WEC Energy Group (WEC): A High Quality, High Dividend Growth Utility

Regulated utilities have long been a core staple in dividend portfolios, courtesy of their high-yields, safe payouts, slow but steady dividend growth, and very low volatility.

 

But while most people focus on the biggest and well-known names in the sector, such as Duke Energy (DUK), Southern Company (SO), and Consolidated Edison (ED), there are a select few faster growing, less known gems hidden in this otherwise boring industry.

 

Let’s examine one such name, WEC Energy Group (WEC), to see if this fast growing utility has what it takes to be one of the top dividend growth performers in this steady, defensive industry.

 

More importantly find out whether or not now could be the right time to add one of America’s best utilities to your own dividend growth portfolio. WEC Energy is a company I am watching closely for our Conservative Retirees dividend portfolio.

 

Business Description

Originally founded in 1896 as The Milwaukee Electric Railway and Light Company, WEC Energy Group has grown through six major acquisitions over the past 120 years to become one of the nation’s largest electric and natural gas utilities.

 

After the last (and largest) merger, the $9.1 billion purchase of Integrys Energy Corp, which transformed it into the Midwest’s largest regulated utility and the 15th largest diversified utility in America, the company changed its name to Wisconsin Energy Corp (now WEC Energy Group).

 

Today the company operates through seven major subsidiaries: We Energies, Wisconsin Public Service, Peoples Gas, North Shore Gas, Minnesota Energy Resources, Michigan Gas Utilities, and Upper Michigan Energy Resources.

 

 

All told, WEC’s 9.5 GW of electric power generating capacity, 44,000 miles of natural gas pipelines, and 70,000 miles of electrical transmission lines serve 4.4 million customers in Michigan, Minnesota, Wisconsin, and Illinois.

 

 

It also owns W.E Power, which designs, builds, and owns power plants, as well as a 60% stake in the American Transmission Company (ATC).

 

ATC is America’s only multi-state transmission only utility and operates 9,540 miles of high-voltage transmission lines in Michigan, Wisconsin, and Illinois.

 

The utility’s power generation is heavily coal dependent. However, management is working hard to increase its generation capacity to cleaner (and cheaper) sources of power, specifically natural gas and renewables (wind, solar, and hydro power).

 

Energy Source	Capacity (Megawatts)	% Of Capacity
Coal	5,044	53.4%
Natural Gas	3,753	39.7%
Renewables	652	6.9%
Total	9,449	100%

Source: Wisconsin Energy Corporation Investor Update

 

As you can see, while the company has made great strides in diversifying its business in recent years, the vast majority of its sales, earnings, and cash flow still derive from its core electrical business in its home market of Wisconsin.

 

However, as we’ll soon see, the majority of the utility’s growth runway lies elsewhere.

 

 

By end user, 37% of WEC Energy’s retail deliveries are to large commercial and industrial (C&I) customers, 35% to small C&I customers, and 28% to residential and farm customers. The company enjoys a balanced sales mix.

 

Business Analysis

Regulated utilities are some of the most dependable businesses in the county. They have minimal competition in the regions they operate in, enjoy guaranteed rates of return on their capital investments, and provide essential services.

 

Take a look at WEC Energy’s stable, steadily growing earnings over the last decade, for example:

 

 

Note that the apparent decline in EPS in 2015 was a result one-time charges and a one-time share dilution involved with the acquisition of Integrys Energy.

 

By 2016, the purchase has become highly accretive for the company and margins have rebounded nicely.

 

Looking at WEC Energy’s long-term growth record, one can’t help but be impressed with the relatively long-term growth rates (for a utility) that the company has generated. More importantly, management has been disciplined in avoiding sacrificing margins for growth.

 

In fact, if we look back further to the last decade, we can see one of the best growth records in the regulated utility industry.

 

As seen below, WEC Energy’s sales and earnings per share (EPS) compounded by 6.3% and 8.1%, respectively, from 2006 through 2016.

 

Year	Revenue	Operating Margin	Net Margin	EPS
2006	$3.996 billion	14.2%	7.9%	$1.33
2016	$7.358 billion	23.1%	12.6%	$2.91
Change	84.1%	62.7%	59.5%	118.7%
CAGR	6.3%	5.0%	4.8%	8.1%

Source: Morningstar

 

In fact, WEC Energy’s management team has done an exceptional job of not just growing while defending its margins, but growing them by targeting new businesses with favorable regulatory relationships, as well as achieving impressive economies of scale.

