Tag Archives: kansas

Atmos Energy’s Outlook Contains Multiple Drivers For Earnings Growth

Summary Natural gas utility Atmos Energy has been one of the sector’s strongest performers over the last five years as the discovery of large domestic gas reserves has spurred its demand. The company also benefits from a diverse geographic footprint and the existence of multiple favorable regulatory schemes in its large service area. While a warm spring dampened its FQ3 earnings, the company continued to report customer growth and higher throughput in its pipelines segment. The company’s shares appear to be overvalued on a P/E basis but its outlook contains multiple drivers for future earnings growth, both near term and long term. Headquartered in Dallas, Texas, Atmos Energy (NYSE: ATO ) is one of the country’s largest natural gas utilities, handling distribution, pipeline transmission, and storage services in several U.S. states. The company has been one of the top performers over the last several years among U.S. natural gas utilities, generating a total shareholder return result that is roughly 50% higher than the average of its peers. More recently, its share price has begun to move higher following multiple quarters of underperformance compared to the S&P 500, setting a new all-time high last week before settling a bit to $59. While the recent performance of the company’s share price has been the result of the Federal Reserve’s delay of an expected interest rate hike, which broadly supported the utilities sector, Atmos Energy’s outlook has also improved over the last several months due to a combination of changing energy consumption habits, proposed federal regulation, and the development of a strong El Nino. This article considers the company as a potential long investment opportunity in the presence of this operating environment. Atmos Energy at a glance Atmos Energy is divided into both regulated and non-regulated segments that operate in eight different states on both sides of the Mississippi River. While its largest areas cover Texas, Louisiana, and Mississippi, which combined are the origin of 80% of the company’s total rate base, it also operates within Colorado, Kansas, Kentucky, Tennessee, and Virginia. Its service area covers several urban centers, providing its regulated distribution segment with roughly three million customers that are supplied via 67,000 miles of distribution and transmission pipelines. This segment’s operations are complemented by the company’s regulated pipeline segment, which transmits natural gas from many Texan shale gas basins via 5,600 miles of intrastate pipelines. Finally, Atmos Energy’s non-regulated segment provides natural gas delivery, storage, and transportation services. The regulated distribution segment generated the majority of the company’s earnings at 61% of the total in recent quarters, followed by 30% from the regulated pipelines segment and 9% from the non-regulated segment. The company’s regulated segments operate within very favorable regulatory schemes, resulting in strong allowed returns on equity compared to its peers. The regulated distribution segment has a blended allowed return on equity of 10.4% while that of the regulated pipeline segment is higher still at 11.8%. The allowed returns are further aided by mechanisms that rapidly increase rates in response to higher capex: the company reports that 91% of its capex is recouped via higher rates within six months and 96% is recouped within 12 months. Indeed, 45% of the company’s FY 2015 capex from its regulated distribution and pipeline operations is completely unlagged. 97% of its rates are further covered by weather normalization mechanisms that minimize exposure of the company’s earnings to weather-induced rate volatility, although this does not extend as far as consumption volume volatility. Atmos Energy earnings are very exposed to the utility’s operations within Texas, providing it with both an advantage and a risk. 60% of consolidated margins, 70% of its asset base, and 70% of its FY 2015 capex are linked to the state, and its distribution network serves 1.8 million customers in the state, including the Dallas-Fort Worth metro area. Of the company’s total rate base, Louisiana is second at 8%, followed by Mississippi at 6%. This exposure to Texas has provided strong support for the company’s earnings growth over the last decade due to the state’s above-average economic growth and growing exploitation of its shale gas reserves. The risk is that Texas could at some point introduce an unfavorable regulatory scheme that, because of the company’s exposure to the state, would have an outsized impact on its earnings despite its diverse geographic footprint. That