A Warm Winter Forecast Provides Downside Risk For CMS Energy
Michigan electric and natural gas utility CMS Energy recently reported Q3 earnings that beat on EPS despite missing slightly on revenue. The company’s earnings report and earnings call were largely upbeat despite the presence of underwhelming demand growth from its overall customer base. Low energy prices will make it possible for the company to maintain earnings growth via higher capex without negatively affecting customer demand via the imposition of higher rates. The company’s shares are overvalued relative to historical valuations, however, even as a strong El Nino is likely to result in a warm winter across its service area. Investors are advised to refrain from initiating a long position in CMS Energy until its share valuation provides them with a larger margin of safety. Michigan electric and natural gas utility CMS Energy (NYSE: CMS ) reported Q3 earnings last month that beat on diluted EPS despite missing slightly on revenue. Revenue came in at $1.5 billion, up by 4.2% YoY but missing by $60 million. Diluted EPS came in at $0.53, missing the analyst consensus estimate by $0.04 and improving from $0.34 YoY. The third quarter is historically one of the company’s weaker periods due to the seasonal presence of mild weather in its service area, however, and the earnings beat only prompted the company to slightly tighten its earnings guidance for FY 2015. The company’s share price has fallen by 3% in the aftermath of the earnings report’s release, although this volatility is likely the result of shifting expectations regarding the Federal Reserve’s upcoming interest rate hike. In a June article on the company I wrote that the interest rate increase would likely cause its share price to decline to $30 from price of $31.59 at the time of writing, although its longer-term growth potential was robust due to a rebounding economy in its service area. Weak U.S. economic indicators caused the Federal Reserve to delay the rate hike, however, resulting in a broad rally in the utilities sector that pushed CMS Energy’s share price as high as $37, although profit-taking and renewed rate hike fears have caused it to settle during the subsequent three weeks. Much of the company’s Q3 earnings report and subsequent earnings call focused on its ability to grow over the next several years by way of capex rather than increases to its customer numbers. One unique strategy that the company is envisioning is to take advantage of the lower natural gas prices that are being passed onto consumers via lower rates by investing heavily in infrastructure upgrades. While the capex would normally be passed onto consumers in the way of higher rates, in this case the impact of the increase would be offset by the effect of lower energy costs. In this way the company could make the investments to its infrastructure that are needed to maintain service reliability without causing rates to rise to the point that customers reduce their consumption in response. Implementation of this tradeoff will require the permission of regulators, although the company is strongly arguing its case. It is important to note that capex growth is expected to be the primary driver of earnings growth moving forward in large part due to a lack of consumption growth in CMS Energy’s service area. While Detroit’s economy in particular has been rebounding following the resolution of its financial crisis, this has yet to translate into demand growth by the utility’s residential and commercial customers. In fact, demand growth by its industrial customers is the only thing keeping the company’s overall demand growth forecast in positive territory over the next year. Barring an unexpected recession in the U.S. this industrial demand is unlikely to worsen, but investors should be aware of the sensitivity of the company’s demand growth forecast to industrial demand. That said, I have grown bearish on natural gas demand by the company’s residential natural gas customers, in particular due to the strong arrival of this year’s El Nino weather event. This year’s El Nino is, as was predicted earlier in the year, already showing signs of being one of the strongest on record. What is expected to be a boon for southern utilities will, counter-intuitively, likely be a detriment for their northern counterparts. Previous El Nino events have been associated with warmer and drier weather across Michigan, including CMS Energy’s service area, between October and April. A similar occurrence in Q4 2015 and Q1 2016 will result in reduced natural gas and, to a lesser extent, electricity demand by the company’s residential customers in particular (industrial customers, on the other hand, tend to base their consumption on facility online time rather than the weather). While not as important to its earnings as electricity sales, a plus-or-minus 5% change to annual natural gas sales has a corresponding plus-or-minus $0.07 change to annual EPS. Furthermore, the company’s natural gas sales tend to be highest in Q4 and Q1, meaning that this sensitivity is likely to be higher still over the next two quarters. An especially warm winter, then, has the potential to noticeably reduce the company’s earnings. The consensus analyst estimates for CMS Energy’s earnings in FY 2015 and FY 2016 have remained steady over the last 90 days, the former actually increasing slightly, despite the growing likelihood of reduced natural gas demand in its service area that has developed over the same period. The company’s trailing and forward P/E ratios remain quite high relative to their historical ranges at 19x and 18.8x, respectively, leaving investors with a minimal margin of safety in the event that this year’s El Nino event is a drag on the company’s Q4 2015 and Q1 2016 earnings. The earlier strength of its share price notwithstanding, then, potential investors are advised for a larger margin of safety to develop before initiating long positions in CMS Energy. The company’s current valuation is simply too high given the downside risks posed by a warm winter and looming interest rate increase.