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Summary El Paso Electric reported disappointing Q2 earnings in response to a mild early summer and regulatory lag that has caused the costs of recent capex to outpace revenue. The utility is well positioned to weather higher interest, rates due to the fact that most of its planned capex for the current decade has already been completed. Furthermore, it is in a better position than its peers to handle new federal environmental regulations, due to the low average carbon intensity of its existing power portfolio. The company’s shares are overvalued on both trailing and forward FY 2015 bases, while its FY 2016 earnings will be exposed to another cold early summer due to El Nino. While El Paso Electric’s long-term position is attractive, I encourage potential investors to wait for a margin of safety to develop to offset weather-related uncertainty in the next 9 months. Southwest electric utility El Paso Electric (NYSE: EE ) recently saw its share price approach an almost six-month high as continued delays to the Federal Reserve’s expected rate hike caused utility shares to rally. The company, which reported disappointing Q2 earnings due to the combination of an unfavorable regulatory environment and an unseasonably mild quarter in its service area, has yet to see its shares break their TTM high, and an unfavorable weather forecast is currently developing in its service area. That said, El Paso Electric occupies a unique position as producer of low- and zero-carbon electricity in states that will be subject to increasingly stringent federal restrictions on power plant emissions of greenhouse gases (GHG) over the next several years, providing it with a competitive advantage. This article evaluates El Paso Electric as a potential long investment in light of these conflicting conditions. El Paso Electric at a glance Headquartered in the eponymous Texas city, El Paso Electric is a public utility company that generates, transmits, and distributes electricity to almost 403,000 customers in west Texas and south New Mexico. The company owns and operates 2,010 MW of generating capacity, including minority stakes in two outside facilities. It also transmits and distributes electricity generated by 107 MW of solar power capacity via power purchase agreements. With a power portfolio that consists of 47% nuclear, 35% natural gas, and only 5% coal, El Paso Electric’s overall carbon intensity (tons of CO2 emissions per MWh of electricity) is substantially lower than the averages of the two states in which it operates and approximately half that of the U.S. average (0.31 tons CO2/MWh versus 0.62 tons CO2/MWh). This comparison will become more favorable still as the company exits its coal-fired power plant minority stake next year. It owns 1,834 miles of transmission lines, including a connection with Mexico, although its operations in Texas are responsible for 78% of its electricity and other non-fuel revenues. El Paso Electric operates within state regulatory schemes that are relatively favorable compared to those in other regions; its most recent rate requests, for example, would result in returns on equity of 10% and 10.1% in New Mexico and Texas, respectively. This advantage is offset by the presence of regulatory lag, however, that increases earnings volatility after the construction of new capacity in particular. Whereas capex increases are ideally quickly offset by rate increases, regulatory lag occurs when the rate increases due not occur until after the utility’s earnings have already begun to be negatively impacted by the consequent increase to depreciation, property tax, and O&M costs. Such lag affected El Paso Electric’s earnings in Q2 following the completion of two 88 MW high-efficiency, rapid start-up natural gas turbines that were brought on-line last March. The company’s capacity expansion has largely been completed, with a net increase of 68 MW planned through 2019, so lag will not be as much of an issue moving forward as it has been in the past. While peak demand has grown at a CAGR of 2.7% and residential customer growth has achieved a CAGR of 1.9% over the last decade, its existing capacity is expected to be sufficient for the time being. Finally, El Paso Electric does not boast as impressive a dividend history as many of its utilities peers, having only reinstated its dividend in 2011. While it has increased by 34% in the subsequent four years, the company’s dividend payout ratio remains below the sector average. Management is targeting annual increases of 4-6% until the payout ratio reaches the average. Even following a recent increase to the quarterly dividend of 5.4%, however, El Paso Electric’s forward yield is not especially high at 3.2%. Q2 earnings report El Paso Electric reported underwhelming Q2 earnings in August that missed on diluted EPS due to the combination of regulatory lag and reduced cooling degree days resulting from mild weather in its service area. The company reported total revenue of $219.5 million, down 13% YoY from $251.8 million (see table). Retail sales of electricity fell by 1.6% YoY as the number of cooling degree days during the quarter came in 15.2% below the previous year’s number and 11.5% below the decade average. The negative impact of this decline was partially offset by customer growth of 1.4% YoY. Fuel revenue fell by 31% YoY, mainly due to the presence of much lower energy prices compared with the same quarter of 2014. El Paso Electric financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 219.5 163.7 196.6 283.6 251.8 Gross income ($MM) 158.0 114.8 126.6 195.1 164.0 Net income ($MM) 21.1 3.5 4.2 52.5 30.1 Diluted EPS ($) 0.52 0.09 0.11 1.30 0.75 EBITDA ($MM) 79.3 52.8 51.6 121.7 90.0 Source: Morningstar (2015) Gross profit came in at $158 million, down by 3.7% YoY, as the revenue decrease was partially offset by a 30% decline to the cost of revenue resulting from a fall in energy prices over the same period. Net income declined by 30% YoY, from $30.1 million to $21.1 million. Diluted EPS fell to $0.52 from $0.75 in the previous year, missing the analyst consensus estimate by $0.08. EBITDA fell to $65.6 million from $74.1 million over the same period. The net income and EBITDA declines were the result of the aforementioned mild weather and regulatory lag, the latter of which caused the company’s depreciation and O&M costs to increase even as revenue declined. Interest costs also increased YoY as a result of the company’s long-term debt increasing by 13.4% YoY. Outlook