Avangrid Inc (NYSE: AGR) generated a below average return on equity of 4.4% over the past twelve months, while the Utilities sector returned 8.4%. Even though Avangrid’s performance is subpar relative to its peers, it’s useful to understand what’s really driving the company’s low ROE and how it’s trending. Understanding these components may change your views on Avangrid and its future prospects.
Avangrid’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
Avangrid’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Avangrid has generally been increasing over the last few years. ROE decreased from 6.8% to 1.9% in fiscal year 2015, increased to 4.2% in 2016 and increased again to 4.4% as of LTM Sep’17. So what’s causing the general improvement?
What’s Driving Avangrid’s Improving Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving Avangrid’s returns.
Avangrid’s Net Profit Margin
It appears that the net profit margin of Avangrid has generally been increasing over the last few years. Margins decreased from 9.2% to 6.1% in fiscal year 2015, increased to 10.5% in 2016 and increased again to 11.2% as of LTM Sep’17.
Therefore, the company’s increasing margins help explain, at least partially, why ROE is also increasing. Now let’s take a look at Avangrid’s efficiency performance to see if that is also boosting ROE.
Avangrid’s Asset Turnover
It appears that asset turnover of Avangrid has generally been declining over the last few years. Turnover decreased from 0.38x to 0.16x in fiscal year 2015, increased to 0.19x in 2016 and decreased to 0.19x as of LTM Sep’17.
source: data explorer – asset turnover
Therefore, the company’s ROE improvement is not as a result of its asset turnover performance which has generally been decreasing.
Finally, the DuPont constituents that make up Avangrid’s ROE are shown in the table below. Note that the table also compares Avangrid to a peer group that includes CMS Energy Corporation (NYSE: CMS), PPL Corporation (NYSE: PPL), Eversource Energy (NYSE: ES) and Edison International (NYSE: EIX).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Avangrid’s general improvement in return on equity is the result of an improving net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Avangrid shareholders may need to start worrying due to the company’s general improvement in profitability along with a general decline in operational efficiency and increasing leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Avangrid to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.