initiating coverage wisconsin energy corp. (wec)

8/10/2019 Initiating Coverage Wisconsin Energy Corp. (WEC)

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INITIATING COVERAGE REPORT William C. Dunkelberg Owl FundOctober 11, 2014

Michael KLead An

mkollar@theowlfund

Nathan Eisenb

Associate Anneisenberg@theowlfund

COMPANY OVERVIEW

Wisconsin Electric Corporation (WEC) is a verticallyintegrated multi-utility operating in Wisconsin and theMichigan Upper Peninsula. WEC operates primarily in twosegments: utility energy (90.9% of FY 13 revenue) and non-utility energy (0.9%). WECs utility segment serves 2.2 millioncustomers and is the largest utility in Wisconsin. The non-utility segment generates power for WEC transmission and

wholesale on the unregulated energy markets.

INVESTMENT THESIS

Currently, the Owl Fund portfolio has an allocation to XLU,

the SPDR Utilities ETF, which is a basket of 30 S&P 500

index utilities. The utility sector is currently trading at the

upper end of its historical valuation because after the U.S.

Federal Reserve cut interest rates, investors deployed capital

into these equities searching to replace yields lost in their bond

portfolios. Since the U.S. economy has stabilized after the 2008

financial crisis, the Federal Reserve has ended quantitative

easing and is seeking to raise interest rates as GDP expandsand unemployment declines. As a result of the expected

tightening monetary policy, the 10 year treasury rate will rise.

Risk-adverse investors will rotate back into fixed income

positions. This will cause an outflow from utility stocks and a

subsequent fall in their value. We believe the Owl Fund can be

proactive and make the tactical decision to reallocate a portion

of capital from the XLU ETF, to a single, undervalued utility

company. Wisconsin Energy Corporation (WEC) offers a

synthesis of undervaluation, premium operational

performance, liquidity, attractive yield and future dividend

growth potential greater than that of its XLU peers. These

factors will provide the Owl Fund with capital appreciation,yield, and downside protection when investors rotate out of

the utilities sector. We initiate coverage of WEC with a Buy

recommendation with a price target of $47.61 which was

achieved using an implied p/e multiple of 18.38x and NTM

Consensus EPS of $2.59. With a 3.4% dividend yield, we

expect a total return of 8%.

Utilities

Multi-

Utilities

Wisconsin Energy Corp.Exchange:NYSE Ticker:WEC Target Price:$47.61

Sector: OutperformRecommendation: BUY

All prices current at end of previous trading sess ions from date of

report. Data is sourced from local exchanges via CapIQ,

Bloomberg and other vendors. The William C. Dunkelberg Owl

Fund does and seeks to do business with companies covered in its

research reports.

Key Statistics

Price Projected $47.61 52 wk High $49.21

Capital Return 5% 52 wk Low $40.11

Shares O/S (mm) 226 Yield 3.42%

Market Cap (mm) $10,275 EV (mm) 15,314$

P/E 17.8 Beta 0.67

Date EPS NIYOY NI Surp Price

3Q2013 $ 0.60 -12% 6.6% -1.22%

4Q2013 $ 0.49 46% 5.6% -0.17%

1Q2014 $ 0.90 18% 7.0% 0.75%2Q2014 $ 0.57 14% 14.4% -2.03%

Earnings History

$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$-

$0.20

$0.40

$0.60

$0.80

$1.00

2011 2012 2013 2014 2015

Diluted EPS & Consensus

Period 2011 2012 2013 2014 2015E1Q $ 0.72 $ 0.74 $ 0.76 $ 0.91 $ 0.87

2Q $ 0.41 $ 0.51 $ 0.52 $ 0.59 $ 0.60

3Q $ 0.55 $ 0.67 $ 0.60 $ 0.50 $ 0.60

4Q $ 0.49 $ 0.43 $ 0.63 $ 0.62 $ 0.63

Year $ 2.17 $ 2.35 $ 2.51 $ 2.62 $ 2.70

Earnings Per Share for FYE Dec.
mailto:[email protected]:[email protected]


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T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Pag

CATALYSTSAlthough utility companies are known for low growth and high regulation,management can create value through superior relationships with regulatorsand financial stewardship with regard to capital expenditures, capitalstructure, dividend payments, and strategic acquisitions. We believe that

WEC possesses a management team that has a strong track record andtransparent objectives that will persist through our investment horizon.

