WEC Energy Group: A Blue-chip Dividend Growth Stock (NYSE: WEC)
Like most dividend growth investors, I aim to achieve financial independence and have the opportunity to live off my dividend income. It requires me to focus on shopping only the best actions for my portfolio.
One such stock that looms large in my portfolio is WEC Energy Group (NYSE: WEC) – the electric and natural gas utility based in my state of Wisconsin. But I don’t plan to add to my position in the title anytime soon.
Let’s review the fundamentals and valuation of WEC Energy Group to better understand why I’m downgrading the stock from my previous buy rating to a hold rating.
Still a top-notch dividend growth stock
WEC Energy Group’s 3-year dividend growth rate of 7.1% per annum is one of the highest in its industry. For context, this is much higher than the industry median 3-year DGR of 5.2%. Fortunately, I think the dividend growth at the same level as the 3-year DGR can be sustained.
WEC Energy Group’s dividend yield of 2.81% is slightly lower than the utilities – regulated electricity industry average of 2.91%. This is a surface level measure that signals that the dividend is safe.
WEC Energy Group produced $4.11 of diluted EPS in 2021 (page 1 of WEC Energy Group Q4 2021 Results Press Release) by paying $2.71 in dividends per share Meanwhile. This equates to a diluted EPS payout ratio of 65.9%.
And based on WEC Energy Group’s forecast for this year, the payout ratio should remain well within the target range of 65% to 70%. Using the company’s median diluted EPS forecast of $4.29 (as per page 2 of WEC Energy Group’s fourth quarter 2021 earnings press release) and forecast dividend per share of $2.91, the WEC Energy Group’s diluted EPS payout ratio would be 67.5% in 2022.
This should give the stock the flexibility to grow its dividend as fast as its earnings. And with analysts anticipating 7% annual earnings growth over the next five years, this gives me the confidence to repeat my annual dividend growth rate of 7% over the long term.
The company had an impressive year
WEC Energy Group has released respectable financial results for the fiscal year ending in 2021.
The company recorded $8.32 billion in operating revenue in 2021, representing a 14.8% year-over-year increase (details taken from page 4 of the earnings press release of the fourth quarter of 2021 of the WEC Energy Group).
Total electricity deliveries increased by 3% in 2021. Residential electricity consumption decreased by 0.6% year-over-year due to the return to the site of some workers. But this was more than offset by a 4.4% increase in electricity consumption by small commercial and industrial customers and a 5.3% increase in consumption by large commercial customers (all information according to pages 1 -2 of the WEC Energy Group Q4 2021 Earnings Press Release). The economic recovery in 2021 is behind this rebound in commercial and industrial electricity consumption.
WEC Energy Group’s diluted EPS increased 8.4% year-over-year to $4.11 in 2021. This is the result of the company’s higher revenue base, which was partially offset by a 90 basis point reduction in its net margin to 15.6% in 2021. (data points per page 4 of the WEC Energy Group Q4 2021 Earnings Press Release).
Even better, WEC Energy Group’s interest coverage ratio increased slightly from 3.9 in 2020 ($1.92 billion earnings before interest and taxes/$494 million interest expense) to 4 .2 in 2021 ($1.97 billion EBIT/$471 million interest expense).
Overall, WEC Energy Group could be a great stock for investors to build wealth if bought at the right valuation.
Risks to consider:
At a glance, quality dividend growth stocks like WEC Energy Group can seem invincible. But they are not. This is not intended to minimize the merit of buying similar stocks. However, investors are more often successful when they know the risks of an investment in advance. That’s why I’m going to review a few risks that concern WEC Energy Group.
The first risk to the stock is one that all companies have increasingly recognized in recent quarters, namely inflation. the March 2022 CPI reading of 8.5% was just ahead of analysts’ expectations of 8.4% for the month.