said, the risk of this happening is much lower than that faced by utilities in states such as California or New York, for example. Atmos Energy has achieved 12 straight years of diluted EPS growth and 31 straight years of dividend increases. The most recent dividend hike came in the form of a 5.4% increase in the current fiscal year. Its forward yield is a relatively modest 2.6% at present, although this is more of a function of the fact that the share price has nearly tripled over the last three years than of a low dividend payout ratio. FQ3 earnings report Atmos Energy reported its earnings in August for the quarter ending June 30 that slightly exceeded the consensus analyst estimate despite the presence of warm spring temperatures. Consolidated revenue came in at $686.4 million (see table), down 27% YoY from $942.7 million. The decline from the previous year was primarily due to a 37% fall in the price of natural gas over the same period and reduced demand due to warmer than normal temperatures, although these impacts were partially offset by a customer increase of 4.6%. Atmos Energy financials (non-adjusted) FQ3 2015 FQ2 2015 FQ1 2015 FQ4 2014 FQ3 2014 Revenue ($MM) 686.4 1,540.1 1,258.8 778.7 942.7 Gross income ($MM) 381.7 520.7 423.3 337.7 359.5 Net income ($MM) 56.3 137.7 97.6 23.7 45.7 Diluted EPS ($) 0.55 1.35 0.96 0.23 0.45 EBITDA ($MM) 187.0 317.0 253.9 151.3 170.4 Source: Morningstar (2015). The company reported gross profit of $381.7 million, up from $359.5 million YoY. All three of its company’s segments reported increases over the same period, led by an increase to that of the regulated distribution segment from $257.7 million to $267 million as higher rates were only partially offset by an increase to revenue-related taxes and a decrease to demand resulting from the warm spring. The regulated pipelines segment reported a similar increase to $97 million from $87.2 million YoY as its capex spending quickly generated higher rates. Finally, the non-regulated segment’s gross profit increased from $14.8 million to $17.8 million YoY as falling natural gas prices pushed its margins higher. Adjusted net income rose to $55.1 million, or $0.54 diluted EPS, from $46.1 million, or $0.43 diluted EPS, beating the consensus EPS estimate by $0.03. The adjustment excluded an unrealized gain of $1.2 million, or $0.01 of diluted EPS. The YoY increase to net income would have been higher still but for an increase to O&M costs over the same period from $125.6 million to $132.4 million resulting from higher maintenance capex. Outlook Based on its earnings through the first three quarters of the 2015 fiscal year, Atmos Energy’s management announced during the FQ3 earnings call that it was both tightening and increasing its annual diluted EPS forecast to $3-$3.10. This would ultimately be below the company’s target annual growth of 6-8% through FY 2018, although such a relative slowdown isn’t surprising given its 12% YoY increase in FY 2014. Management expects to support its long-term EPS growth target by maintaining its current high levels of capex, reaching around $1 billion annually through FY 2018 and resulting in a rate base CAGR of 9-10% over the same period. Most of this capex will consist of reliability spending by its regulated distribution segment; only 12% will go towards customer expansion. Atmos Energy’s outlook through FY 2018 will be most impacted by three factors: weather, interest rates, and natural gas demand. Barring an interest rate increase before the end of the year, weather will be the first factor to make its presence felt. Meteorologists now attribute a high degree of certainty to the arrival of a strong El Nino this year, with the only questions remaining relating to its ultimate strength. Previous such events have been characterized by substantially colder than normal temperatures across Texas, Louisiana, and Mississippi between January and May. Virginia and Kentucky have also experienced slightly colder temperatures during previous El Nino events, although Colorado and Kansas have experienced warmer temperatures. Given the strong influence of natural gas demand in Texas, Louisiana, and Mississippi on Atmos Energy’s consolidated earnings, however, the net impact of El Nino should be higher natural gas demand. While weather-normalization mechanisms in its service area will insulate the company from higher rates resulting from strong demand, it will benefit from higher volumes resulting from people running their heaters more than normal. Interest rates will also impact Atmos Energy’s earnings in FY 2016 and beyond. The company ended FQ3 with only $43 million on hand, making it likely that it will turn to the debt markets to finance its planned capex