DTE Energy Common Is Overvalued, Consider High-Yield Baby Bonds (NYSE:DTE) (2024)

DTE Energy (NYSE:DTE) is the largest utility in the State of Michigan, incorporated in 1995. Its four wholly-owned subsidiaries are DTE Electric (founded in 1903 as the Detroit Edison Company), DTE Gas (founded in 1849 as City of Detroit Gas), DTE Vantage, and DTE Energy Trading (started in 1998). Vantage operates renewable natural gas projects and provides energy consulting services. DTE Electric has 2.3 million customers in southeast Michigan, which includes the City of Detroit. DTE gas has 1.3 million customers spread across the state. Electricity operations usually provide 50% of net income, gas about 19.0% and DTE Vantage and Energy Trading a not insignificant 31%. Standard & Poor’s rates DTE Energy debt as BBB, or lower medium investment grade. The company has a total market cap of $24.0 billion, and according to Edison Electric Institute, it is the fourteenth largest investor owned utility in the US.

DTE Electric has a total generating capacity of 11,959 megawatts provided by coal plants, natural gas, nuclear and wind. Its largest generation asset is the Fermi 2 nuclear plant, located just south of the Detroit metro area, which provides 30% of Michigan’s nuclear capacity. The company operates exclusively in Michigan. The electric service area is in the southeastern corner of the state, which notably includes the City of Detroit. Detroit’s population was 1,027,974 in 1990, 713,777 in 2010, 639,111 in 2020 and 603,410 in 2024. Obviously, the city population is declining, but the surrounding areas are stable or increasing slightly in population to offset this. The Detroit Warren Dearborn MSA in DTE's service area is the 14^th largest in the US, and if you count the nine-county area it is actually growing in population. This region also includes the well to do communities of Bloomfield Hills, Farmington Hills and Ann Arbor. Gas operations are in parts of the state where the population is stable or increasing slightly. In general, the State of Michigan’s population is growing slowly by about 0.5% per year and has increased from 9.87 million in 2010 to 10.04 million in 2023.

A Dividend Grower, But a 3.5% Yield in a 5.0% World

DTE is currently paying a dividend of $1.02 per share quarterly, for an annual yield of 3.52% based on the current price of $115.79. The company has raised its dividend every year for the last 14 years and has done so at a compound annual rate of 6.0%, generally exceeding inflation during that time. DTE looks to grow its dividend at the same pace as its earnings estimate of 6.0-8.0% per year. During the span of 2007-2010, the Great Financial Crisis, the company left the dividend fixed at $0.451 per quarter, but it never it, as many companies did during that time.

While the company does not have a stated payout ratio target, it says that it plans to keep its payout ratio in line with that of other pure play utilities. The industry average for 2003 was 64.2%, while the average yield was 3.8%. Below is a table of DTE’s historic and projected payout ratios. The numbers are generally in the 57.0% to 64.0% range except for 2021, when DTE had energy trading losses after gas prices spiked at the end of the year combined with losses from paying off its debt on the spinoff of DT Midstream (DTM), which is currently paying a dividend of 4.36%.

Consider the Baby Bonds Instead

Baby bonds are unsecured debt obligations, structured to trade like preferred shares of stock, and paying quarterly interest. These typically trade in $25 amounts. The interest is taxable as income to the buyer, and deductible as an expense for the issuer. Depending on their tax rate, investors may find these instruments more attractive than the common share dividend.

DTE Energy currently has three series of junior subordinated debentures, or baby bonds. These are the 2021 Series E 4.375% (DTG), the 2017 Series E 5.25% (DTW), and the 2020 Series G 4.375% (DTB). DTG has a current yield of 5.62% and a share price of $19.47. DTW has a current yield of 5.69% and a share price of $23.05. DTB has a yield of 5.68% and is priced at $19.24 per share. All these shares trade on the NYSE. The DTW shares are due in 2077 but are redeemable after December 2022 at $25.00 per share. The DTG shares are due in 2081 but redeemable after December 2026. The DTB shares are due in 2080 DTB with a call date of October 2025. Distributions are paid quarterly and because these are interest payments, they are not eligible for preferred tax treatment. The payments are cumulative, however. All these issues were rated BBB-, or lower investment grade, by Standard & Poor’s. DTG and DTW have NYSE a volume between 20,000 and 30,000 shares per day, while DTB’s volume is closer to 12,000 per day.

