Turns out power plants aren’t very profitable, but this utility company has figured out a better business model
Utility firms tend to be boring but steady names for investors to park their money in. However, today’s company breaks the industry mold.
Not only do investors lump this firm in with the rest of the industry, but as-reported financials also add to the confusion.
Also below, the company’s Uniform Accounting Performance and Valuation Tearsheet.
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When investors think of utility companies, one example they think of is electricity. To get electricity to people’s homes requires power plants, transmission, and distribution. These three industry segments are not always run by the same company.
Power plants are individual sites that generate energy from a variety of fuel sources.
The transmission industry sends the power created by power plants to the main distribution points, such as substations or high tension power lines.
Distribution is focused on servicing the customer. This is the last mile in the process of getting power from a substation to an individual customer. The distribution industry is responsible for the collection of payments from customers.
It’s common to see these three areas combined in the U.S. However, in other parts of the world, such as Germany, these three parts of delivering electricity to customers are unbundled.
Today’s firm, FirstEnergy (FE), breaks for the typical U.S. mold for a power company. It’s especially unique because it doesn’t own any power plants. FirstEnergy only owns the transmission and distribution lines.
At first blush, this business line should be a winning move for FirstEnergy. Power plants are massive investments, and they require a lot of capital to maintain and operate.
By dumping the most asset-intensive part of the electricity supply chain, the company can focus on making money selling directly to customers.
The issue is, by not owning the power plants, you lose control over a big piece of the supply chain.
A similar mechanic has plagued The Coca-Cola Company (KO) since its inception. Since the 20th century, management has consolidated and then spun out its bottling business several times over.
Management has been unable to weigh controlling the entire supply chain with divesting unprofitable segments.
Using as-reported accounting, it’s difficult to say whether these asset-intensive businesses make a difference to earnings power.
FirstEnergy’s as-reported ROA was a weak 3% in 2019. This was a 1% decline from the 4% ROA in 2018. In fact, as-reported ROA has not been above 4% in the past five years.
By looking at as-reported metrics, investors might conclude that this utility stock generates returns lower than the corporate average, and not owning the supply chain is a disadvantage compared to other utilities.
In reality, this is not an accurate picture of FirstEnergy’s performance. The firm does have higher than average returns for a utility stock. This achievement can be attributed to the firm’s strategy in only owning transmission and distribution lines
The average utility stock has Uniform ROA levels of 3% to 4%. FirstEnergy (FE) generated a Uniform ROA of 5% in 2019. In addition, Uniform ROA has been consistently above 4% levels the past few years.
When looking through a Uniform Accounting lens, it becomes clear that the firm’s business model is better than it seems.
While not seemingly a large difference between as-reported and Uniform metrics, the utility industry is a game of inches, and 3% ROA vs. 5% ROA can be make-or-break.
As you can see, FirstEnergy’s Uniform ROA levels are trending better than as-reported metrics, which portrays how easily as-reported metrics can misrepresent reality.
Without Uniform Accounting, investors would be unsure of the validity divesting asset intensive businesses. While the verdict is still out on Coca-Cola, FirstEnergy has benefited compared to its peers.
SUMMARY and FirstEnergy Corp. Tearsheet
As the Uniform Accounting tearsheet for FirstEnergy Corp. (FE:USA) highlights, the Uniform P/E trades at 23.1x, which is around the global corporate average of 25.2x, but below its own historical average of 31.9x.
Low P/Es require low EPS growth to sustain them. That said, in the case of FirstEnergy, the company has recently shown a 1,705% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, FirstEnergy’s Wall Street analyst-driven forecast is a 99% and 23% EPS growth in 2020 and 2021, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify FirstEnergy’s $31 stock price. These are often referred to as market embedded expectations.
The company needs to have Uniform earnings grow by 8% per year over the next three years in order to justify current stock prices. What Wall Street analysts expect for FirstEnergy’s earnings growth is above what the current stock market valuation requires.
Furthermore, the company’s earning power is below the long-run corporate average. Also, intrinsic credit risk is 150bps above the risk-free rate and cash flows and cash on hand are just slightly below its total obligations—including debt maturities, capex maintenance, and dividends. All in all, this signals a moderate credit risk.
To conclude, FirstEnergy’s Uniform earnings growth is above its peer averages but the company is trading below average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research