I keep hearing about how the world will be permanently scarred from the pandemic.
NYC is dead, everyone will work from home, and commercial real estate is suddenly worthless?
Sounds like emotional hyperbole mixed with recency bias to me.
That said, I do think a number of industries will be impacted to varying degrees by the crisis.
And that’s why it’s so important to invest in industries that haven’t been negatively impacted.
The hospitality industry, for instance, is an industry that’s super tough to invest in right now.
That’s because almost nobody is traveling, which severely curtails long-term cash flows for businesses in that industry.
On the other hand, many industries have cruised right along as if there were no pandemic at all.
Nobody saw any of this coming, though, and that’s why diversification is your friend.
This six-figure portfolio, which I call the FIRE Fund, generates enough five-figure passive dividend income for me to live off of.
This allows me to be retired at a very young age, as I lay out in my Early Retirement Blueprint.
By living below my means and intelligently investing my capital, I was able to quit my job and retire in my early 30s.
One could argue about which investment strategy is the most intelligent of all, but I can tell you that dividend growth investing has served me well.
I’m talking about companies like you can find on the Dividend Champions, Contenders, and Challengers list.
Any business that can afford to pay out a growing cash dividend for years – or even decades – must be doing a lot of things right.
As always, though, investing is most intelligent when it’s businesslike.
Every stock is a slice of a real business.
As such, it’s imperative that you do your analysis and make sure you’re paying an appropriate price.
Valuation can play a huge role in the outcome of an investment.
Price is only what you pay. It’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
Investing in unaffected industries, and doing so at attractive valuations, could be one of the intelligent things an investor can do right now.
The valuation aspect, at least, has been made much easier via fellow contributor Dave Van Knapp’s Lesson 11: Valuation.
Part of a more comprehensive series on dividend growth investing, Lesson 11 puts forth a valuation template that you can apply to just about any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Portland General Electric Company (POR) is a regulated electric utility that serves approximately 900,000 customers across the state of Oregon.
Founded in 1889, the company is a $3.7 billion (by market cap) vertically-integrated utility that’s engaged in generating, purchasing, transmitting, distributing, and retail selling electricity.
FY 2019 retail revenue breaks down across the following customer classes: 52%, residential; 35%, commercial; and 12%, industrial.
Their generation mix is: 33%, natural gas; 30%, purchased power; 14%, hydro; 14%, coal; and 9%, wind.
This generation mix, however, is set to become cleaner with the development of the Wheatridge Renewable Energy Facility.
This will be the nation’s first major renewable energy facility to integrate wind and solar generation with battery storage in one location. Portland General Electric has partnered with the venerable NextEra Energy Inc. (NEE) on this facility.
The utility industry entered the health crisis in a great position.
After all, electricity is a basic need that modern society cannot live without.
We’ve seen that position of strength play out over the last few months. The pandemic hasn’t really affected utilities.
There’s been a shift in terms of where usage occurs, and industrial activity is certainly down, but the core business model is as necessary and strong as it’s ever been.
That’s great news for investors.
And it’s also great news for dividends in this space.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, Portland General Electric has increased its dividend for 15 consecutive years.
In fact, they just increased their dividend at the end of July by almost 6%.
If that’s not a sign of strength, I don’t know what is.
The 10-year dividend growth rate is 4.1%.
That vigorous growth comes on top of the stock’s starting yield of 4.39%.
This yield, by the way, is almost 140 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 62%, based on TTM EPS, the dividend is easily covered and within management’s targeted payout ratio range of 60% to 70%.
Revenue and Earnings Growth
Great dividend metrics, but much of this is looking backward.
It’s future results that ultimately matter most.
We investors are putting today’s capital on the line for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking trajectory for the company’s growth, which will later help us estimate intrinsic value.
This trajectory will partially rely on what the business has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this manner should allow us to draw some reasonable conclusions about where Portland General Electric is going.
The company grew its revenue from $1.783 billion in FY 2010 to $2.051 billion in FY 2019.
That’s a compound annual growth rate of 1.57%.
It’s not an excellent result, but this isn’t out of line with what I commonly see across the broader utility space.
Meanwhile, earnings per share advanced from $1.66 to $2.39 over this period, which is a CAGR of 4.13%.
That lines up very well with the 10-year dividend growth rate.
Notably, this is on the low end of management’s own future guidance. Management is calling for 4% to 6% long-term diluted EPS growth.
There’s been a nice expansion in margins over the last decade, which has helped to propel that excess bottom-line growth.
Looking forward, CFRA is projecting that Portland General Electric will compound its EPS at an annual rate of 4% over the next three years.
This isn’t exactly a stretch. It’s basically an assumption that the status quo will continue.
