Xcel Energy Is A Buy (NASDAQ:XEL)

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Xcel Energy (NASDAQ:NASDAQ:XEL) is positioning itself to become a competitive player in an emerging industry. The operators of grid-scale energy storage profit from the arbitrage opportunity that occurs because the price of wholesale electricity varies predictably throughout the day. Our electric grid is in the process of transitioning from one that relies on fossil fuels into one that mostly relies on intermittently sourced renewable energy.

The fact that iron-air batteries are a disruptive technology is what makes Xcel Energy stand out. Unlike present grid-scale energy storage options, their extreme cost savings allows for widespread adoption. As the amount of our energy that comes from intermittent sources increases, the role energy storage providers will have to play in the electric grid becomes vital.

As an early adopter of iron-air storage, Xcel Energy will be in a position to leverage their experience and expand their energy storage division into one that could be operating systems that arbitrage electricity in the service areas of utility companies across North America. This is why I’m rating Xcel Energy a buy – it’s making the initial moves to potentially become a significant player in an extremely lucrative energy niche still in its infancy.

Company Background

Xcel Energy provides electricity and natural gas to several million consumers. The company already uses a diverse mix of fuels that include biomass, coal, nuclear, and natural gas; it has pledged to have transitioned to 100% carbon-free electricity by 2050. The recently announced partnership with Form Energy gives Xcel the final tool it needs to provide reliable service from mostly intermittent renewable sources.

Big Problems Lead to Big Solutions

Even more important than their ability to supply electricity during shortages, grid-scale battery storage can efficiently make use of the excess that solar produces during the middle of the day. As the popularity of solar grows over time, its presence has warped the demand curve the rest of the grid has to try to match with supply. We call this the “Duck Curve.” This dip in the middle of the day means that base load plants and solar are oversupplying the grid. And since coal, nuclear, and hydroelectric are vital for producing that strong, stable signal that we’ll need later during the evening ramp-up period, we’re forced to disconnect a portion of the solar panels. That’s right – every day, during their most productive time, we’re forced to temporarily disconnect some number of solar panels from the grid so they don’t damage it.

Large battery backup systems are not a new concept. Some hospitals employ them over fuel cell or diesel generators, many off-grid houses have one, and Tesla even installed a grid-scale unit in Texas in response to the 2021 winter outage. Most of these are typically made out of lithium-ion, which has an average cost of $151 per kWh, but can cost up to as much as $406 per kWh. However, the new iron-air type is expected to cost only about $20 per kWh. The dramatically reduced cost of production coupled with the abundance of raw material is what makes iron-air storage so disruptive. This type of battery can be employed across our entire electric grid, and it can be done so relatively cheaply.

What Does This Mean for Xcel Energy?

The payoff for Xcel comes from arbitrage opportunities that exist because the cost of wholesale electricity varies predictably throughout the day. The ever-expanding supply and demand imbalances caused by the growth of solar will allow Xcel to buy electricity from the grid in the early afternoon when production is at its highest and price is at its lowest, and then later that evening sell it back into the grid when both demand and prices are higher.

Arbitraging electricity with grid-scale energy storage was already a $42 billion-dollar-a-year industry in 2022, and projections are expecting the energy storage niche to experience an average annual growth rate of roughly 28% up until 2032. When you look at 28% compounded annually over 10 years, this $42 billion is projected to grow to $495.8 billion, representing 1,180% growth. Also, since iron-air batteries are significantly more cost-effective to build than other battery types, we can expect them to eventually become the most common type employed within this niche.

It’s hard to tell how the company will play their hand over the next several years, but there is clear potential for this to really pay out well for Xcel. This is especially true if they manage to turn their early adopter advantage into a true moat and establish dominance in this sub-sector as it develops. Their iron-air battery division could be installing and operating facilities well outside of their current service area – they could eventually be coast to coast.

Long-Term Trends

Our electric grid is supplied on an instantaneous basis, so we are forced to always try to match demand with supply. Because of the significant lag time between when we first ask large power plants to start producing power and them actually being able to get their turbines up to speed and in sync with the grid, we are forced to anticipate future supply. The people who are in charge of coordinating all the various power sources have to try to bullseye future demand as it changes throughout the day, while always maintaining a small oversupply to avoid brownouts.

The inclusion of storage providers will remove the need for grid managers to forever juggle the rest of the system around the capabilities of base load providers. As the amount of storage in the system increases, base load providers will no longer be asked to provide a majority of the electricity for our grid. They will lose most of their pricing power and will no longer be able to negotiate top dollar for the price of their electricity. Their role will be diminished into one of signal provider, and even that role is becoming less and less relevant as we continue developing better power inverters.

The continued cost reduction and rise in popularity of residential scale solar and wind means that we will eventually reach a state where a majority of our grid is supplied by decentralized sources. Once this threshold is crossed, the storage providers will have more bargaining power than the source providers.

Financials

As of the end of January 2023, Xcel Energy has a market cap of $37.63 billion, trades at a trailing P/E ratio of 21.67, and had a share price of $68.77. In 2022, it generated $1.736 billion in net revenue and paid a 2.85% annual dividend.

Looking at the last five years of operations makes it clear that revenue has been steadily and consistently rising from $11.537 to $15.310 billion per year, a 32.7% increase. Over that same five years, net income has steadily risen from $1.372 to $1.736 billion, a 26.4% increase. Since 2015, their dividend has steadily risen by an average of 6.285% per year.

