• Inexpensive price given low investor sentiment on New York rate freeze through 2015
• One of the highest yields in the S&P Dividend Aristocrats with stable dividend growth
• Upside to shares through the next few years on rate negotiations and marginally higher volume
Consolidated Edison (ED) is the holding company for two regulated utilities serving New York, New Jersey and Pennsylvania. Utility operations generate almost all (90%) of operating income with the energy marketing business and infrastructure investments accounting for the rest.
Being a regulated monopoly has its advantages and disadvantages. The company is guaranteed sales in a competition-free environment, leading to sustainable cash flows. Against this, the company must negotiate rate increases with regulators and profits are generally capped. High property taxes and cost of living in New York have always been the key burden for ConEd, keeping public pressure on rates.
Shares of ConEd have suffered over the last year with the freeze on its New York rates, scheduled through 2015. There is a silver lining here though with weak investor sentiment leading to low valuations on the shares. The city’s infrastructure is centuries old and needs regular investment. This should give ConEd a good case for rate increases, especially in 2016 after the freeze, and could significantly boost income.
The Indian Point nuclear plant, built by Consolidated Edison but now owned by Entergy Corp (ETR), has come under public scrutiny lately and state environmental regulators have proposed a shutdown of the plant over summer months. The plant draws 2.5 billion gallons of water a day from the Hudson River to cool equipment then discharges the water back into the river at a slightly higher temperature. The regulator has proposed cooling towers, which Entergy is against and says would lead to higher rates. The issue could be a positive for ConEd leading to higher rates in the area or higher volume during the summer months if the nuclear plants are closed.
Sales growth is relatively stable at utilities but you really need to watch operating income. Since companies are only able to increase rates so much and volume is relatively stable from year-to-year, investment return comes down to how well the company manages its expenses. ConEd has been able to grow operating income at a much faster pace than sales growth and has a strong 19% operating margin.
The company’s balance sheet is typical for a utility company with half (50.4%) of the capital structure in debt and just enough current assets to cover current liabilities. This isn’t worrying because the company knows how much it will be collecting in sales and there is little chance of any liquidity problems.
Cash flow is pretty volatile for a utility company but cash flow from operations is still fairly stable. Sizeable investment projects to upgrade New York’s infrastructure mean that free cash flow will vary quite a bit but will increase over the long-run.
Dividends and Growth
ConEd offers one of the highest dividend yields of all the S&P Dividend Aristocrats with a 4.5% yield, just above its average of 4.4% over the last five years. The company is paying out 58% of its income as dividends, significantly below the average of 66% over the longer-term. This means the upcoming February increase could be substantially higher than the 1.25% increase at which the dividend has grown over the last five years.
ConEd is one of the oldest publicly-traded companies in the United States with a dividend that dates back to 1885 and 39 years of consecutive increases. The company does not have a stock repurchase program but has not issued additional shares for the last few years either, preferring to use debt to cover funding needs.
Shares trade at 13.6 times earnings, well under the industry average of 19.3 times and below the company’s own five-year average of 15.2 times earnings. The rate freeze for New York has limited share prices while earnings continue higher, giving investors a rare opportunity in a market that is generally fairly-valued or worse. I think sentiment could easily improve to 14.5 times earnings over the next year and the stock price could rebound to over $60 per share.
A valuation by discounted cash flows shows the shares to be at fair value though I have used conservative estimates. I have assumed dividend growth of just 1.5% which is higher than the last five-year average but still easily within the company’s ability. Dividend growth may speed up in 2016 as the company renegotiates rates in the New York area.
I like shares of Consolidated Edison for their high dividend yield and attractive valuation. While stock price gains will be relatively limited, an improvement in investor sentiment when the company can unlock New York rates should provide for a good upside. Risk in the shares is basically negligible so the risk-adjusted returns are extremely good even if total return is only around 6% or 7% over the long-term.