I would look at this 4% EPS growth rate projection as the low end of what the company is capable of moving forward, and that also translates over to the dividend growth.
Meeting in the middle would be 5%. And I think that’s a perfectly rational expectation.
For comparison, Morningstar states “PGE can grow the dividend 6% annually, in line with peers, given the growing economy in its service territory, investment opportunities, and cash flow to support up to a 70% payout ratio.”
One ugly wart on an otherwise attractive utility business is the very recent disclosure of rogue energy trades in the wholesale electricity markets leading to $100+ million in losses for the businesses.
Two employees are on administrative leave. The news also clobbered the stock, down as much as 14% on August 25.
That clobbering is why I’m writing about this stock, and it’s why I’m so enthusiastic about its prospects at this time.
If you buy a stock when it’s all roses and sunshine, you pay a high price.
Indeed, I’ve long seen this as an overvalued utility, and I never featured it in this series. But the valuation has finally come down to a reasonable level, and here we are now talking about it.
This stock was $63 back in February. It’s now well below $40. You choose which price you’d rather pay.
While the rogue trading news is unfortunate, it’s a one-time event that doesn’t change the long-term story.
Morningstar lowered its fair value on the stock by $1 after the news came out, which I think is appropriate. Portland General Electric has ~90 million shares outstanding. A $1 cut in value per share roughly corresponds with the size of the loss.
CFRA, on the other hand, lopped $12 off of its 12-month target price, which I see as a gross overreaction.
Guggenheim analyst Shahriar Pourreza had this to say about the news after maintaining their price target: “While the announcement is an unpleasant surprise, the loss is containerized to 3Q, with the company concurrently reaffirming its long-term 4-6% EPS growth rate, maintaining its dividend plans, and already holding discussions with the ratings agencies. POR had a strong liquidity position coming off COVID in 2Q and plans to issue some additional L-T debt to cushion the impact. We see this as an unfortunate one-off event.”
I strongly agree with Pourreza.
Financial Position
Moving over to the balance sheet, the company has a solid financial position that’s in line with what I’d expect for a utility.
The long-term debt/equity ratio is 1.0, while the interest coverage ratio is near 3.
Profitability is fairly robust, with the company sporting numbers that are competitive with much larger utilities.
Over the last five years, the firm has averaged annual net margin of 10.07% and annual return on equity of 8.30%.
The business model has been virtually unaffected by the pandemic.
The rogue trading, while unfortunate, didn’t have anything to do with the pandemic or otherwise indicate a problem with core operations.
If anything, the dramatic pullback has moved this stock from mildly undervalued to one of the more compelling opportunities in the entire utility space, in my opinion.
The company’s geographic monopoly, regulatory framework, and scale are mighty competitive advantages, protecting the future of the business.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Regulation is a key risk that’s particular to all utilities.
Local governments heavily regulate utilities and cap their growth. In exchange, utilities are allowed to run local monopolies that have built-in profit which scales up with operational costs.
The recent trading issue shows a clear need for better internal controls and governance.
This utility isn’t as geographically diversified as some larger utilities, and Portland General Electric’s fortunes will largely rise and fall with the fortunes of the greater Portland, Oregon area.
There’s also political risk here, due in large part to the service area. The Portland area will likely be more aggressive than average in terms of pushing cleaner energy initiatives.
Overall, I now see this as one of the most appealing utility stocks out there.
The ~40% drop from its 52-week high has created an amazing opportunity in terms of valuation…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 14.11.
That’s well off of the stock’s own five-year average P/E ratio of 20.2.
It’s also way below the broader market’s earnings multiple.
Then there’s cash flow.
The P/CF ratio, at 5.7, is materially lower than the stock’s three-year average P/CF ratio of 7.2.
And the yield, as shown earlier, is significantly higher than its own recent historical average.
So the stock does look cheap based on basic valuation metrics. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate (to account for the high yield) and a long-term dividend growth rate of 5%.
This DGR is basically splitting the difference between the company’s own short-term and long-term dividend growth rate. It’s also splitting the difference between management’s future EPS growth guidance and CFRA’s near-term EPS growth projection.
I think the company is perfectly capable of doing better than this, as evidenced by recent dividend increases and Morningstar’s forecast.
But the recent trading issue will curtail near-term growth, and I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $42.79.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
Even after a conservative valuation model, the stock still looks cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates POR as a 4-star stock, with a fair value estimate of $43.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates POR as a 3-star “HOLD”, with a 12-month target price of $38.00.
I came out almost exactly where Morningstar is at, which I think is accurate. Averaging the three numbers out gives us a final valuation of $41.26, which would indicate the stock is possibly 11% undervalued.
-Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is POR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 73. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, POR’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
