CMS Energy: Buy, But Favor The Subsidiary Preferred (NYSE:CMS)

With the recent rise in the utility segment valuations as investors prepare for the strong potential of lower competitive interest rates, CMS Energy Co (NYSE:CMS) stock price has been strong. This has led to an overabundance of “Hold” recommendations for CMS stock. However, for long-term investors, CMS should be viewed as a high-quality selection, both in earnings and dividend production and, more importantly, in its supportive regulatory background. I do not own the common as I missed the opportunity a few months ago but have been building a position in its subsidy Consumers Energy Company’s $4.50 Series Cumulative Preferred Stock Series B preferred stock (CMS.PR.B).

Overview

CMS Energy was founded by William Augustine Foote in 1886 and is headquartered in Jackson, MI. CMS is the holding company for its main regulated utility subsidiary, Consumers Energy Company, and its merchant power subsidiary, NorthStar Clean Energy. CMS is Michigan’s largest regulated utility serving ~68% of state residents. CMS offers both regulated electric and regulated gas services, and, combined, regulated utility services comprise 95% of CMS earnings. Electric services comprise $15.1 billion in rate base assets, or 61% and natural gas encompasses $9.6 billion in rate base assets, or 39%.

Consumers Energy provides electric service to 1.9 million and natural gas service to 1.8 million customers. Among the largest cities served are Battle Creek (electric), Cadillac (electric), Grand Rapids (electric), Muskegon (electric), Lancing (gas), Livonia (gas), Bay City (electric & gas), Flint (electric & gas), Jackson (electric & gas), Kalamazoo ( electric & gas ), Midland (electric & gas), and Saginaw (electric & gas). In addition, CMS operates 9.3 GW of regulated power capacity in Michigan. From a fuel consumption vantage point, 54% of regulated power generation was derived from gas, 21% from coal, 13% from renewables, and 13% purchased power. Hydro and pump storage are important renewables, as are regulated wind and solar projects, and the firm anticipates being coal-free by the end of next year. Consumers Energy operated two nuclear power plants in Michigan, with them closing in 1997 and 2022. Unless “offshore wind” invades the Great Lakes, CMS has no exposure to this financial albatross, which should be considered a positive for investors. CMS operates one of largest FERC-regulated underground natural gas storage networks in the US. Historically, FERC-regulated assets earn a higher ROE than state-regulated assets.

NorthStar Clean Energy provided 5% of 2023 revenues. As of Dec 2023, NorthStar had ownership interest in 2.0 GW of merchant power fueled by the “all of the above” sources of natural gas, coal, wood waste, wind, and solar. These projects are located across 8 states, including Texas, Arkansas, and Ohio.

Regulatory Environment and Earnings Quality

CMS Energy is a great example of melding a positive regulatory environment with a high quality of earnings. As long-time readers know, Regulatory Research Associates RRA, a subsidiary of S&P Global (SPGI), rates the regulatory environment by state. As the ultimate gatekeeper of utility profitability, S&P understands and appreciates the impact utility regulators have on both utility earnings and credit profiles. RRA has been offering its proprietary rating system for over 30 years, and I have been using them as a primary due diligence tool for over 20 years.

Regulatory Research Associates’ rating system has three major categories (Above Average #1, Average #2, Below Average #3) and three minor categories of the same names. The best state for regulatory oversight is Alabama with a 1-1 rating (Above Average – Above Average) and the worst is Arizona with 3-3 rating (Below Average – Below Average). An Average state oversight is rated as 2-2 (Average – Average). My RRA target is to invest in states with an Above Average rating of 1-1 to 2-1. Michigan has earned a 1-3 RRA rating and falls into my preferred state range. In reviewing my files of past RRA ratings, Michigan has been rated by RRA as one of the best states for regulatory oversight since at least 2006. The current proprietary rating list from Dec 2022 can be found in utility commentary from Gabelli Funds.

An example of this regulatory support is the latest rate case settlement for Consumers Energy’s service. According to CMS Energy’s Sept 2023 Investor’s Presentation, Michigan regulators recently approved a 9.9% Allowed ROE for both its electric and natural gas subsidiaries. This rate compares favorably with the national average of utility regulatory settlements of 9.5% Allowed ROE for the 4th qtr. 2023, as reported by the industry association Edison Electric Institute.

How has CMS Energy exploited this high level of regulatory support? According to the stock research firm CFRA, management has earned an SPGMI Quality “A” rating for 10-yr consistency in earnings and dividend growth. When CFRA purchased the Stock Report business from S&P several years ago, they maintained the SPGMI rating system, which has a 50-yr history of evaluating management quality using earnings and dividend returns to shareholders. According to the Schwab stock screener, of the 135 multi-utility companies, only 11 have an “A” rating and none have an “A+” rating. CMS Energy is among a select slice of the industry with a superior earnings and dividend growth profile.

It becomes clear that management has utilized its positive regulatory support and created a company with a history of above average earnings and dividend growth.

Valuation

Of the brokers offering CMS Energy recommendations, 58% rate the stock as Overweight with 42% as Neutral or Equal-weight. Price targets range from $55 to $75, with the average $68, or about where the stock currently trades. Earnings are expected to follow industry trends and grow by 6% to 8% annually, fueling a similar dividend growth rate while maintaining a 62% dividend payout ratio. Management’s 2024 adjusted earnings guidance is for $3.29 to $3.35 per share. The current valuation matrix of a 21x TTM PE and a distribution yield of 2.96% are in line with its better utility peers but are also unexciting fundamentals. Like its higher-quality peers with above average regulatory support and an excellent history of rewarding shareholders, CMS Energy is a core utility holding and buying at any point in the economic cycle should be considered.

Consumers Energy Preferred Stock CMS.PR.B

CMS Energy has an appealing preferred stock issue. CMS.PR.B is Consumers Energy Co., $4.50 Series Cumulative Preferred Stock, par value $100 per share. Of interest is this issue is issued by the subsidiary Consumers Energy and not the holding company CMS Energy Inc. Usually, utility subsidiary preferred stocks are a notch above holding company preferreds as subsidiaries distribute debt and preferred stock payments before moving funds up to the parent holding company. This means Consumers Energy debt and preferred stock service takes precedent over CMS Energy debt service. CMS.PR.B has no mandatory redemption date and is callable anytime at $110 a share. Last month, Fitch Ratings affirmed CMS Energy, the parent holding company, long-term credit rating as BBB and its subsidiary, Consumers Energy, long-term credit rating of A-, both with a Stable outlook. CMS.PR.B has a higher credit rating than its parent, reflecting the position of the subsidiary preferred within the hierarchy of CMS Energy debt instruments. It should be noted the average daily volume is ~500 shares, making limit orders and patience required to buy and sell. With low liquidity, CMS.PR.B is not a good trading vehicle but rather an excellent long-term income selection.

The chart below shows the price of CMS.PR.B from Jan 2021 to Sept 10, 2024. As expected, with the sharp rise in interest rates, the price of the fixed-rate preferred stock declined from $112 a share (for a 4.0% yield) to a low of $75. The current price is $80.32 for a 5.6% current yield. In the age of declining rates, a 5.6% yield on a A- fixed income selection should be an acceptable risk/reward.

CMS Energy offers above an average, consistent, and low-risk growth utility opportunity that warrants the stock to trade at a premium relative to most large cap peers, especially those in states with Below Average regulatory oversight. Income investors should evaluate both the common and the preferred issue. I have been building a larger-than-average position in the preferred and will buy the common on any future market weakness.