NextEra Energy And VPU: Worst Time In A Decade To Buy Utilities (NYSE:NEE)

Thesis

We follow a top-down investment approach. We first check the market at a sector level to see the forest and then check a few leading stocks to see the trees. Here is what we see at the sector level, represented by the Vanguard Utilities ETF (NYSEARCA:VPU). With the 10-year treasury rates pushing toward 3%, many “safe” sectors and stocks such as utilities and consumer staples are no longer safe, as you can see from our market dashboard below. Among all market sectors, utility is actually the most expensively valued sector relative to the risk-free rates, and consumer staples are the fourth most expensively valued sector. The mechanics of the market dashboard are detailed in our earlier article here and you are welcome to download it here.

At the individual stock level, the next chart compares the sector leader, NextEra Energy (NYSE:NEE), against VPU. As you can see, admittedly, NEE enjoys superior profitability metrics. It is net profit margin is about 2.7 times higher than the sector average. And its return on equity (“ROE”) is about 1.5 times higher than the sector average. It has also just delivered a strong Q1 with 10.4% adjusted EPS growth (more on the highlights of Q1 results later).

However, it is also valued at a significant premium relative to the sector. Moreover, the valuation premium is even higher than on the surface shown here, as to be shown in a later section. Note that the second chart is based on data provided either from Yahoo Finance or Seeking Alpha after the market closed on April 29. Given the large volatilities these days, these numbers might have changed a bit when you read this article.

Next, we will review some basics of VPU and NEE, examine NEE’s Q1 earnings closely, and comment on their valuation risks.

VPU and NEE – the fund and its leader

VPU is a popular utility sector fund and I assume readers are already familiar with the basics. As of this writing, it holds a total of 66 stocks. The chart below shows its top 10 holdings. And NEE is its largest holding, representing almost 14% of the total assets. The fund is top-heavy and the top 10 holdings represent almost 55% of its total assets.

Both the fund and NEE have delivered solid total returns in the past as you can see from the second chart below. Given the large weight of NEE in the fund, VPU’s performance has been correlated with the performance of NEE. However, with its superior business model and growth, NEE has delivered a higher total return than VPU by a large margin (by more than 6.5% per annum).

However, as to be detailed next, we are concerned about both VPU and NEE given their current valuations.

As a side note before leaving this section, note that NEE actually suffered lower worst year performance and lower maximum drawdown than VPU. We ourselves love a concentrated portfolio because our experiences repeatedly show that a few well-understood stocks not only deliver superior returns but also at LOWRE risks. The VPU vs NEE example here is another example where the addition of a bunch of extra stocks (65 of them) actually made the price volatility worse during turbulent times.

NextEra Energy Q1 2022 earnings highlights

NEE reported its first Quarter 2022 earnings on April 21, 2022. Overall, NEE delivered another strong quarter, as commented by Kirk Crews (EVP and CFO):

NextEra Energy delivered strong first quarter results and is off to a solid start to meet its overall objectives for the year. Adjusted earnings per share increased by 10.4% year-over-year, reflecting successful performance across all of our underlying businesses. During the quarter, we were honored that NextEra Energy was again ranked number one in its sector of Fortune Magazine’s world’s most admired companies list for the 15th time in 16 years.

In particular, as you can see from the next chart below, such healthy EPS growth was driven primarily by continued investment in the business. It completed the planned solar build for 2022, commissioning ~450 MW of new solar and bringing the total owned and operated solar portfolio to more than 3,600 MW, which is the largest of any utility in the country. Overall, its Regulatory Capital Employed grew by 11.3%, laying the groundwork for sustainable future growth.

NEE management is also optimistic about the broader economic environment and secular support. As shown in the second chart below, Florida’s economy remains healthy and FPL’s retail sales continue to show strong underlying growth trends. In particular, Florida’s Unemployment rate is near the lowest level since 2012 and its Labor Participation Rates have almost recovered to the pre-pandemic levels.