through FY 2018. Higher interest rates resulting from bullish Federal Reserve action will increase the company’s interest costs moving forward compared to in the past. That said, a couple of factors will limit this impact. First, 71% of its long-term debt matures after FY 2024, leaving it with breathing space. Second, its most expensive debt matures over the next few years. Finally, the favorable regulatory environment that the company operates in minimizes regulatory lag, preventing it from finding itself in the unenviable position of many of its peers when higher interest costs are not offset on the earnings statement by higher rates. The company’s longer-term earnings will likely be positively impacted by the U.S. Environmental Protection Agency’s [EPA] recent unveiling of its Clean Power Plan, which requires individual states to achieve reductions to the average carbon intensities (pounds of CO2 per MWh of electricity generated) of their power plants between 2022 and 2030. Each state’s required reduction operates as a function of its current average intensity, with those states having the highest intensities being required to achieve the largest reductions, although not necessarily the lowest ending intensities. Texas must achieve a 24% reduction by 2022, increasing to a 33% reduction by 2030, although its ending intensity can ultimately be met by employing natural gas complemented by wind. Arkansas must achieve an even larger reduction. The Clean Power Plan will ultimately drive demand for natural gas in power plant applications, both in Texas and the broader U.S., creating an additional source of demand for Texan shale gas. Atmos Energy’s regulated pipeline segment only operates at 51% of its peak capacity, leaving it with the slack to take on additional volumes at a very attractive allowed ROE. Finally, it is unlikely that the company will need to wait for the Clean Power Plan to go into effect before realizing additional natural gas demand in both its distribution and pipelines segments. The price of natural gas has fallen sharply over the past 12 months as commodity prices have broadly moved lower. This has caused natural gas consumption to move higher even as the number of heating degree-days in the U.S. has decreased, with the replacement of coal by natural gas at power plants providing a major impetus for this trend. Following the recent decline to the price of natural gas, the U.S. Energy Information Administration [EIA] is now forecasting total natural gas consumption to increase by 7% between 2013 and 2016 even as cooling degree-days decline. Texas, with its ample reserves of shale gas, can be expected to meet much of this demand, and Atmos Energy’s pipelines are available to connect the state’s gas fields with the rest of the country’s pipeline network. Valuation The consensus analyst estimates for Atmos Energy’s diluted EPS results in FY 2015 and FY 2016 have moved slightly higher over the last 90 days, the former in response to its FQ3 earnings beat and the latter in response to expectations of a cold winter in the company’s service area and the resumption of the natural gas price’s earlier trend lower. The FY 2015 estimate has increased from $3.04 to $3.07 while the FY 2016 estimate has increased from $3.23 to $3.25. Based on a share price at the time of writing of $59, the company’s shares are trading at a trailing P/E ratio of 19.1x and forward ratios of 18.3x and 17.5x for FY 2015 and FY 2016, respectively. All three of these are notably higher than their long-term historical averages of 14-15x. Conclusion Natural gas utility Atmos Energy has been a top performer from a shareholder return perspective compared to its peer group over the last several years, benefiting from its close proximity to inexpensive and abundant Texan shale gas and a diverse geographic and regulatory footprint. Its P/E ratios have moved higher over the last five years as both its earnings and dividends have moved steadily higher, and the company appears to be overvalued on the basis of these historical values. That said, its outlook contains a number of potential drivers to additional earnings growth, including the strong likelihood of a colder than normal winter across much of its service area resulting from this year’s El Nino event, increased demand for natural gas across the country in response to falling prices, and the implementation of a federal regulation that will spur additional demand for natural gas by electric utilities. While potential investors are unlikely to be interested in the company’s relatively low dividend yield, existing investors should remain in their positions despite the high valuation due to the number of potential positive catalysts on offer.