Below are examples of catalysts unique to WEC that will deliver higherearnings, improved cash flow, and create a runway for future dividendincreases greater than that of its peers. We do not contend that these factorsare not priced-in to the stock; however, we are less concerned with capitalappreciation and more concerned with downside protection and higher yield

our primary reasons for rotating out of the XLU ETF and increasing theFunds exposure to this specific utility.

Integrys Acquisition (NYSE:TEG)On June 23, 2014 WEC and Integrys Energy Group Inc.(NYSE:TEG) entered into a definitive agreement in which WECwould acquire TEG in a cash and stock transaction valued at $9.1billion, including $3.3 billion of new debt to be issued by WEC.Management stated this transaction met its three criteria for a

strategic acquisition: 1) Accretive within 12 months; 2) Credit-Neutral; 3) Long-term earnings growth of combined company wouldbe greater than that of WEC as a stand-alone company. TEG has aneed for capital investments in infrastructure which provides arunway for future earnings growth as regulated ROE will be raised inorder for the company to recover these costs. By acquiring TEG,WEC can inorganically supplement its own earnings growth, realizesynergies in operations, and enhance reliability to its customers.

Majority Ownership ofATCPost AcquisitionUpon the closing of the TEG acquisition, WEC will have a 60%economic interest of American Transmission Company (ATC), thelargest independent electricity transmission company in the UnitedStates. ATC will require capital investments as it expands. Future

ROE increases will boost WECs overall ROE and grow earnings.

Frac sand mining operations expandingWI is seeing a boom in industrial growth in the western part of thestate as frac sand mining has increased to support hydraulicfracturing activities in the Permian, Eagle Ford, and Bakken Basins.Licensed sand operations have increased from 10 in 2010 to 115 asof September 2014. Frac sand is transported by rail and as such,lower weight, or tonnage, results in lower costs. Frac sand is moistwhen extracted and to reduce its weight, miners use industrial driersto dry the sand in preparation for transport. WECs exposure to thisgrowing industry provides a hedge against energy use curtailmentdue to conservation efforts and more efficient use by consumers.

Conversion from propane to natural gasDue to the lower cost of natural gas, both residential andcommercial & industrial utility customers have converted frompropane to natural gas. WI is the fifth heaviest propane using state inthe U.S., indicating conversions will persist over the long term. Thisshift will boost WECs natural gas connections going forward, whichincreased 8.5% in 2Q2014. This conversion will be accretive toWECs bottom line because the natural gas side of WECs businesshas a higher allowed ROE; 10.5% in natural gas to 10.4% in electric.

ECONOMIC MOAT

Moderate / Stable

Wisconsins favorable regulatory environment

Unregulated revenue stream

Geographic monopoly of +4 million customers

RISKS

Weather: Inclement weather can disrupt power

grids and destroy infrastructure, requiring

additional operations & maintenance expenditures

which can adversely impact earnings.

Cool Temperatures: Electricity demand is greatest

in the summer, from mid-July to mid-August, when

temperatures are highest. Air conditioning units,

both residential and commercial, run longer and

harder to provide additional cooling. Little to no

+90 degree days in this time frame can severely

affect earnings. Regulatory Environment:WEC is regulated at

the state level by multiple utility commissions and

also at the federal level by the Federal Energy

Regulatory Commission, the Environmental

Protection Agency, and the Federal

Communications Commission. Changes in

regulations may have adverse effects on WECs

earnings.

Acquisition:WEC is in the process of a large

acquisition. While we strongly believe the

acquisition will be accomplished in an effective and

timely fashion, its completion is subject to

shareholder and regulatory approvals.

Project:WEC has numerous outstanding projects.

Delays and cost overruns may impact financial

results.

POSITIVES

Low Risk Business: Customers need to turn on

the lights and run air conditioners - even during

recessions.

Low Beta: Utility stocks are equities, however,

their returns are more similar to fixed income

assets and are not correlated to the broader equity

markets.