WEC Energy Group has done a masterful job of steadily reducing operating and maintenance expenses over the years (per slide 45 of April 2022 WEC Energy Group Investor Presentation). But in a business environment where inflation is accelerating, there is a risk that the company may not be able to significantly reduce its O&M. This could temporarily weigh on earnings growth.
Due to soaring inflation, the Federal Reserve will continue to gradually raise interest rates in the coming months. If interest rate hikes don’t fall exactly within the Goldilocks zone (eg, neither too hawkish nor too dovish), the economy could slide into a recession.
This could result in lower energy consumption by its customers, which would adversely affect WEC Energy Group’s operating and financial results for a period of time.
Recent outperformance has taken the stock too far, too fast
It’s no secret that market volatility can cause stocks to move aggressively in the direction of undervaluation or overvaluation. WEC Energy Group has beaten the S&P 500 index by 8% since the publication of my previous article.
Based on the two valuation models I use to assess a stock’s fair value, this appears to have moved WEC Energy Group from undervalued to overvalued.
The first valuation model that I will use to estimate the fair value of WEC Energy Group shares is the discounted cash flow model. This involves three entries.
The first input into the DCF model is a stock’s last twelve months of earnings. This amount is $4.11 in diluted EPS for WEC Energy Group.
The second input to the DCF model is made up of the growth assumptions. It is crucial to make reasonable forecasts with regard to the contribution of growth.
Based on WEC Energy Group’s current fundamentals and past growth, I will use a diluted annual EPS growth rate of 6.5% for the next five years. I will then take into account a slowdown to 5.5% in the following years.
The third input to the DCF model is the discount rate, which is simply the annual total rate of return that an investor needs. I will use 10% as I feel it adequately rewards me for my efforts.
Using these inputs for the DCF model, I am left with a fair value of $100.64 per share. This indicates that WEC Energy Group shares are trading at a 2.9% premium to fair value and are down 2.8% from the current price of $103.59 per share (as of April 14 2022).
The second valuation model I will use to arrive at a fair value for WEC Energy Group shares is the Dividend Discount Model or DDM. This is also composed of three entries.
The first entry for the DDM is the expected dividend per share, which is another term for the annualized dividend per share. WEC Energy Group’s annualized dividend per share is currently $2.91.
The next entry in the DDM is the cost of equity, which is the annual total rate of return an investor demands on their investments. I will again use 10% for this entry.
The last entry in the DDM is the DGR or long-term annual dividend growth rate.
Unlike the first two inputs for the DDM which require basic data retrieval and subjectivity, accurately predicting the annual dividend growth rate over the long term requires an investor to consider many variables: these include a stock’s payout ratios (and whether those payout ratios are positioned to contract, expand or stay the same in the future), future annual earnings growth, industry fundamentals and the statement of the balance sheet of an action.
As I stated earlier in the section on dividends, I stand by my expectation of an annual DGR of 7%.
Taking these inputs into the DDM, I arrive at a fair value of $97.00 per share. This suggests that WEC Energy Group shares are valued at a 6.8% premium to fair value and incur a capital depreciation of 6.4% over the current share price.
When I average these two fair values together, I calculate a fair value of $98.82 per share. This means WEC Energy Group shares are trading at a 4.8% premium to fair value and are down 4.6% from the current share price.
Summary: A wonderful stock for your watchlist
WEC Energy Group has increased its payout to shareholders for nearly two decades. And given the stock’s high dividend growth rate, it’s not just about extending its dividend growth streak. Given that WEC Energy Group’s payout ratio for 2022 is expected to be in the middle of its long-term target, I would be surprised if the 7% annual dividend growth did not persist.
This is especially the case because WEC Energy Group had a remarkable 2021. Add in the outstanding and improved interest coverage ratio and you have a fundamentally sound stock.
But the title seems to be more than fully valued at this point. Thus, I will wait for an increase in earnings, a decline in share price, or a combination of the two before upgrading WEC Energy Group to a buy rating.