Dividends as a measure of owners’ earnings

Now on to valuation. As mentioned in the second chart at the beginning, despite its superior profitability and scale, NEE is currently trading at a substantial premium relative to VPU. In terms of PE and price to book value ratio, NEE’s premium relative to VPU is about 15% to 75%. Admittedly, the price to book value ratio can be misleading because NEE earns about 50% more in terms of ROE relative to VPU, but a 75% premium is still high.

Another effective way to evaluate their valuations is by their dividend yield, and an effective way to evaluate their relative valuations is by their dividend yields either relative to each other or relative to the risk-free rates. Details of these concepts and approaches have been provided in our earlier article. Dividend yields and yield spread are what we first check before making any investment decisions. We’ve fortunately had very good success with this approach because of:

• The common PE or Price/cash flow multiples provide partial and even misleading information due to the differences between accounting earnings and owners’ earnings.
• Dividends provide a backdoor to quickly estimate the owners’ earnings. Dividends are the most reliable financial information and least open to interpretation.
• The dividend yield spread (“YS”) is based on a timeless intuition. No matter how times change, the risk-free rate serves as the gravity on all asset valuations and consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates.

With this background, you will see below that when adjusted for interest rates, both VPU and NEE’s current valuations are at the most expensive level relative to risk-free rates in a decade.

The first chart below shows the yield spread between VPU and the 10-year treasury. The dividend yield is calculated based on the TTM dividends. As can be seen, the spread is bounded and tractable most of the time between about 0% and 2.25% the majority of the time. You can see the screaming signal in 2020 when the yield spread surged to ~2.5%+ level – and this is why this dashboard is the first thing we look at when we make our investment decisions.

As of this writing, the spread is about negative 0.14% as you can see. It is a level that is among the narrowest in a decade. Such a narrow yield spread signals substantial overvaluation relative to risk-free rates. The picture for NEE is very similar as you can see from the second chart below.

Now in terms of their relative valuation, the next chart shows the yield spread between NEE and VPU. The dividend yield is again calculated using their TTM dividends and based on quarterly averaged prices. As can be seen, the spread is negative most of the time because NEE has enjoyed higher growth, stronger profitability, and hence higher valuation understandably.

However, the yield spread between NEE and VPU has steadily declined to the current level which is almost the most negative range in a decade as you can see. Again, remember that VPU itself is already near its highest valuation premium relative to the treasury rates.

Summary and other risks

We follow a top-down investment approach to examine the forest first then the trees. Currently, for the utility sector (represented by VPU), it is the worst time to buy the sector in a decade because its yield spread relative to risk-free rates is among the lowest level in a decade. At an individual stock level, its leader NEE is even more expensively valued. The premium of NEE valuation relative to VPU is near the highest level in a decade (and remember that VPU itself is near its highest premium relative to the treasury rates). We do not feel NEE’s growth prospects and stronger profitability can support such valuation premiums.

A few other risks to consider:

• The utility sector faces fundamental challenges in the long term. Climate and environmental concerns are a risk for all of the stocks in the sector.
• The energy sector also faces macroscopic risks now. Both for VPU and NEE, their current prospects depend on the assumption that the pandemic does not become worse from here (and does not lead to another wave of government-imposed restrictions for example).
• Specific to NEE, its outlook also depends on a healthy economy. However, a recession could be possible in the U.S. The Bureau of Economic Analysis just reported that GDP unexpectedly falls in Q1 2022 as inflation continues to rise. A recession is defined as a GDP contraction in two consecutive quarters.
• Lastly, a word about the risks of using dividends as a backdoor to approximate owners’ earnings. As detailed in our earlier article,

Dividend yields do not always reflect business fundamentals due to several factors such as tax law, political climate, the composition of the market index, et al. As a result, we do not directly use the yield spread in our investment or asset allocation decisions. In practice, we first adjust for the above corrections and then use the adjusted yield spread in our investment decision. But the data and approach illustrated here is the first place we check.