Shares Look Better Under $105 than at Today’s $115

Earnings per share have been variable over the last five years and without a specific pattern. They were $6.17 in 2018; $6.31 in 2019, $7.08 in 2020, $4.67 in 2021, $5.52 in 2022 and $6.76 in 2023. This variation is largely due to weather’s impact on earnings. Winter 2022-2023 was among the top 10 warmest in 125 years of recordkeeping, and average temperatures for much of the state were above freezing. Electric sales in 2023 decreased due to this unfavorable weather as did gas sales. However, DTE was able to lower operating expenses from 2021 to 2023, offsetting the slowdown in sales of electricity and gas.

In March this year, management reaffirmed its $6.54-$6.83 EPS guidance range for 2024 and its 6%-8% annual earnings growth rate through 2028. Value Line estimates earnings per share of $6.80 at the upper end of this range for 2024, as the company is often conservative with guidance. The winter of 2023-2024 was also a mild winter in its market, thus the low estimate after 2023’s earnings of $6.76. Management estimated that this cost the company $0.28 per share for 2024; however, an unusually warm summer could easily make up for this. Based on $6.80 earnings, DTE shares are trading at a P/E ratio of 17.0x. This is about equal to the current P/E ratio of the S&P 500 utilities, as shown in the chart from Yardeni Research below.

Today's average P/E ratio for the utility sector is above the 16.4 median of the last two decades, and its future direction will depend on what the Fed does with rates. Chairman Powell’s recent comments suggest that we are on a higher for longer trajectory, and while the market anticipates a single rate cut this year, the Fed did not explicitly rule out the possibility of an increase.

To value DTE’s shares, I have used a P/E multiplier and a discounted cash flow. The median P/E for the last 20 years has been 16.4 times earnings. However, Gabelli Funds projects a lower rate of 15.6x for electric utilities and 15.2x for gas utilities. DTE Energy is both. I will lean towards a P/E of15.5, so the fair value of DTE’s shares become 15.5 x $6.80 = $105.40.

I have also used a discounted cash flow to value the shares. DTE is forecasting EPS growth at 6.0-8.0% per year, but this has not panned out consistently. So, for the DTE discounted cash flow, I used a growth rate of 6.0% per year, to be conservative. EPS is estimated at $6.80 for 2024, or Year 1 of the analysis. For a discount rate, I have used 9.75%. This number is about equal to the long-term average annual return of the S&P 500, which is an estimated 9.8%. The reversion rate used in here was 7.5%. The results are presented below, with a present value share price of $107.95:

As a value conclusion, I am leaning towards the discounted cash flow, which uses more variables over time. So, at the current market price of $115.79, shares are about 7.0% overvalued versus the discounted cash flow number of $107.95. At $105.00, the shares are more attractive as the yield is closer to 4.0%, and an increase in the dividend at the end of the year, as is typical, would move it over that line.

Capital Expenditures and Renewables Transition

As we have seen, warmer weather can impact DTE’s earnings, and the utility is in an area with relatively slow population growth. According to Morningstar, in the future, “the clean energy transition will be the cornerstone of DTE’s growth.” There is a lot of work to do to get to the net zero carbon target of the future. Today, there are two coal-fired plants from the 1970s and 1980s (Monroe and Belle River) and a well-known nuclear plant (Fermi) built in 1988. Coal provides 34.3% of the company’s power generation today, while wind and solar provide about 14.0%. Nuclear and gas fired plants provide the rest.