Great Plains Energy: Reliance On Coal Remains A Problem

Summary 80% of energy generation comes from coal. Upgrades to coal plants to maintain compliance has cost the company billions. Cash outflows in 2014/2015 related to higher capital expenditures have increased a utility with already high leverage. Management has guided down capital expenditures for the next five years, in spite of at the same time hinting at replacing 700MW of coal generation with an alternative source. Great Plains Energy (NYSE: GXP ) owns and operates power generation facilities that provide energy to nearly one million customers in Kansas and Missouri. The company has been a stalwart of the Midwest region and has long been a favorite of institutional and retail investors. Unfortunately, Great Plains has been dead money for investors for years – the ten-year return on shares is actually negative ignoring the dividends collected. Is it time for investors to give up on the company or is there meaningful returns for shareholders on the horizon? Ugh – Coal-Fired Generation Coal. I’m not a big fan of coal-fired power generation in my utility investments and unfortunately, that makes up more than 80% of Great Plains’ power production, forming the foundation of their base load generation. I will give the company credit as its facilities are newer and more up to date than most of the facilities that are still operational in the United States. The company has been taking big steps to cut emissions, at no small cost to the utility and its customers. * Great Plains Corporate Presentation Great Plains has lowered sulfur dioxide and nitrogen oxide emissions levels measurably over the past ten years through the addition of various emissions reducing technologies at its plants such as scrubbers. However, the company has yet to make progress on actually changing its energy production makeup. Most other utilities are years ahead in the addition of natural gas energy production (widely viewed as the “transition” fuel between coal and renewables) and renewables like wind, solar, and hydroelectric. While the company is currently in compliance with current mandated power generation laws in the states it operates in, there is no guarantee state regulators or the EPA do not enact stricter rules in the coming years. Coal-fired generation just makes for an easy target for activists and the government due to its dirtier nature compared to alternatives; even the cleanest coal-fired plants emit substantially more harmful gases than natural gas-fired plants. Further compounding risk, Duke Energy’s (NYSE: DUK ) coal basin issues and PNM Resources’ (NYSE: PNM ) saga with the Obama administration regarding its San Juan facility show how easily utilities (and shareholders) can get stuck on the hook for hundreds of millions of dollars with no means of recapturing the outlay through rate increases on customers. Does Great Plains have a way out, or at least an idea of how to change its reliance on coal? We do have some vague guidance from management. Investors have been told that the company will cease coal-fired operations (700MW worth) at some of its plants “in the coming years.” Beyond that, we have no detail. How many years? How will the output be replaced? All questions we haven’t gotten an answer on (and one analysts haven’t bothered to ask). I think it is likely that we see a plan similar to that with Portland General’s (NYSE: POR ) Boardman coal plant in Oregon: building a natural gas plant adjacent to the existing coal plant and once complete, flipping the switch off at one facility and on at the other. This is likely to be at least a five-year project at minimum from the date of announcement. (click to enlarge) *Great Plains Corporate Presentation Unfortunately, per capital expenditure guidance given above, we haven’t been given any signs of when this will come into place. Management is guiding capital expenditures to come down across the board over the next five years, doing so to likely assure support for their dividend growth guidance while alleviating concerns about cash flow issues, which will be touched on later. Operating Results There is something to be said for top line consistency and Great Plains has it. While Missouri and Kansas aren’t the best areas of operation, they have been steadily improving over the past several years. Regulators in both states aren’t too harsh and there are several accelerated rate case mechanisms in place to allow yearly adjustments to the rate base. Nonetheless, operations and maintenance costs have exceeded revenue gains due to the additional maintenance needed on core facilities and the transmission/distribution infrastructure. When I mentioned investor concern regarding cash flow earlier, you can see how 2014/2015 have definitely resulted in sizeable cash outflows that are not covered by operations. Investors have watched the debt rise $500M from the end of 2013 to present. Net debt/EBITDA now comes in at 4.6x, indicating a substantial amount of leverage present in the business. Further compounding pressures, Great Plains has had a large debt balance outstanding for some time. This fact, along with its relatively smaller size, has resulted in a premium on the interest rates of company debt. More than 35% of operating income in 2014 ended up going to creditors, with similar percentages likely in 2015. This can’t continue, which means that capital expenditure guidance has to come down. Conclusion Management is in a tough place. Upgrades to bring coal plants into compliance have been expensive, running into the billions. Debt remains elevated, yet further costs related to a shift away from coal are around the corner. Management has no guidance on replacing 700MW of power with an alternative source and where those funds will come from is up in the air. Great Plains also seems stubbornly intent on sticking by their 4-6% annual dividend growth targets, despite the impact of the tens of millions of dollars in additional outflows these yearly increases cause. Shares of Great Plains have underperformed and trade at a discount to peers, but this is likely for a good reason. I don’t see a compelling investment opportunity here and I would advise owners to evaluate their holdings to see if this remains a good fit within their portfolios.

