A Low-Key Dividend Machine

01/05/2010 11:13 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar FundInvestor, and analyst Travis Miller say a Farm Belt utility knows how to play the regulatory game and take care of shareholders. 

After operating in survival mode between 2002 and 2006, Westar Energy (NYSE: WR), Kansas’s largest electric utility, is now in the midst of one of the largest capital-investment programs in the US relative to its size.

In preparation for a ten-year, $3-billion plan announced in 2005, management sold non-utility oper­ations, reduced debt, issued almost $500 million of equity, and began improving regulatory relations.

The numerous projects, which include new power plants, environmental upgrades, wind farms, and large transmission lines, represented nearly 1.5x the company’s 2006 market capitalization.

Utilities that serve areas with low population growth, like Kansas, require new infrastructure investments to increase earnings. But to turn those investments into earnings, regulators must allow the company to charge customers for those capital costs and a return on capital. It receives those approvals by filing rate cases every couple of years. Many of its current investments are in response to government mandates, which helps smooth the regulatory approval process.

Westar has a near-perfect batting average with its recent regulatory proposals, including preconstruction support for nearly two-thirds of the projects in its long-term investment plan.

In January 2009, regulators approved a $130-million rate increase to help compen­sate the company for completing about one-third of its $3-billion growth plan. Despite a 27% haircut from its ambitious original request, the rate increase still lifted normalized operating earnings some 40%.  

Westar should recover another third of that $3 billion through automatic quarterly or annual rate increases during the next four years. We expect the final third to be recovered through another large rate increase request in 2012.

Even with the $3 billion of investment that rate payers will have to fund, Kansas’s inexpensive coal and nuclear power plants should keep power prices well below average US rates. This helps reduce regulators’ and consumers’ sensitivity to price increases.

In 2009, with earnings depressed by cyclical factors (industrial demand and unfavorable, cool summer weather), Westar’s payout ratio may top 80%. That said, we forecast much-improved earnings in 2010 thanks to a more stable economy, better weather, and recent customer rate hikes, and we believe Westar’s 60%–75% payout ratio target is a healthy one.

Since 2004, Westar has re-established a favorable record of dividend growth. [This] year’s dividend increase is likely to be modest; probably a penny per share on a quarterly basis, a 3.3% hike.

But even after economic and weather conditions normalize, we anticipate steady earnings and dividend growth in the 4%-5% range thanks to large capital investments that have already been approved by regulators. This outlook incorporates dilution associated with new equity issues that will help fund construction projects.

Given a sound yield and modest, achievable growth prospects, we estimate Westar’s annual total return potential to be around 10%. We think the shares are worth considering up to $23. (They closed below $22 Monday—Editor.)

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