Earnings Track Record / Future Growth

Positive Free Cash Flow:WEC offers positive

free cash flow, while many utilities post negative

free cash flow due to required capital investments.

Lower Payout Ratio:WECs lower payout ratio

indicates the company spends less net income to

pay dividends relative to its peers.

Fully-Funded Pension Plan


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Fall 2014


PEER GROUP IDENTIFICATION

This peer group includes other members of

the S&P 500 Multi-Utility index that operate in

similar climates and main energy sources are coal andnatural gas.

American Electric Power (AEP)

Xcel Energy Inc. (XEL)

Northeast Utilities (NU)

CMS Energy Corp. (CMS)

TARGET PRICE

We reached a target price using an implied price to

earnings multiple for WEC relative to its peer group.

Currently, WEC is trading at a 3.7% and 0.96% discountto and index of its peers on a one- and three-year basis,

respectively.

Target P/E Multiple = 18.38X

NTM Consensus EPS = $2.59

Target Price = $47.61

Bloomberg 12M TP Consensus: $46.58

Projected Capital Return: 4.5%

INDUSTRY OVERVIEW

U.S. Utilities

The U.S. utilities industry provides electric power services to residential (45.2% of industry revenue),

commercial (36.7%), industrial (17.9%) and transportation (0.2%) markets. Utilities serve an essential public

good; and as such, demand is fairly inelastic in the short-term, consumption being relatively unaffected by

sudden changes in energy-commodity prices. Thus, utilities are often seen as independent of economic cycles.

Shareholders are rewarded in this mature market through high-dividend yields that cause utilities to function

like fixed income vehicles. The capital-intensive infrastructure required and lack of substitute goods have

consolidated the utility market, most utilities operating as near-monopolies in their geographic region ofoperations. While most utilities remain regulated, vertically integrated from power generation to distribution,

the early 1990s saw the deregulation of wholesale electricity prices; opening up the market to speculative,

merchant generators who sell electricity on unregulated markets.

Regulated Utilities

Regulatory bodies such as the Federal Energy Regulatory Commission (FERC) and local public utility

commissions (PUCs) impose strict guidelines on regulated utilities rates, service standards and power

transmission. This highly regulated environment keeps electricity costs and utilities earnings fairly stable and

predictable. Utilities achieve revenue growth through incremental electrical and natural gas demand increases,

as well as periodic customer rate increases. Rate increases are accomplished when a utility company receives afavorable judgment from a PUC in a rate case- a formal process in which a utilityapplies for the approval to

raise utility rates on customers for the purpose of recovering costs of required infrastructure maintenance and

investment, as well as fuel costs. These costs are a function of a test year, a specified period of time

regulators use as a base for measuring a utilitys costs. It should be noted that depending on the state, test

years may occur every year or every two years, and test years can be backward- or forward-looking; a utility

either projects its expected costs or applies to recover costs already incurred. WI uses forward-looking test years

and has test years every two years, with January 1, 2015 representing a new test year. Factors impacting a


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Fall 2014


PUCs judgment in approving rate includes consideration of the utilities quality of service and responsiveness

to blackouts. Essentially, a utility companys growth is boosted by cost increases and capital expenditures,

while their recovery is as a function of a target ROE for the company. Successfully passing rate cases is vital

for a utilitys continued profitability: corporate image is a significant factor.

Deregulated Utilities

Deregulatory trends have continued since the 1990s, state-by-state. Merchant generators market wholesale

electricity to service providers and network operators, but do not participate in the transmission or

distribution end. Consumption is both cyclical (higher in the summer and winter months) and volatile

(subject to weather conditions). This makes it difficult to predict demand, exposing wholesale generators to

greater price risks. For instance, a mild summer could curtail demand as a result of lighter air conditioner-use.

Accurate speculators can achieve greater returns then their regulated counterparts, however. Many regulated

utilities have wholesale subsidiaries that can sell electricity back to the parent company or other service

providers. Commodity volatility in recent years has led some utilities to divest their generation segments,

while others are looking to grow wholesale segments.

