount model analysis with a 9% discount rate and a long-term dividend growth rate of 4.5%. That dividend growth rate is on the low end of recent guidance so as to build in a margin of safety. That’s a pretty reasonable assumption moving forward although sustained lower natural gas pricing and any unfavorable changes in home markets could prove that to be not conservative enough. That said, I view this as a reasonable expectation looking out over the long haul. The DDM analysis gives me a fair value of $22.99.
Conclusion
All in all, this is a pretty standard utility when looking at its regulated businesses. But the exposure to midstream assets, lack of electricity generation and placement in some of the best areas of the country all whet my appetite more than usual.
Above all, though, I think this stock is most attractive at this very point in time simply due to the valuation and yield. The valuation is much lower than it’s been over the last few years, consequently pushing the yield much higher. When compared to most utilities, especially those with heavy generation exposure, this is an opportunity that should really be carefully considered. I’m not necessarily interested in going crazy here, but I’m more than pleased to be able to buy into a small position in CenterPoint at this price.
I have a rather large handful of free trades right now, which is why I was able to split these transactions up like I did.
These purchases add $79.20 to my annual dividend income, based on the current 24.75-cent quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates CNP as a 4/5 star valuation, with a fair value estimate of $23.00.
S&P Capital IQ rates CNP as a 2/5 star “sell” with a fair value calculation of $18.10.
I’ll update my Freedom Fund in early November to reflect this recent purchase.
Full Disclosure: Long KO and CNP.
Have you taken a look at this stock? Like it? Why or why not?
