NextEra Energy (NEE -0.06%) has rewarded investors with market-beating returns over the last one year, five years, three years, and 10 years, all while growing its adjusted earnings and dividend. Wall Street reacted favorably to NextEra's Q2 2022 earnings, as NextEra stock gained 1.75% on 7/22 despite a down day for the broader indices. But if we dig deeper into NextEra's results, it quickly becomes clear that the company is facing degrading profitability.
Here's a breakdown of what's driving NextEra's weakening profitability, and if it affects the company's long-term investment thesis.
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A quick primer on profitability ratios
If you're new to investing, or even if you've got a few years of experience under your belt, financial ratios can be confusing and intimidating. You've probably heard of the price-to-earnings ratio, which is the price of a stock divided by the trailing twelve month (ttm) earnings per share (EPS). Another way of finding the P/E ratio is the ttm net income divided by the market cap. The P/E ratio simply tells investors the multiple of what the company is worth relative to a year's worth of earnings. A P/E of 20 would indicate the market cap is 20 times its ttm earnings. Simple enough.
Profitability ratios are quite different than the P/E. Instead of talking about the valuation of a stock, profitability ratios can be more useful because they look at how well the business is performing -- not whether it's overvalued or not.
A few profitability ratios that are worth knowing are return on assets (ROA), return on equity (ROE), return on capital employed (ROCE), and cash flow to total assets or cash flow from operations (CFO) to assets. The higher all four of these ratios are, the better.
The formula for ROE is net income divided by shareholders equity (SE). SE is a simpler way of saying the net worth of a company if all assets were sold and debts were repaid. Put another way, assets minus liabilities equals SE. ROE tells an investor how effective the business is at putting equity to work.
Meanwhile, ROA is simply the net income divided by total assets. While ROE takes into account liabilities, ROA does not. Instead, it shows how effective a company is at generating net income from its assets.
ROCE is a bit different. Instead of using net income as the numerator, it uses earnings before interest and taxes (EBIT) as a purer way to gauge the business. It then divides EBIT by capital employed -- providing a raw look at the use of capital and how much the business is earning from it.
Meanwhile, CFO to assets shows the cash flow from operations, not the net income, divided by total assets. It's a good metric for looking at how much cash flow a company is generating from its assets.
Taken together, these four profitability metrics provide insight into a company's results relative to its historical performance and how its peers are doing.
NextEra Energy as a real-world example
Four years ago, NextEra Energy was not only growing quickly, but it was also using capital, equity, and its assets incredibly effectively. Let's look at NextEra Energy and the 10 largest U.S. regulated electric utilities by market cap.
Four years ago, NextEra Energy had the highest ROE of its peer group. Today, it has the second-lowest.
NEE Return on Equity data by YCharts
Same thing for ROA, NextEra went from first to 9th in just a few years.
NEE Return on Assets data by YCharts
The story is the same for ROCE
NEE Return on Capital Employed data by YCharts
Yet for CFO to assets, NextEra Energy ranks fourth and has historically been in the middle of the pack or just slightly above it.
NEE CFO to Assets (TTM) data by YCharts
Why isn't the stock crashing?
Given the stark decrease in NextEra's profitability metrics, you may be wondering why the stock is doing well relative to the S&P 500. There are a few reasons for this. For starters, the company has been measuring and executing on its goals using adjusted EPS, not EPS.
NextEra's adjusted EPS accounts for non-qualifying hedging contracts, impairment charges, income tax expenses, and other factors. The company believes adjusted EPS better shows its progress. In the 15-year period from 2006 to 2021, NextEra Energy grew its adjusted EPS at a compound annual growth rate (CAGR) of 8.4%, and its dividend per share (DPS) grew at a 9.8% CAGR. It expects to grow its adjusted EPS at a 10% CAGR at the high end of its guidance range from 2021 to 2025, and then 6% to 8% per year off its adjusted EPS range for 2024. Similarly, it expects to grow its DPS at around 10% annually through at least 2024.
NextEra's adjusted EPS may be growing nicely. But its unadjusted EPS is weak. For example, for the six months ended June 30, 2022, its adjusted EPS was $1.54, but its diluted EPS was just $0.47. Given that profitability metrics are unadjusted, NextEra's ROA, ROE, and ROCE all look low because its net income is low. As for its CFO to assets, the company's CFO remains strong relative to its net income.
The stock market is forward-looking
NextEra's energy development pipeline is growing at its fastest pace ever, with more renewable electric generating capacity coming online in the next four years than currently exists for the entire company. Capacity additions have resulted in a spending spree as it builds out its renewable portfolio and transitions further away from natural gas and toward solar. The spending has come at the expense of its profitability, and has boosted debt on its balance sheet. However, realizing that NextEra's adjusted EPS has been growing nicely and that it hasn't realized the full extent of its earnings and the CFO potential of many of the multi-decade assets it has invested in makes its weakening profitability metrics understandable.
Hopefully this exercise casts light on the benefits and drawbacks of using profitability metrics to value a company.