Wisconsin

Wisconsin (WI) residential consumers use 103 million BTU of energy per home, 15% more than the national

average. However, lower electricity and natural gas costs result in 5% less spending on energy than the

national average. Due to somewhat cooler weather, WI consumes more electricity during the winter and less

during the summer than the average.WIsrobust industrial sector, which includes chemical manufacturing,

food processing, plastics and forest products, demands higher-than-average energy use, accounting for nearly

one-third of the states consumption. Coal is the single largest source (62%) of net generation. WI is also

home to the corporate headquarters of Harley Davidson, Kohls, Johnson Controls. WI also has an

unemployment rate of 5.7%, below the national average.

Frac Sand Industry in Wisconsin

The soil in the western part of Wisconsin is largely sand, and has a complimentary composition to the

requirements of hydraulic fracturing proppant. Sand mining operations has grown recently to support the

increased drilling activity in the Permian and Bakken Basins. This is a positive for WEC because frac sand is

wet upon mining and must be dried before being shipped via rail car in order to reduce tonnage and

transportation costs. Many of the frac sand miners complete this task using natural gas fueled, industrial sized

driers. Additional driers and frac sand mining will increase energy demand in the region and help offset

conservation and efficient use seen in the residential sector.

Outlook

Growth in electricity consumption has slowed every decade since the 1950s as growth in electric services ispartially offset by increased efficiency. Nevertheless, demand is expected to grow roughly one-percent each

year through 2040. Utility consolidation is a recent trend aimed at achieving geographic synergies, with total

M&A expected to reach a record $25 billion in 2014 as deregulation continues. Finally, natural gas is expected

to be the fastest growing source of generation as environmental legislation curbs coal profitability.


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Fall 2014


DETAILED COMPANY OVERVIEW

Business Segments

Utility Energy

WECs utility energy segment is We Energies, consisting of Wisconsin Electric and Wisconsin Gas. WeEnergies provides electricity to over 2.2 million customers in Wisconsin and the Upper Peninsula of

Michigan. This segment comprises 90.9% of WECs FY 13revenue ($4.46 billion) and is both the largest

electric and natural gas utility in Wisconsin. In addition to generation and distribution, We Energies buys and

sells energy on the MISO wholesale markets. Power generation is achieved through three main fuel types:

coal (63.48% net output, natural gas (33.95%) and renewables (2.57%, which includes hydroelectric, biomass

and wind power).

We Energies submitted a biennial rate case earlier this year for 2015 and 2016. Agreements for target ROE,

capital structure and base rate changes were settled in May.

Wisconsin Electric ROE: 10.2%, Wisconsin Gas ROE: 10.3% Wisconsin Electric 51% equity (unchanged), Wisconsin Gas equity increased 200 bps to 49.5%

Electric rate increase of 1.4% in 2015 ($41.5 million)

Rate case finalization is expected this fall.

Non-Utility Energy

WECs non-utility energy segment consists of power generating plants under WECs We Power subsidiary,

which comprises 9.1% of FY 13 revenue. We Power, through its Power the Future (PTF) program, leases

generating plants to Wisconsin Electric in order to supply their energy generation capacity. Fuel types used to

generate power are: bituminous and Powder River Basin coals and natural gas.

Oak Creek Expansion Units 1 & 2

Port Washington Generating Station Unit 1 & 2

American Transmission Company

WEC holds a minority interest in ATC, a regional transmission company that

owns and operates electric transmission systems in Wisconsin, Michigan, Illinois

and Minnesota. ATC, in conjunction with Duke Energy, is expanding its

transmission footprint in the mid-west and into California, now through 2016,

with over $1.3 billion in CAPEX.WECs acquisition target TEG is also controls a

minority interest in ATC. Post-acquisition, WEC will have a 60% economic

interest in ATCs earnings.


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Mergers & Acquisitions

TEGWe find the announced acquisition of TEG to be a catalyst for both capital appreciation and dividendincreases. The transaction would create WEC Energy Group, Inc. (still traded as NYSE:WEC), and expand

WECs current footprint from solely Wisconsin, to Michigan, Illinois, and Minnesota. Post-acquisition, WEC

would have a market capitalization of $15 billion and raise WECs aggregate customer base 95.5%, from 2.2million to 4.3 million customers. The combined company would control the 8thlargest natural gas distributionoperation in the U.S. and possess a 60% economic interest in ATC, the largest independent transmissioncompany in the United States. This acquisition is anticipated to be accretive in the first calendar year and willcontribute to WECs expected annual EPS growth of 5% - 7% and annual dividend growth of 7% - 8%.