 

For example, Wisconsin’s investment into ATC opened up a great long-term growth opportunity with very high returns on equity of 12.7%, among the most profitable regulated utility businesses in the U.S.

 

In fact, for such a small utility, Wisconsin Energy is amazingly profitable relative to its industry peers.

 

Company	Operating Margin	Net Margin	Return On Assets	Return On Equity	Return On Invested Capital
Wisconsin Energy	23.1%	12.6%	3.2%	10.6%	6.3%
Industry Average	23.0%	10.9%	2.8%	9.2%	NA

Source: Morningstar.

 

Better yet, the recent moves into natural gas distributions and electrical transmission have opened up a vast growth market for WEC Energy, in terms of lots of profitable growth investment potential over the next decade.

 

The company plans to invest more than $1.5 billion per year on capital projects through 2025, with gas delivery accounting for roughly half of total capital expenditures.

 

Low-cost natural gas and continued pipeline development activity have made gas delivery a hot growth area for utilities, and WEC Energy’s business should benefit from this development.

 

 

Keep in mind that this ambitious growth plan doesn’t even include planned growth initiatives for ATC, which will further add another $2.3 billion or so to the company’s total growth backlog; which stands at $20.3 billion.

 

 

In addition, ATC’s growth plans could be expanded in the coming years thanks to WEC Energy’s 50/50 joint venture with Duke Energy on things like California’s PATH 15 transmission line, the Zephyr Transmission project, as well as other transmission projects throughout the US.

 

All told, management expects long-term earnings growth of 5% to 7%, and most analysts expect that to be to the higher end of that range.

 

Since management is targeting an EPS payout ratio of 65% to 70%, dividend growth should track closely with that impressive earnings growth (for a regulated utility).

 

Key Risks

Like all regulated utilities, there are a few important risk factors to keep in mind when considering WEC Energy.

 

First, in a rising interest rate environment, refinancing debt over time is likely to become more expensive.

 

That means a gradually rising cost of debt (and capital) that could increase margin pressure, as well as limit the amount of growth projects WEC Energy can invest in, given management’s disciplined approach of refusing to invest into less profitable businesses.

 

The other major risk is political and regulatory. Specifically, WEC Energy initially grew strongly in its home market, where management has had very good relationships with regulators.

 

This is evident in the high authorized returns on equity that the utility is permitted.

 

 

However, now that the company is expanding aggressively into other regulatory domains, specifically Minnesota and Illinois, management will have to deal with potentially less friendly regulatory regimes. Especially in Chicago, where higher living costs increase political pressure to keep rates low.

 

For example, in order to get approval for the Integrys Energy acquisition that added a large number of Chicago and Illinois gas customers, management was forced to accept some margin-sapping concessions, including a two year rate freeze and maintaining a minimum level of union jobs for at least two years.

 

Going forward, as WEC Energy grows and potentially further diversifies into other states, these kinds of regulatory uncertainties will probably increase further.

 

The company’s dependency on coal power (53% of capacity) also results in somewhat heightened regulatory risk. For example, the EPA’s Clean Power Plan, issued in 2015, could result in significant compliance costs.

 

Dividend Safety Analysis: WEC Energy Group

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

WEC Energy Group has a Dividend Safety Score of 92, indicating the current dividend (3.6% yield) is very safe and dependable, as seen by the continued growth of the payout during the financial crisis.

 

 

However, you might have noticed that WEC Energy Group cut its dividend in half back in 2000. Electricity demand was growing about 3% annually, but this actually caused problems for the company.

 

WEC Energy helped pay for a $6 billion construction plan to build more electric generation and distribution facilities to meet growing demand. Slashing the dividend freed up cash to reinvest into the business, reduce leverage, and protect the balance sheet.

 

This does not seem like an issue that will repeat anytime soon, and WEC Energy’s financial foundation is very strong today.

 

In fact, WEC Energy has a strong dedication to dividends, with 74.5 straight years of consecutive payments to shareholders.

 

That makes sense, given the fact that 99% of the company’s revenue is derived from regulated industries and the recession-resistant nature of its increasingly diverse businesses.

 

As you can see below, WEC Energy’s sales dipped by just 7% in 2009 and its diluted earnings per share actually grew each year during the financial crisis. Households and businesses continue needing electricity and gas even during tough times.

 

 

With 13 consecutive years of dividend increases under its belt, Wisconsin Energy is a dividend achiever and more than halfway to becoming a dividend aristocrat.

 

The key to the safety of the dividend remains the conservative management team, which targets a 65% to 70% EPS payout ratio.