El Paso Electric’s management stated during the Q2 earnings call that the company only had sufficient cash on hand to continue operations for 12 months, and it will need to raise new debt by late 2015 to finance capex beyond that point. Management also reduced its FY 2015 diluted EPS outlook range to $1.75-2.05 from $1.75-2.15 due to its poor Q2 result. New rates offsetting Q2’s regulatory lag are not expected to go into effect in New Mexico and Texas until Q2 2016. The earnings call was rather vague as to how the summer weather would impact the full-year results, although in past years, Q3 has usually been the company’s most profitable year due to high electricity demand from air conditioners fighting the summer heat. Temperatures in the service area were indeed high during Q3, although it remains to be seen whether or not this was enough to increase the number of cooling degree days on a YoY basis and offset the impact of the mild Q2 weather on the FY 2015 earnings. El Paso Electric’s earnings outlook for FY 2016 has diminished over the last several weeks, although this has not yet been reflected by analyst estimates. Meteorologists are continuing to forecast this year’s El Nino event to be one of the strongest on record . Previous such events have been characterized by colder- and wetter-than-average conditions in Texas and eastern New Mexico, with the most abnormal impacts being felt in Q1 and Q2. While more heating degree days in Q1 could provide the company’s earnings with a small boost due to electric heaters being employed, this will most likely be outweighed by yet another mild Q2 as El Nino remains in place through late spring, causing cooling degree days in El Paso Electric’s service area to remain below the decade average. While the company’s FY 2016 outlook has been dampened somewhat by the strengthening El Nino forecasts, recent federal regulatory developments have caused its long-term outlook to improve relative to its peers. In August, the U.S. Environmental Protection Agency [EPA] released its Clean Power Plan, which requires every state to achieve predetermined reductions to the average carbon intensity of its power plants by 2030. The regulation resembles a similar rule in the European Union in that each state’s target is a function of its current carbon intensity. In other words, the states with the highest starting intensities will be allowed to have the highest intensities by 2030, although, in the process, they will also have to achieve the largest reductions . Texas and New Mexico both have average intensities that are higher than the U.S. average, but below those states (such as Wyoming) that have the highest intensities. While they will be required to achieve sizeable reductions as a result, El Paso Electric’s average carbon intensity is well below the averages of both Texas and New Mexico as well as the U.S. Unlike its peers in both states, then, the company will not be required to phase out its existing (primarily coal) facilities in favor of new ones utilizing natural gas and/or renewables. It is therefore possible that the company will benefit under the Clean Power Plan if state regulators increase rates in both jurisdictions to compensate those utilities that still rely heavily on coal and petroleum for the expenses incurred in switching to less-polluting fuel sources. Finally, while the prospect of an interest rate increase by the Federal Reserve has inflicted substantial volatility on the utilities sector in recent months, El Paso Electric is unlikely to be as negatively impacted as its peers when the increase ultimately does occur. This is because the company is forecasting (.pdf) its capex to have peaked in FY 2014, with FY 2017 spending expected to be 38% below that high, and even FY 2019 spending to remain 8% below it in nominal terms. While the company’s interest costs on new debt will increase when the rate hike inevitably occurs, it will not be as exposed as those of its peers that anticipate ramping up their own capex over the same period. While management would not have known it at the time, El Paso Electric’s decision to undertake $1.3 billion in capacity investment between FY 2010 and FY 2015 could not have been better timed from the perspective of taking advantage of low debt costs. Valuation The consensus analyst estimates for El Paso Electric’s diluted EPS results in FY 2015 and FY 2016 have declined slightly over the last 90 days, in response to the company’s Q2 earnings report and a diminished weather outlook for the first half of next year. The FY 2015 estimate has fallen from $2.00 to $1.98, while the FY 2016 estimate has been revised to $2.56 from $2.58. Based on a share price at the time of writing of $37.34, the company’s shares are trading at a trailing P/E ratio of 18.5x and forward ratios of 18.9x and 14.5x for FY 2015 and FY 2016, respectively. The trailing and forward FY 2015 ratios are near the top of their respective 3-year ranges, albeit lower than they were at the beginning of this year. That said, the FY 2016 ratio is near its own low over the same period, creating a situation in which the company’s shares can only be considered to be undervalued in the event that its earnings next year achieve a 29.3% YoY increase. Conclusion El Paso Electric reported disappointing Q2 earnings in August, resulting from mild weather and continued regulatory lag. Management has reduced the upper limit of its FY 2015 EPS outlook range in response, although a hot Q3 may offset the previous quarter’s negative impact to a certain extent. Ultimately, I am more concerned about the likelihood that the strong El Nino event that has developed this year will persist into Q2 2016, in which case historical records suggest that the company’s service area could experience yet another cool start to the summer and a reduced number of cooling degree days. Over the longer term, I believe that the company’s outlook is superior to that of many of its peers due to its low carbon intensity and lack of planned capex during a future period of higher interest rates. However, given that its shares are overvalued on trailing and forward FY 2015 bases, and that the shares are only undervalued on a forward FY 2016 basis in the event that normal weather conditions prevail during that year, I encourage potential investors to wait for a margin of safety to develop in the form of underdeveloped shares to compensate them for the risk that El Nino will negatively impact earnings. Scalper1 News
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