Dividend Of FirstEnergy Is Less Attractive Than It Seems (NYSE:FE)

FirstEnergy (NYSE:FE) has outperformed the broad market by a wide margin over the last 12 months. During this period, the stock has gained 3% whereas the S&P 500 has shed 17%. In addition, the utility stock is currently offering a 4.3% dividend yield, with a reasonable payout ratio of 65%. It is thus natural that the stock will entice some income-oriented investors. However, the dividend is less attractive than it seems on the surface.

Business overview

FirstEnergy is a highly diversified utility, which generates, transmits and distributes electricity in the U.S. It serves approximately 6 million customers and has facilities that operate with hydroelectric energy, coal, nuclear power, natural gas and renewable energy.

Just like most utilities, FirstEnergy has proved essentially immune throughout the coronavirus crisis. It has also proved resilient in the highly inflationary environment prevailing right now. The surge of inflation to a 40-year high has greatly increased the operating costs of most companies and thus it has pressured their profit margins but this is not the case for FirstEnergy, which can easily pass its increased costs to its customers.

The resilience of FirstEnergy is clearly reflected in its business performance. The company posted all-time high adjusted earnings per share of $2.60 last year and has maintained decent momentum this year. In the most recent quarter, it grew its commercial sales by 1.5% and its industrial sales by 2.5% over the prior year’s quarter, to levels above the pre-pandemic levels. On the other hand, its residential sales slipped 1.6%, primarily due to unfavorable (mild) weather, and thus its earnings per share declined 12%.

While the gyrations of weather are inevitable, management maintained its positive long-term outlook, expecting 6%-8% average annual growth of earnings per share. Thanks to the regulated nature of its business, the company can be reasonably expected not to deviate much from its guidance. Analysts seem to agree, as they expect FirstEnergy to grow its earnings per share by approximately 6% per year on average over the next four years.

A portion of this growth is likely to come from the investments of FirstEnergy in charging infrastructure for electric vehicles. Given the high-growth phase of electric vehicles, the focus of the company on charging infrastructure is undoubtedly positive.

However, it is important to note a striking difference of FirstEnergy from typical utilities. While most utilities have exhibited a consistent growth record, FirstEnergy has posted a markedly volatile performance record. To be sure, the company incurred excessive losses per share of -$14.50 in 2016 and -$3.88 in 2017, mostly due to write-offs of unsuccessful investments. In addition, its bottom line has been highly volatile, with the utility having grown its earnings per share by only 2.8% per year on average since 2012. This is undoubtedly a slow growth pace, even for a utility. It is also worth noting that management cut the dividend by 35% in 2014 due to poor business performance.

On the bright side, FirstEnergy seems to have turned around, with its management doing its best to improve results. Management has contacted thousands of employees, either in person or in virtual meetings, in recent months in an effort to pinpoint weak points and improve performance. This certainly bodes well for the efforts of the company to establish a reliable growth trajectory, like most utilities. On the other hand, these efforts also indicate that FirstEnergy still has a long way to go to maximize its performance.

Dividend

Most shareholders of utilities purchase the stocks of this slow-growth sector for their attractive dividends. FirstEnergy is currently offering an above average dividend yield of 4.3%. This is higher than the 1.7% yield of the S&P 500 and the 3.7% median dividend yield of the utility sector. As FirstEnergy has a decent payout ratio of 65%, its dividend has a meaningful margin of safety.

However, investors should note the poor dividend growth record of the company. While many utilities have long dividend growth streaks, FirstEnergy has frozen its dividend for three consecutive years. It also slashed its dividend by 35% in 2014 and kept the reduced dividend constant for five years. The poor dividend growth record of the company renders its dividend much less attractive, especially in the highly inflationary environment prevailing right now, which reduces the real value of the constant income stream that the shareholders receive. To cut a long story short, the 4.3% dividend of FirstEnergy can be considered safe for the foreseeable future but investors should not expect material dividend growth anytime soon.

Valuation

FirstEnergy is currently trading at a price-to-earnings ratio of 15.2. This earnings multiple is much lower than the median price-to-earnings ratio of 17.7 of the utility sector. On the one hand, the stock seems undervalued when compared to its sector. On the other hand, there is a good reason behind the low earnings multiple, namely the unreliable performance of FirstEnergy, which is in contrast to the consistent growth trajectory of most utilities. Overall, FirstEnergy seems to be fairly reasonably valued right now.

Debt

Thanks to their resilience to recessions, utilities can normally handle higher amounts of debt than companies of other sectors. FirstEnergy has a high debt load. Its interest expense consumes 49% of its operating income while its net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $32.7 billion. As this amount is 160% of the market capitalization of the stock, it is undoubtedly high.

As a utility, FirstEnergy enjoys somewhat predictable cash flows and hence it is not likely to have any problem servicing its debt. On the other hand, its high interest expense takes its toll on its bottom line while it is also indicative of somewhat poor returns of past investments.

Final thoughts

Due to the perfect storm created by the ongoing bear market and the surge of inflation to a 40-year high, income-oriented investors are striving to protect the real value of their portfolios from eroding. Some investors may find FirstEnergy attractive for its above-average dividend yield and its decent payout ratio. However, they should note the choppy performance of the company, particularly when compared to its peers. Companies with volatile business performance tend to underperform the broad market over the long run. The vast underperformance of FirstEnergy over the last decade (-20% vs. +151% of the S&P 500) is a testament to the risk of underperformance of this stock.