 

While that may seem high, keep in mind that regulated utilities often have relatively high EPS payout ratios of 75% to 85%. Their stable earnings profile allows them to maintain a higher payout ratio without running into trouble.

 

With the most recent EPS payout ratio at 69% over the trailing 12 months, WEC’s management believes it has sufficient financial flexibility in terms of retaining enough profits to reinvest in the business while also providing payout security via a nice cushion of excess profits and cash flow.

 

 

It’s also worth noting that WEC Energy is one of the very few utilities that actually generates positive free cash flow. The company has had cash left over after investing in large projects and paying its dividend in recent years, an impressive feat that underscores management’s solid capital allocation skills and the favorable regulation in WEC’s primary geographies.

 

 

The other important factor supporting a safe dividend is a strong balance sheet. While WEC Energy, like all utilities, has a large amount of absolute debt, management has been careful to make sure that its earnings and cash flow are sufficient to cover its debt services and short-term liabilities.

 

 

This becomes abundantly clear when we compare the balance sheet against its industry peers. While the leverage ratio is slightly above average, the strong interest coverage ratio, current ratio, and strong growth profile help explain why WEC Energy has an excellent credit rating.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
Wisconsin Electric	3.69	6.63	48%	0.90	A-
Industry Average	3.34	NA	48%	0.87	NA

Sources: Morningstar, Fastgraphs

 

The company’s solid credit rating allows it to borrow cheaply, minimizing its overall cost of capital and helping to maintain above average profitability that secures the current dividend.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

WEC Energy has a Dividend Growth Score of 50, indicating that its dividend growth potential is about in line with the market’s historical average 6.1% dividend growth rate.

 

But don’t let WEC’s average dividend growth rating fool you because the company has one of the best long-term dividend growth records of any regulated utility.

 

WEC Energy’s dividend has been growing like a weed since 2003. Of course, the sensational five and 10 year dividend growth rates were courtesy of management raising the payout ratio to its long-term target of 70%, which means that investors can’t expect that kind of fast payout growth going forward.

 

 

However, given the strong long-term growth runway represented by the company’s diversification into gas and interstate electrical transmissions, management seems likely to achieve its long-term EPS growth target of 5% to 7%.

 

That should allow Wisconsin Energy to generate 5% to 7% dividend growth, in line with the company’s most recent 5.1% dividend increase.

 

Valuation

With the stock market approaching the 9th year of an epic bull run and trading at all-time highs, many investors are nervous about putting new capital to work.

 

This is especially true in the utility sector, which has seen massive amounts of capital inflows as yield-starved investors have been attracted to regulated utilities as safe, high-quality bond alternatives.

 

High valuations indeed appear to be a justified concern. After all, Wisconsin Energy is currently trading at a significant premium to both the average utility P/E, as well as its historic median P/E.

 

However, WEC Energy is currently offering a yield superior to most regulated utilities and well above its long-term median historic yield.

 

Company	TTM P/E	13-Year Median P/E	Yield	13-Year Median Yield
Wisconsin Energy	20.1	16.4	3.6%	2.9%
Industry Average	16.7	NA	3.3%	NA

Source: Gurufocus

 

When it comes to what matters most, a safe and growing yield, WEC Energy may not be as overvalued as it initially appears, especially given that the company’s long-term earnings growth rate is higher than most utilities’ growth profiles.

 

Assuming the company’s earnings compound by 5% to 7% annually as management expects, WEC’s stock offers annual total return potential of about 8% to 11% (3.6% dividend yield plus 5% to 7% annual earnings growth).

 

WEC Energy’s valuation doesn’t seem totally unreasonable today, but it’s not exactly a bargain either. Perhaps if U.S. interest rates rise three times in 2017 like the Federal Reserve is predicting, then utilities as whole will finally experience a meaningful pullback.

 

A stock price in the low $50s (versus $58 today) would push WEC’s yield up to 4%, which would represent a seemingly attractive investment opportunity considering the stock’s stability (WEC’s beta of 0.04 means WEC has historically been 96% less volatile relative to the S&P 500) and long-term total return potential.

 

Closing Thoughts on WEC Energy Group

While not nearly as well-known as some of its larger cousins, WEC Energy Group is a true Grade A, high-yield blue chip utility and a true “sleep well at night” stock.

 

With a very low risk profile, a rock solid payout, and a strong long-term growth runway, WEC Energy makes a solid holding in most dividend portfolios at the right price, whether you’re looking to fund your retirement or just enjoy decades of low-risk income growth.