Empire District Electric: A Small Utility In An Uncertain Region

Summary Regulated electric and natural gas utility Empire District Electric has seen its share price fall sharply YTD in response to uncertainty over interest rates and state and federal regulations. Further uncertainty has arisen in recent months in the form of El Nino’s temperature impacts, with a warm winter in its service area likely. The company’s shares appear to be undervalued on a P/E ratio basis but this doesn’t account for the possibility of reduced natural gas demand in Q4 and Q1 2016. I encourage income investors to wait for the company’s shares to fall below $20 in response to disappointing Q4 and Q1 earnings before investing. Regulated electric and natural gas utility Empire District Electric (NYSE: EDE ) reported Q2 earnings that missed on both lines as mild weather in its service area hurt both sales volumes and margins. The company’s share price declined in the weeks following the report’s release, continuing a sharply lower trend that has been in place YTD in the aftermath of an adverse state court ruling (see figure). While the company’s share price is nearing a 5-year low, its investors are about to be confronted by additional weather-related uncertainty as well as looming federal regulations that could impact its energy generation portfolio. This article evaluates Empire District Electric as a long investment opportunity in light of these developments. EDE data by YCharts Empire District Electric at a glance Headquartered in Joplin, Missouri, Empire District Electric is a combined electric and natural gas utility, although it also operates small water and fiber optic services as well. Its service area encompasses 218,000 customers residing in 10,000 square miles of the tri-state border region of Missouri, Kansas, and Oklahoma, as well as part of Arkansas. Its electric generation, transmission, and distribution segment covers the full service area, although 86% of its revenues are derived from its Missouri operations. The natural gas service is limited to western and northwestern Missouri. Empire District Electric is a relatively small utility with a $948 million market cap at the time of writing, reflecting the sparsely populated and mostly rural nature of its service area. The company generates 94% of the electricity that it sells via 1326 MW of owned generating capacity. While its fuel source portfolio has shifted in recent years, it is mostly comprised of coal and natural gas complemented by a small amount of hydro. The balance of its electric sales are derived from 86 MW of coal and wind via power purchase agreements, bringing its total capacity to 1412 MW. Another 108 MW of natural gas combined cycle capacity is currently under construction and expected to begin operations in the first half of 2016. The electric segment is responsible for the bulk of the company’s revenues, bringing in 91% of the total on a TTM basis as well as 92% of gross income (or gross margin in the company’s parlance) over the same period. Its customers are broadly split between residential, commercial, and industrial, with residential being the largest group. The natural gas segment, which is comprised of transmission and distribution components, generated 7.5% of TTM revenue and 6% of TTM gross income, although both numbers were lower than in previous years. Finally, the water and fiber optic segments generated only 1.3% of TTM revenue and an unknown percentage of gross margin. The last several years have been rough for Empire District Electric and it underperformed the broader sector for many of them. Its annual earnings remained relatively flat between FY 2008 and FY 2012, only beginning to grow strongly in FY 2013. Unusually, for a utility, its annual dividend has actually declined and is now 12% lower than in FY 2008-2010. Reflecting the unique weather conditions in which it operates, the company had to suspend its dividend in the second half of 2011 after a category EF-5 tornado hit Joplin, destroying 7,000 houses and causing the company’s number of customers to decline by 1.5% for the year. Its ROE on a non-weather adjusted basis has largely lagged behind the sector average, excepting a period from late 2013 to early 2014 that saw it report above average returns thanks in part to large temperature swings in its service area. Empire District Electric’s earnings and share price volatility is largely due to the fact that the Missouri regulatory scheme that it operates within does not contain a weather decoupling mechanism. Such mechanisms, which are found in some regulatory schemes, establish a base rate case and then allow the regulated utility to either charge or refund customers on the basis of the difference between the case and its weather-related earnings. Such a mechanism would have a large impact on Empire District Electric given the large temperature swings that occur in its service area over the course of a year: Joplin records average highs of 91 degrees F in July and August and an average low of 25 degrees F in February, while heat index and wind chill factors make this range appear to be even larger. The company’s earnings are therefore very sensitive to abnormal temperatures since its natural gas segment is in demand in the winter while its electric segment is in demand in the summer. Missouri’s scheme does include a