TEG is in close proximity to WECs existing infrastructure and the combined company will be able to realizesynergies and improve reliability of its services to customers. Because utility companies are mainly fixed assetssuch as power plants and infrastructure, we see limited risk in its integration and results. The transaction issubject to approvals by: WEC and TEG shareholders; the Federal Energy Regulatory Commission; theFederal Communications Commission; and WI, MI, MN, and IL state regulators. The transaction is expectedto close at the end of 2Q2015.

Aside from TEG, WECs is not very acquisitive, making only 6 small acquisitions in the last ten years.

FINANCIAL ANALYSIS

Revenue

Revenue grew from $4.2 billion to $4.5 billion, a 1.83%

CAGR since 2010. Cost hedging mechanisms make gross

margin a more relevant performance indicator, as

described below.

Margins

Gross Margin

WEC believes gross margins to be a better indicator of

performance than revenue as fuel price fluctuates intandem with energy sales. Gross margins have grown at a

CAGR of 9.29% since 2010. GM in 2010 and 2011 were

somewhat depressed due to increased operations and

maintenance expenses from aging infrastructure.


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Electric

Electric utility gross margins grew slightly at just under a one-percent CAGR since 2011, fluctuating

between 63.9% and 65.86%. Warmer weather during 2012 and a cold 2012 favorably impacted

electric gross margins.

Gas

Gas utility gross margins also grew slightly, at just over a one-percent CAGR since 2011. Natural gas

prices experienced greater volatility during this period, contributing to wider gross margin

fluctuations between 38.31% and 43.3%.

Capital Expenditures/Depreciation

Capital expenditures decreased at a 6.12% CAGR since 2011, primarily due

to decreased expenditures need on WECs Oak Creek AQCS plant. WEC

currently has a CAPEX to depreciation ratio of 1.8x, which has remained

near or above 2.0x since 2011, emphasizing WECs commitment to a

growing rate base.

Free Cash Flow

One of the most attractive aspects of WEC is its positive freecash flow. The company has made significant investments to itsinfrastructure and power plants and these large projects are ontrack to be completed by the end of 2015. We expect WECsFCF to improve from its current level of $455.86 million.Management has stated that it is shifting its focus away fromlarge projects to smaller projects, such as repairing and replacing

telephone poles and wires. These smaller projects carry less riskas they are not as subject to cost overruns as larger projects. Wefeel comfortable that WEC will be able to grow its positive cashflow going forward, which is uncommon in the utility sector.

Debt & Liquidity

Given the capital intensity of operating and sustaining a utility company, leverage is quite high. In FYE 2013,

WEC had a debt-to-equity ratio of 123% and a debt-to-capital ratio of 55.2%. D/E has decreased at a 1.8%

CAGR since 2010; D/C decreased at a 0.8% CAGR since 2010. Long-term debt represents 82.4% of the

firms total debt. WEC has an interest-coverage ratio of 4.3x and positive cash flows (which many integrated

utilities lack). These metrics proves WEC will allow it meet its short and long-term debt obligations, as well as

sustain its dividend payments.


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DuPont Analysis / ROE

WEC operates in a very favorable rate

environment and has a strong track record

of winning rate cases. This is evidended by

its high return on equity relative to its peer

group and the broader XLU ETF.

Dividends

The primary consideration when investing in a utility company is

yield, and its ability to grow dividends per share. WEC has a

dividend yield of 3.4%, a long term track record of increasing

dividends, and leads the entire XLU ETF in dividend growth.

WEC has five-year dividend growth of 14% vs. peer groups

average of 6%.

WEC has a payout ratio of 57% and management has guided it

seeks to steadily increase this ratio to 65% - 70% by 2017.

VALUATION

Undervaluation

Utility companies have stable, predictable cash flows, lowgrowth, and are highly regulated. Their businesses are notimpacted by economic shocks and demand for their serviceselectricity - is inelastic. As such, their valuations are largely

indicative of true intrinsic value, more so than other sectors.Shareholders are more concerned with a utilitysability to paydividends and less concerned with capital appreciation.