Given that I like to invest in innovators, I typically end up looking at companies that are in a much earlier stage of their business life cycle. Most of them aren’t profitable yet, so I’m used to having to evaluate them based on things like enterprise value and P/S ratios. By comparison, the financials of this already well-established utility with steady growth appears extremely healthy.

In 2022 they had an EPS of $3.17, and with their dividend of $1.95 per share they are left with $1.22 per share to expand and innovate. This gives them a dividend payout ratio of 62%, which is a bit high for most industries but considered sustainable for utilities. I really like that the remaining 38% left the company with a little over $650 million in extra cash for 2022. Innovation costs money, and this company has an ample supply of it.

Using 2022’s annual growth rate of 6.3%, an annual dividend of 2.85%, and a P/E ratio of 21.67, Peter Lynch’s fair value formula produces a value of 0.829. That falls into over valued territory as it’s below 1. This translates to a fair value price of $57.01 per share. Using 2023’s estimated annual growth rate of 6.8% gives us a value of 0.894, which translates to a price of $61.50 per share.

The fear with dividend stocks is that after you buy them, the company is going to lose some of their edges and their already established moats will be eroded as they slowly slip into irrelevancy. This company’s pledge to produce 100% carbon-free electricity by 2050 sets up a narrative that helps them stand out from other energy and utility companies. I’m not looking at Xcel Energy because I want to buy it for its present value, or even its calculated expected future value. I am looking for the strategic move they are currently making to lead to a fundamental change in how the company operates, and the potential for that change to cause a dramatic rise their future value above and beyond what a future cash flow or terminal value calculation could ever show me.

This is not the highest-paying dividend stock in the energy sector, or the fastest growing. This is the most forward-thinking large utility company in the U.S., in my opinion.

Risks

Depending on who gains political power over the next decade, we could see either additional subsidies and government assistance, or the already existing subsidies and assistance revoked. The present momentum is clearly in favor of additional subsidies, but this could change.

The deal between Xcel Energy and Form Energy was only recently announced. It’s unclear to me at this time if the contract gives them exclusivity rights, or if other energy companies in North America are also partnering with Form Energy.

These two test facilities are designed to be able to supply power to the grid for up to 100 hours. The first time their local electric grids experience a major outage the performance of the technology will come under public scrutiny. If the outage happens to hit at a time when the batteries are close to empty, they will only be able to supply energy to the grid for a small portion of that 100 hours. If the first major outage after their construction lasts longer than the batteries happen to have supply for, then the public has the potential to perceive them negatively.

Catalysts

If you buy shares now expecting some huge announcement to happen in the next couple of months, you will very likely be disappointed. These two facilities are both projected to be in operation as early as 2025. Then, they will have to conduct an efficacy study before they release data indicating long-term viability. This typically means they will want to collect data on the new equipment through at least one winter and one summer before they fine-tune the design and then build more facilities. While initial results might be announced earlier, I expect to wait roughly 12 months from the end of construction for the release of official data.

Potentially months before the results of a long-term efficacy study are published, look for the company to announce the construction of more facilities. The engineers at Xcel Energy will have early access to information; if the company starts the process of building more facilities before the results of the studies are published, it will be a clear sign the company is trying to establish a moat. When or if the announcement comes regarding them building more facilities, I will be asking myself: How early is this? How many new facilities? This is what I will be looking for as a way to measure of the degree of confidence the company has with this project.

Conclusion

I will be keeping a very close eye on both Xcel Energy and Form Energy. If this project proves to be successful, not only will it give the entire energy sector a blueprint for the future, it will also give Xcel Energy first-mover advantage with a disruptive technology in an already rapidly growing and lucrative niche.

Because the damage the company might incur from wasting money and time on this comparatively small project is minimal when compared to the potential upside that comes with its success, the prospect that it might turn out a failure for both the company and for iron-air battery technology as a whole does not deter me from making an investment into Xcel Energy. With a history of steady net revenue growth, a clear long-term strategy, and a huge growth potential, this is exactly the type of company I look for when I look for dividend stocks.

What’s My Investment Plan for Xcel Energy and Iron-Air Batteries?

Well, just because I consider Xcel Energy a buy does not mean it’s a great buy at any price. I have been following Form Energy and their revolutionary battery technology for over a year now, and immediately after the announcement I bought a single share of XEL. It stares at me every day while I trade as a reminder that I need to establish an initial position the next time XEL establishes a bottom at or below fair value. Over the next year, I will continue steadily adding to my share count at future bottoms until I reach what I consider a small position size. I’m expecting to hold this small position until it becomes clear the project was a failure, or the company experiences a decline of its fundamentals, or a loss of its already existing competitive edges.

If Xcel Energy starts building more facilities before the results of an efficacy study are released to the public, I will grow my small position into a large position with the intention of holding for the next decade or more as the storage niche goes through the rapid growth phase of its logistic growth curve. Since Form Energy is a privately held company and not publicly traded, I will continue watching for other early adopters of their batteries. I will make sure to have exposure to any iron-air storage provider that has sound fundamentals and adopts an expansionist attitude. If at any point in time Xcel Energy or any other large utilities start building and operating storage facilities in the service areas of other utility providers, it will be the beginning of a new era. Because I believe the storage providers will eventually gain pricing power over producers, I will consider it the investing opportunity of a lifetime.