fuel recovery mechanism, however, to minimize the impacts of the kind of energy price volatility that the U.S. has experienced over the last year. Q2 earnings report Empire District Electric reported Q2 revenue of $134.5 million, down by 10.2% YoY and missing the consensus estimate by $17.1 million. The presence of mild weather during the quarter compared to both the previous year and the long-term average as well as the presence of a fuel cost refund of $1.4 million resulted in the decline. This was partially offset by a $3.5 million increase resulting from customer growth and the implementation of a previously approved rate increase. Mild weather also reduced natural gas demand for heating purposes in the early part of the quarter, although the fact that the quarter is generally slow for the segment meant that this had only a small negative impact on the revenue result. Gross income (or margin) came in at $93.3 million, up slightly YoY from $92.7 million. The electric segment’s margin increased by 1% YoY as lower fuel costs and higher consumption by its commercial and industrial customers offset lower revenue overall and reduced consumption by its residential customers. The natural gas segment’s margin remained flat YoY and, as with revenue, only made a small contribution to the company’s total result. Net income came in at $6.8 million (see table), down from $11.2 million YoY. This resulted in a diluted EPS of $0.15 for the most recent quarter, down from $0.26 in the previous year and missing the consensus analyst estimate by $0.09. Both the decline and miss were almost entirely the result of higher O&M costs and depreciation expenses, both on a YoY basis. The negative impact of the former, which was the result of a planned major maintenance outage, on the company’s FY 2015 earnings should be offset by lower O&M costs in the rest of the fiscal year. Empire District Electric financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 134.6 164.5 151.4 171.5 149.8 Gross income ($MM) 65.7 75.6 67.3 86.0 65.1 Net income ($MM) 6.8 14.6 11.1 23.9 11.2 Diluted EPS ($) 0.15 0.34 0.26 0.55 0.26 EBITDA ($MM) 39.8 48.2 39.7 56.1 41.6 Source: Morningstar (2015). The depreciation increase, on the other hand, was the result of an air quality control system that the company had installed at one of its power plants in order to bring it into compliance with U.S. Environmental Protection Agency [EPA] restrictions on power plant emissions. Existing investors are already familiar with such costs, which are the result of a structural lag in Missouri’s regulatory scheme that prevents utilities from rapidly recouping capex in the form of a rate base increase. Instead, capex such as the control system purchase and installation negatively impact the company’s earnings in the form of higher depreciation costs and property tax payments before (hopefully) being offset by a rate base increase several months later. The company’s management has indicated in previous earnings calls that it does not expect for this lag to be eliminated anytime soon, further increasing its share price volatility. Outlook Investors should be aware of three major developments set to occur over the next twelve months that could have a substantial impact on Empire District Electric’s earnings results. The first of these is the prospect of higher interest rates for the utility sector resulting from a rate increase by the Federal Reserve. Utility capex has been bolstered over the last several years by the presence of historically low interest rates, allowing them to increase maintenance, replacement, and new capacity spending without negatively impacting earnings via substantially higher interest costs. While the market has been expecting such an increase to occur in 2015, a decision by the Fed not to implement an increase at its most recent meeting and a weak October jobs report has caused expectations of a 2015 rate hike to fall sharply. The utility sector has been one of the market’s stronger performers over the last several weeks as a result of this delay. When the inevitable hike does occur, however, Empire District Electric is unlikely to be as severely impacted as many of its peers due to the fact that most of its debt does not come due until after 2030, while recent borrowings have achieved a roughly 4% interest rate. Investors can expect Empire District Electric’s earnings to smooth out somewhat over the next year since the company expects its capex spending to decline sharply through FY 2017 following a large increase in FY 2014. As a result of this decrease, it is only forecasting a 4% rate base CAGR in 2014-2019. Furthermore, customer growth in its electric segment is expected to remain quite low, averaging less than 1% annually over the same period. This latter expectation is surprising given the robust economic strength of its service area’s economy. For example, the unemployment rate in Joplin and the surrounding area recently fell to 4.3% as compared to 5.6% in Missouri more broadly (see figure). The Joplin housing market has also been growing at a faster rate than Missouri’s (see second figure) following a brief downturn in the wake of the 2011 tornado strike. While the service area’s economy is strong, however, the region does not have any of the population growth drivers found in either metro areas or rural areas (a latter example