PPL Corporation Stock Risk Analysis

This is a risk analysis of PPL Corporation stock for a friend of mine that was hired by the company.  Those of you who want to know how I think about risk management are perfectly welcome to read it but it is specifically targeted so I’m not sure how useful you’ll find it.

I’ve worked my way through a few hundred pages of the PPL 10K report and I already reached several conclusions. Here are my thoughts. Take them for what they are worth. They are most certainly not recommendations, just observations based upon if I were in your situation.

First, PPL Corporation appears to be a perfectly fine business with a good collection of energy generating assets. The rate caps that were in place since the 1990′s due to Pennsylvania legislation expired, meaning it is possible for the company to make more selling power at market rates going forward beyond 2010, which certainly represents upside. Like almost all utilities, most of the return is going to come in the form of a cash dividend on the common stock. At current market prices, the dividend yield is just shy of 5% (e.g., for every $100 in stock you owned, you would collect $5 in cash dividends mailed to your house or deposited into your account to buy more shares and earn more dividends).

My Basic Findings on the Company

I’m going to skip the long financial analysis because this is not the type of simple company that would serve to make finance easier.  Regulated utilities, especially with energy trading divisions, can be more complex.  The best way to think of them, though, is an “equity bond”.  With some retained earnings, my guess is that the best a stockholder of the company could hope for on a long-term basis is 7% to 11% compounded annually, with dividends reinvested.

For example, if we were to split the difference at 9%, let’s say you and your wife used $2,000 per month once you are further along in your careers and you used it to buy the stock. Thirty five years later, at that rate of return, the stock would be worth $5,177,058 before adjusting for inflation, and should generate $258,853 per year in dividend income for you, or $21,571 per month. (If inflation ran at 3%, this would result in about $7,670 per month pre-tax in today’s purchasing power without ever touching your principal.) This doesn’t include any matching, tax sheltered accounts, home ownership, or anything of that nature, which could add much more to your net worth and, again, it assumes you don’t spend any of that principal at any time in your life.

Honestly, the industries in which you both work offer far higher savings opportunities as you advance along your career so saving only $2,000 per month once you’re further up the ladder would mean you were buying a lot of new BMW’s or Wolf appliances. I pulled the employment agreements with the SEC for some of PPL’s executives and they are making upwards of $30,000 per month plus more than that in stock grants and retirement benefits. There is a huge earnings potential and equity ownership potential for those who go on to get a graduate education and / or MBA and start running the company (which, according to the documents, PPL will pay for!).

That is the framework with which I approached the PPL Corporation report. Here are my actual thoughts …

Examining the Specific Risks of Your Situation

The first objective is to avoid what Charlie and Warren call wipe-out risk or what Tweedy Browne & Company calls permanent impairment of capital. To determine if this potential exists, and to what degree, we have to look at several considerations.

Consideration 1: You Will Be Employed by the Company

If there were a catastrophic accident (e.g., the Susquehanna plant had an accident comparable to Chernobyl or an accounting scandal comparable to Enron), you would find yourself not only potentially incapacitated, but also possibly unemployed, in an area of the country where housing values would also fall due to the mass layoffs or environmental considerations, and the stock you held in PPL would be decimated almost instantaneously at the very moment you needed the funds most.

The calculation would be different if you worked for, say, Procter & Gamble because it is unlikely a Tide plant exploding in some far flung corner of Europe or South America is going to hurt a company that diversified both in product revenue source, profit center, and industry. With PPL, at least 32% of the actual power sold last year (not capacity) came from the nuclear operations at the Susquehanna facility according to the consolidated 10K filed with the Securities and Exchange Commission.

Put another way, imagine both you and I had no debt and no assets except for $100,000 in cash. We both buy $100,000 worth of PPL stock. I work for Microsoft. You work for PPL. We make the same salary. If a catastrophic event strikes, we both lose our investment, but I am still getting a paycheck so I can rebuild much faster and cover my house bills.

Consideration 2: The Company Operates In a Single Industry

PPL Corporation is a very large company with a $12 billion market capitalization (and a much higher enterprise value). However, it effectively exists only in the energy industry. A competitor like MidAmerican Energy, on the other hand, is a subsidiary of a much larger Berkshire Hathaway, which could serve as a deep source of liquidity if the world fell apart. That means that PPL is more dependent upon the credit markets and overall economy than a diversified conglomerate with $200+ billion in assets such as Berkshire.

That “risk differential”, if you call it that, must factor into the calculation of overall wipe-out exposure. (You already inherently know this: In other words, imagine that there was a Chernobyl accident at Susquehanna. It is reasonable to presume that PPL stockholders would either be wiped out or lose 90% of their investment; dividends would almost certainly be shut off for years on end. The same accident at MidAmerica would cost stockholders in Berkshire Hathaway huge sums of money but they would quickly recover as the furniture companies, candy manufacturers, and insurance group generated profits to plug the hole.)

Consideration 3: PPL Debt Is Investment Grade … But Not By Much

PPL Corporation says it purposely manages its capitalization structure to maintain investment grade credit, which is perfectly reasonable. However, there is a world of difference between a BBB corporation and an AAA corporation. This is interdependent with our last consideration because any time a company exists in a single industry, there are concentration risks.

My Thoughts on Owning PPL Stock …

PPL Corporation, while a good company, isn’t like a Microsoft or a Harley Davidson in that it owns a proprietary product you can’t get anywhere else. The result is you can get almost the same investment returns by owning a “basket” of utility stocks, while diversifying away most of the risk of a catastrophic accounting scandal or meltdown.

