Westar Energy: Why I’m Buying This Midwest Utility
Summary Westar Energy is a solid utility company with an 11-year history of increasing its dividend. Kansas economy grows despite tax problems initiated by its state governor. Westar stock sports a 3.89% yield. I’ve been watching Westar Energy (NYSE: WR ) since 1999. As a journalist, I covered the rise and fall of David Wittig, former Westar Energy CEO, who ran the utility like a hedge fund, making a big bets on various businesses unrelated to electricity generation. Westar Energy was for many years a natural gas and utility business. Because of Wittig’s mismanagement, the company was forced to sell natural gas assets to pay down debt. The debt reduction and subsequent CEOs’ focus on improving Westar’s utility business helped the company’s bonds become investment grade by the rating agencies. The company is way more attractive today as an investment than 16 years ago when I started covering it. I have met every CEO of this company since 1999. Toward the end of his reign Wittig was trying to dismantle the company by selling off assets, it was sad to watch. Investors who bought the stock at $9 per share during the crisis in the early 2000s have done quite well, but at the time, there was a very dark cloud over the company. I believe Wittig should have been running a hedge fund, not a regulated utility. Wittig resigned in November 2002 amid a scandal that involved a local banker in a real estate deal. Wittig’s cloud hung over the company until the two parties settled for $36 million payout to Wittig in 2011. Under CEO Jim Haines, Westar streamlined into a pure-play utility company. Bill Moore continued this mission while embracing wind power and cheap natural gas generation. Current President and CEO Mark Ruelle has picked up momentum by investing in wind generation and transmission projects while upgrading coal fired power plants to meet stringent emission standards. Westar spent over $1 billion in air quality investments in the past five years. The company is winding down expenses in air quality, from upwards of $200 million annually to less than $100 million this year and less than $30 million 2016. A June 2, 2015, presentation says Westar has seen “dramatic improvements in air quality.” Wind Renaissance Meanwhile, Westar Energy has really increased its use of renewable energy, especially wind. Renewable energy is currently 9% of generation mix — more than uranium at 8%. Renewable energy will grow to 16% in 2015. This is huge. And coal is declining. Westar uses cheap natural gas to generate electricity. Natural gas is easier to use than coal. Coal plants take some time to start up and shut down. Natural gas generators are quick to turn on and off. So natural gas assets are timely when the wind isn’t blowing, although the wind blows mightily in western Kansas most of the time. (click to enlarge) A year ago, Prairie Wind Transmission, LLC, a joint venture between Westar Energy and Electric Transmission America, celebrated completion of its 108-mile, 345-kilovolt high-capacity electrical transmission line in south-central Kansas. The double-circuit line will serve as an electric energy super highway between eastern and western Kansas, promoting growth of renewable energy in Kansas, providing greater access to lower-cost electricity and improved reliability in the region. Electric Transmission America is a joint venture between subsidiaries of American Electric Power (NYSE: AEP ) and Berkshire Hathaway Energy (NYSE: BRK.B ) to build and own electric transmission assets. “With our current wind resources and those we’ve already committed to next year, we’ll have enough renewable energy to power half our residential customers,” Ruelle said in a recent call with investors. Ruelle said Gov. Sam Brownback has favored renewables. “It’s just pragmatic Kansas politics,” Ruelle said . “He has been a big sponsor of renewables and supported renewables for what it means for rural Kansas. But as you also know there are folks that don’t like the concept of subsidize the energy period and Kansas has made a lot of progress in renewables and everybody has sort of been doing it…We have been doing it because that makes sense economically. And basically Kansas got to a place where we didn’t think a mandate was probably needed to step it up. We’re doing it not because of the mandate, we’re doing it because it’s relatively inexpensive and it’s a good way to navigate the environmental rates.” Westar Energy is the largest electric energy provider in Kansas, providing generation, transmission and distribution to approximately 687,000 customers in east and east-central Kansas. The company is headquartered in Topeka, and employs about 2,400 people in Kansas. Its energy centers in 11 Kansas communities generate more than 7,000 megawatts of electricity, Westar operates and coordinates 34,000 miles of transmission and distribution lines. The Economy The Kansas economy has grown slowly and steadily since the Great Recession of 2008-09, but lags the robust growth of Nebraska or Colorado. Kansas Gov. Sam Brownback is business friendly, but his tax policy has drained state reserves and forced cuts to education and welfare. The political situation here is backward to say the least. Growth occurs in places like Wichita because it is more entrepreneurial than Topeka, it’s not surprising that Pizza Hut started in Wichita. You will find more entrepreneurs in western Kansas than in the statehouse of Topeka. Kansas’ Gross State Product has grown from $121 billion in 2009 to $144 billion in 2013. In a recent conference call, Ruelle said, industrial sales were mixed to down. “The biggest negatives are from our largest chemical manufacturer and pipelines reflecting the impact of lower oil prices,” Ruelle said. “On the positive side, the refineries were operating at capacity and commercial aerospace remains strong. Other good news is that the large candy maker (Mars) who just came to our service territory a couple of years ago has already announced a big expansion and that will add a few more megawatt to our sales.” Rate case Westar Energy asked regulators for a $152 million rate increase but the Kansas Corporation Commission staff recommended $55 million based on a 9.25% Return on Equity (ROE). “If adopted that would be among the lowest authorized ROEs in the nation,” Ruelle said on the investor conference call. I believe the KCC’s proposed 9.25% ROE is lower than the historically 10% to 11% ROE built into previous rate cases. The KCC’s decision on the rate case is expected by Oct. 28 with implementation of new rates in November. I predict a negotiated settlement somewhere around $75 million. That would add $0.53 cents per share in revenue or about $0.06 cents per share in profit. EPS for the trailing 12 months was $2.25 per share, while the company is predicting 2015 earnings guidance at $2.18 to $2.33 per share. An additional $0.06 cents from the rate case would increase EPS by 2.6%. With large air quality projects finishing in 2015, the company’s need to raise capital has diminished. The company has a decent balance sheet, plenty of liquidity and no need for new equity. As a result, I expect the company to continue its trend of increasing its dividend. Growth and income investors will like this: The company has increased its dividend every year for 11 years. Payout ratio is reasonable at Westar Energy. Company pays out 60% to 75% of earnings in dividends. The current $0.36 cent per share quarterly dividend is a yield of 3.89%. I like the stock at $36.00. I believe the stock is fully valued at $40 per share. WR was trading at $39 per share in mid August before the recent stock market correction. Risks It is likely the Federal Reserve will start raising interest rates. This may or may not happen in 2015, but I do expect rates to go up by fall 2016. The cost of debt will go up for all utilities, including Westar Energy. However, I believe we will see relatively low interest rates for many years, perhaps the next decade. Economic growth is sluggish in Kansas. Gov. Sam Brownback eliminated income taxes for most small businesses, with the hope the owners would re-invest the tax savings into job creation. But business owners, farmers and ranchers did not need additional employees, so they never went on a hiring spree as Brownback had hoped. With a reduction in state revenue, local school boards will likely raise property taxes to fund the education gap. Weather has been mild all year, reducing the need for a boost in generation that is typical in summer months. Conclusion Westar Energy is a solid company with good management. A year ago I had purchased Westar stock at $36 per share and sold it at $40 per share. I recently bought shares at $37.07, and may add shares at lower prices. The stock market is going through substantial volatility. I can sleep at night owning this stock. People need electricity. Westar rates are among the most affordable in the country. I believe a rate increase will happen this fall and the company will be able to raise its dividend in 2016. Disclosure: I am/we are long BRK.B, WR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.