being the Dakotas up until a year ago). While the economy will prevent customer growth from turning negative, then, the fact that southwest Missouri and the tri-state area have few major draws will prevent it from increasing by much either. Missouri Unemployment Rate data by YCharts Joplin, MO House Price All-Transactions Index data by YCharts I do expect the company’s earnings to falter a bit in Q4 and Q1 2016 as the effects of this year’s especially strong El Niño are felt. Historically, the company’s service area has experienced warmer than average temperatures between October and March during previous El Niño events, raising the prospect of similar mild conditions and consequent reduced natural gas demand over the next six months. While long-range weather forecasting is by nature an inexact science, the probability that this year’s event will remain strong have only increased over the last several weeks, boosting the likelihood that Empire District Electric’s earnings will be weaker than expected when it reports in January and April 2016. Finally, potential investors should be aware of a recent federal regulatory development that has the potential to impact Empire District Electric’s longer-term operations, although the timing of the impacts will be difficult to predict. In August, the White House and EPA, making good on its previous threats to respond to Congressional inaction on greenhouse gas [GHG] emissions by wielding federal regulations, announced a Clean Power Plan that will require each U.S. state to reduce the carbon intensity (e.g., unit of CO2-equivalent emissions per unit of electricity) by a predetermined amount over the next 15 years. Missouri is required to achieve an especially large reduction . While each state will be allowed to draft its own plans for achieving its individual reduction and, in the case of Missouri, this likely will be accomplished in consultation with the state’s utilities, in practice the plans will almost certainly take one of two forms: either coal-fired power plants will be replaced by natural gas-fired plants or large investments in new renewables capacity will be made. It is worth noting that Missouri can achieve its required reduction by phasing out coal in favor of natural gas, a process that is especially attractive in light of other recent EPA regulations restricting other types of coal-related emissions from power plants. Such a scenario would likely result in higher capex for Empire District Electric as it improved the efficiency of and converted its existing coal-fired plants, thereby supporting long-term rate base increases despite a lack of customer growth. The Central Plains region is host to a large amount of potential wind energy , however, and it is also possible that Missouri would focus on minimizing electricity prices and simply require the utility to purchase wind-derived electricity from independent producers of renewable power. Alternatively, the state could also opt for distributed generation, such as the residential PV installations that were the subject of the aforementioned state court decision. These latter scenarios would not support the company’s capex to nearly the same extent. Valuation The consensus analyst estimates for Empire District Electric’s diluted EPS results in FY 2015 and FY 2016 have held steady over the last 90 days despite its share price volatility. The FY 2015 estimate remains at $1.39 while the FY 2016 estimate remains at $1.51. Based on a share price at the time of writing of $21.69, the company’s shares are trading at a trailing P/E ratio of 16.7x and forward ratios of 15.6x and 14.3x for FY 2015 and FY 2016, respectively (see figure). The forward ratios in particular have declined sharply since the beginning of the year and are approaching their respective 5-year lows. I do believe that a warm winter will cause the company’s FY 2015 EPS to come in under the analyst consensus, ending up near the bottom end of management’s range of $1.30-$1.45. In this case, the company’s shares appear to be fairly valued at present on a historical basis. EDE PE Ratio (TTM) data by YCharts Conclusion Empire District Electric’s share price has fallen sharply YTD as abnormal weather conditions and an unfavorable regulatory structure have helped to produce more volatility than normal. While the company’s forward P/E ratios have fallen to levels that would normally suggest undervalued shares, the analyst consensus for FY 2015 and FY 2016 have remained flat over the last 90 days even as the likelihood of higher than average temperatures occurring in the company’s service area in Q4 and Q1 has grown. That said, I do believe that recent federal regulations on power plant emissions could present the company with an opportunity for long-term capex growth, although this will depend on how the state of Missouri decides to adapt to the recent Clean Power Plan. As attractive as Empire District Electric’s 4.8% forward dividend yield is, I would prefer to see a larger margin of safety in the form of undervalued shares to compensate potential investors for a lack of near-term capex growth and customer growth. While that margin is not available at present, I would consider purchasing the company’s shares in the event that the share price falls below 15x its FY 2015 earnings, or $20/share at the time of writing, in response to warm winter weather.