The most popular option is something called the Utilities Select Sector SPDR, which trades under the ticker symbol XLU. You buy it just like a stock but it is really a sort of trust fund that owns shares of utility companies. In fact, PPL is among the top 25 holdings. Click on the image to the right to see the percentage of the “trust” assets that are allocated to each utility company. You’ll probably recognize most of the names because they are the biggest in the utility sector.

The dividend on the utility trust is almost the same as the one offered by PPL. Your only additional cost is really a 0.23% basis point deduction the trust sponsor takes for creating the financial instrument. I don’t recall exactly the rules, but once your holdings reach a certain size, you have the right to redeem your shares for stock in the underlying companies, taking physical possession of them (so you would get the 35 stocks it owns deposited into a brokerage account). There is a small fee for “breaking” your trust shares up and it normally requires several hundred thousand dollars (possibly a few million), but that is not really germane because they are so heavily traded liquidity is not a problem. On a normal day, roughly 7 million shares trade hands (or $207,000,000 worth of trust shares, so unless you have to sell more than that in a single day, it’s a non-issue).

Here is how I think about it: If something went terribly wrong at PPL and you had 100% of your retirement assets invested one of two possible ways, here are the results …

Scenario #1: Fully Invested in PPL Shares: Result = Catastrophic loss and wipeout
Scenario #2: Mostly Invested in Utilities Select SPDR ETF = Less than 5% to 10% loss of market value of investment

The Things That Could Change the Calculation

Sometimes, companies like PPL offer “incentive” programs to executives, managers, and employees that may include some or all of the following:

• 401(k) matching in the form of company shares
• Discounts on shares of company stock purchased through a payroll deduction plan (usually 15% off market)
• Executive and management stock ownership requirements

Both of these drastically change your valuation and potential return. For example, despite the concentration risk, you would almost always want to take all of the matching you could get in a 401(k) because it is an instant 100%+ return – the company is handing you free money in the form of stock. Then, after the holding restrictions have passed (sometimes they can last up to 5 years or longer), you can tell your 401(k) administrator to sell your PPL shares and buy an S&P 500 index fund or bond fund or something. This would require you to take half a day each year and rebalance your holdings to make sure you take money off the table that you no longer want exposed to PPL. In exchange for that only half-day a year, though, you could earn a lot of free money over the course of your career.

That is why I said I can’t get more specific unless you find out the details of the programs. The specific retirement package will determine a lot.

Furthermore, some companies offer discounts on stock purchase. For a utility, discounts on common stock mean you can get a higher dividend yield. For example, let’s say a stock sold at $100 and offered a $5 dividend (for a 5% yield). If you could buy the stock at a 15% discount, or $85, your yield is going to be nearly 5.89% ($5 dividend divided by $85 = 5.8823% yield).

Also, the higher up the chain employees go, the more the company requires stock ownership equal to a multiple of base salary. This is non-negotiable. When this happens, you just have to own the stock; it’s part of your employment requirements and is generally not open for debate. By this time, however, your salary should be sufficiently high that you have tens of thousands of dollars in monthly income to fund other investments outside of the company, whether buying individuals stocks or building apartment buildings.

The Bottom Line

I work every day to make sure I can never wake up and find that most of my money is gone. Pearl Harbor, September 11th, Chernobyl, 3 Mile Island … it doesn’t matter. I want to know that my net worth is invested in such a way that I will be fine so no matter what unfolds, I’m still rich. I don’t want to “Go back to Go” on the Monopoly board, to borrow a phrase from Charlie Munger.

As an Employee / Investor

Thus, if I were in your situation, I would take advantage of all of the matching I could, all of the discount stock purchases I could, and then I would sell off the PPL stock when it became eligible according to the program terms, putting the money to work in a Utility SPDR or index fund, which offered the same economics but much lower risks.

I would comply with the stock ownership requirements of the company as I was promoted, but I would do everything possible to make sure that PPL stock represented no more than 10% to 20% of my net worth and no more than 30% of my household income. This will be difficult, if not impossible in the early years when most of your profit comes from the company, but as you earn higher salaries and generate more investment income, it becomes much easier mid-career and beyond because you have more cash to do what you want.

Those guidelines would make sure that I always had the financial ability to tell someone to go to hell if I didn’t like working there any more, and no matter what happened in the world, I could still have control over my time due to earnings coming in from other sources.

All in all, PPL seems like a good company with which you could build a great career, have a successful life, and use the rare skills you have as a nuclear engineer.  If you work your way up the corporate ladder, you could help shape the role of a major power company in one of the largest and richest nations on the planet.

As an Investor Only

As an investor only, if I were running a $300 million mutual fund with a retirement dividend focus, I may be perfectly content to put $5 million to $10 million in shares of PPL. I wouldn’t let my exposure exceed that at current market prices.

Related posts:

1. The Compensation System for Benjamin Graham at the Graham-Newman Corporation
2. 101 Things Every Investor Should Know About Stock and the Stock Market
3. Video Blog on Launch of eBay Store, Risk and Compounding
4. Reynolds Tobacco Company and Its Legendary Employee Stock Ownership Plan
5. The Valuation on Tiffany & Company Common Stock Continues to Perplex Me
6. Eastman Kodak Shares Reach Penny Stock Territory After 131 Years In Business
7. Sun Trust Bank and the Coca-Cola Stock
8. A 20 Year History of Colgate-Palmolive Stock
9. You Have to Focus on Valuation Metrics in the Stock Market!
10. A 20 Year History of Procter & Gamble Stock