Large capital investment will be needed to retire the aging coal plants. FTE plans to achieve this by spending $25 billion through its 2024-2028 Integrated Resource Plan. It will stop using coal at Belle River in 2025 and 2026 and close Monroe in 2028. It has targeted 6.5 gigawatts of new solar generation and 8.9 GW of new wind generation to replace these. The key to DTE’s renewables transition is its goal to create energy storage capacity of 780 megawatts by 2030. Energy storage is the challenge for many utilities.

FTE’s plans are a response to Michigan's new strict environmental standards, enacted last year as the Clean Energy and Climate Action Package. This requires Michigan utilities to use 50.0% renewable energy by 2030, 60% by 2035 and 100% clean energy by 2040. The state goals are stricter than the federal targets, like those of 2022's Inflation Reduction Act, which would move greenhouse gas emissions to 40% below 2005 levels by 2030, though the act offers $370 billion in tax credits and incentives to get to these levels. There is also the Federal Sustainability Plan, which has a net zero emission standard by 2050, economy-wide.

In its transition to renewables, the company has upgraded more than 1,300 miles of electric infrastructure in 2023 and installed 10,000 smart grid devices to reduce outage duration. It has also replaced aging gas infrastructure, some 1,700 miles so far, to minimize leaks and reduce costs. Installation of public charging stations for EVs is also underway.

A Supportive Regulatory Environment

Michigan Public Service Commission ("MPSC") regulates DTE Energy and is composed of three members, each appointed by the Governor to serve staggered six-year terms. The commission is generally considered utility friendly. DTE Energy has a 9.9% allowed return on equity for both the gas and electric utilities this year. These numbers are above the US utility averages, which according to S&P, were 9.60% for 2023, up from 9.54% in 2022 for electric companies. For gas utilities, it was 9.64% in 2023, up from 9.53% in 2022.

Gas revenues are decoupled, meaning they are granted a return on equity that is not sales dependent. According to Fitch DTE's decoupling allows “full pass-through of fuel costs, forward-looking test years… and an infrastructure recovery mechanism to help DTE Gas reduce exposure to regulatory lag. Electric operations are not decoupled at this time.

DTE Gas filed a rate case in January requesting a higher base rate by $266 million and an increase in its return on equity to 10.25%. A decision in this case is expected in November 2024. In December 2023, the MPSC approved a 6.4% rate increase for DTE Electric, with revenues higher by $368.1 million but with the return on equity remaining at 9.9%. The initial request was for a $622 million raise, with a 10.25% return on equity.

As for electric rates, DTE is in the middle of the pack of the 44 US investor-owned utilities. The average DTE consumer pays $0.1367 per kilowatt hour for electricity compared to extremes like Sempra (SRE) at $0.3225 per kilowatt hour or Hawaiian Electric (HE) at $0.4030 per kilowatt hour. DTE's rate is just slightly less than CMS Energy Corporation (CMS), Michigan’s other major electric utility, which averages $0.1414 per kilowatt hour.

Conclusion

DTE Energy has many positives and a few negatives. It is in a friendly regulatory environment, but with a slow growing population. Its earnings are impacted by global warming, but its gas operations are rate decoupled. Long-term debt is moderate and generally trending downward. In 2023 it was $17.4 billion or 38.9% of total assets, while in 2020 it was $19.0 billion or 41.7% total assets. Most of this debt is at rates ranging from 3.3% to 4.2% with maturities rolling through 2053. The earliest large amount to come due is $800 million in 2028, currently at a rate of 4.875%.

I expect DTE to continue its streak of dividend increases, but right now the 3.5% yield it offers is not compelling. Many money markets offer rates over 5.0% like T. Rowe Price U.S. Treasury Money (PRTXX) at 5.02% or Fidelity Government Money (SPAXX) at 5.05%. DTE shares are only compelling on a pullback that would move the dividend to 4.0% or higher. This happened in October of 2023 and in January of 2024. However, I do think this is a stable utility for long-term investors, but the right entry point is key, and that point is about 10% below today’s price. But for right now, the baby bonds are offering attractive yields over 5.6% and they are taxed the same way as money market income.

Dividend Grower