Another consideration regarding utility company valuations is the 10 year treasury yield. After the U.S.Federal Reserve cut interest rates, risk-adverse investors deployed capital into utility equities searching toreplace yields lost in their bond portfolios, inflating valuations. Also, given the markets recent volatility,utility companies have appreciated due to a flight to safety. We expect continued volatility in the near termdue to ongoing concerns of European economic growth, weak demand in China, and the looming tighteningof U.S. monetary policy. WEC is trading 1.1% above it one-year historical average, a 3.9% discount to itsthree-year historical average, and a 4.0% discount to its five-year historical average. Compared to an index ofits peers, WEC is trading at a 3.76% discount to its three-year historical average. We believe that the TEGacquisition and WECs ability to receive future rate increases will bring it to our target implied p/e multiple of18.38x.

DuPont Analysis

Company

Tax

Burden

Interest

Burden

Operating

Margin

Asset

Turnover

Leverage

Ratio ROE

BB

Check

Wisconsin Energy 62.41 0.87 0.24 0.34 0.03 15.4% 14.5%

Average 64.11 0.76 0.18 0.33 0.04 11% 11%

American Electric Power 64.61 0.80 0.19 0.30 0.04 9.9% 10.8%

Xcel Energy Inc. 65.73 0.79 0.17 0.34 0.04 10.6% 10.1%

Northeast Utilities 63.15 0.78 0.21 0.27 0.03 8.0% 7.8%

CMS Energy Corp. 62.96 0.67 0.17 0.41 0.05 14.9% 14.8%


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Comparable Analysis

APPENDIX

Margins

Stock Equity Enterprise

Price Market Market ROE ROA ROC WACC

v en

Yield

ear

Dividend Payout

ross

Margin

ro t

Margin

urrent

Ra ti o Be ta

% % % % % Growth Ratio % %

Company Value Value LTM NFY LTM NFY LTM LTM LTM LTM NTM LTM LTM LTM LTM

WEC $45.56 $10,275 $15,314 17.8 16.9 9.8 9.7 13.7 4.3 8.3 1.77 3.39 13.94 56.96 55.27 12.78 1.04 0.67Mean 16.3 15.6 9.3 8.8 11.2 2.9 6.1 1.3 3.52 6.07 60.36 56.0 9.0 0.9 0.7

Median 16.1 15.6 9.0 8.7 10.6 2.9 6.3 1.2 3.56 6.43 59.28 57.4 9.2 0.8 0.7

AEP $53.89 $26,334 $45,378 14.8 15.2 8.6 8.5 11.0 3.1 6.5 1.23 3.69 4.17 64.46 62.67 9.64 0.71 0.75

XEL $31.58 $15,960 $28,398 16.3 15.1 9.5 8.9 10.1 2.9 6.1 1.23 3.67 7.27 58.43 52.10 8.69 0.88 0.69

NU $46.46 $14,699 $24,152 18.2 16.1 10.6 9.4 8.5 2.7 5.2 1.12 3.27 6.88 58.87 62.70 10.77 0.64 0.61

CMS $30.51 $8,423 $16,207 16.0 16.2 8.6 8.4 15.0 2.9 6.8 1.62 3.44 5.97 59.69 46.70 6.88 1.30 0.69

P/E Multiple EV/EBITDA

Wisconsin Energy Comparable Analysis($ in millions except per share)

Capitalization Valuation Multiples Ratios


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T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Page

DISCLAIMER

This report is prepared strictly for educational purposes and should not be used as an actual investment guide.

The forward looking statements contained within are simply the authors opinions. The writer does not own any

Wisconsin Energy Corp. stock.

TUIA STATEMENT

Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his

tireless dedication to educating students in real-world principles of economics and business, the William C.

Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging,

practical learning experience. Managed by Fox School of Business graduate and undergraduate students with

oversight from its Board of Directors, the WCD Owl Funds goals are threefold:

Provide students with hands-on investment management experience

Enable students to work in a team-based setting in consultation with investment professionals.

Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs

and partial scholarships for student participants.

initiating coverage wisconsin energy corp. (wec)

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