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DTE Energy (DTE) Q3 2015 Results – Earnings Call Transcript

DTE Energy Company (NYSE: DTE ) Q3 2015 Earnings Conference Call October 23, 2015 9:00 am ET Executives Anastasia Minor – Executive Director, IR Peter Oleksiak – SVP and CFO Jeff Jewell – VP and Controller Mark Rolling – VP and Treasurer Analysts Julien DuMoulin Smith – UBS Dan Eggers – Credit Suisse Matt Tucker – KeyBanc Capital Markets Jonathan Arnold – Deutsche Bank Shar Pourreza – Guggenheim Partners Operator Good day and welcome to the DTE Energy Third Quarter 2015 Earnings Release Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Anastasia Minor. Please go ahead. Anastasia Minor Thank you, Kyle, and good morning everyone. Welcome to our third quarter 2015 earnings call. Before we get started, I’d like to remind you to read the Safe Harbor statement on Page 2, including the reference to forward-looking statements. Our presentation also includes reference to operating earnings, which is the non-GAAP financial measure. Please refer to the reconciliation of GAAP net income to operating earnings provided in the appendix of today’s presentation. We also are now including additional data in the appendix which we have historically provided in a supplemental document. With us this morning is Peter Oleksiak, our Senior Vice President and CFO; Jeff Jewell, our Vice President and Controller; and Mark Rolling, our Vice President and Treasurer. We also have members of our management team with us to call on during the Q&A session. I’d like to turn it over to Peter to start our call this morning. Peter Oleksiak Thanks, Anastasia, and good morning everyone and thank you for joining us today. Those of you who know me know that I always like to start off with a quick update on my Detroit Tigers. The Tigers looked towards the future at the July trade deadline this year, and [indiscernible] best pitcher, outfielder and closer. With that they slipped firmly into last place by the end of the season. I guess all I can say is, there’s always next year and our focus now is on the Red Wings making another playoff run, and I will not be mentioning the Lions or the Pistons on this call. DTE is continuing to have a successful year in 2015. As you know, we raised our operating earnings guidance a few weeks ago at our Analyst Day. I feel very confident that we will be able to comfortably achieve our guidance. We had a very successful third quarter and we expect a solid quarter to finish the year. We also provided a 2016 early outlook during our Analyst Day and I’m confident we can reach our 2016 EPS targets as well. Jeff and Mark will be going through third quarter results in more detail, but before we move on to that, I’d like to do a quick overview of our business strategy as well as some highlights of what’s happening at DTE. Turning to Slide 5, Slide 5 provides an overview of the business strategy and investment thesis. Our growth plans for next 10 years at both utilities are highly visible. Electric utility growth is driven by the renewal of our generation fleet and replacing and upgrading the electric distribution system. Our gas utility growth is driven by infrastructure investments, the mainline replacement, pipe replacement and a system expansion to accommodate the increased volumes for the Nexus pipeline into the rest of pipeline. Complementing our utility growth are meaningful growth opportunities in our non-utility businesses which provide diversity in earnings and geography. The structure of regulatory environment, engaged employees, continuous improvement and top-level customer satisfaction continue to be priorities that drive DTE success. The constructive regulatory environment is important as our two utilities are investing significant capital in the state of Michigan, and we know fostering this environment is a two-way street. I’ll be updating you on some of the regulatory proceedings our utilities are currently working through. Our highly engaged workforce continues to be a key to our success, and we have described our success throughout the year with the recognition we have received from the Gallup organization over the last three years. Our focus on continuous improvement is distinctive in the industry as the utilities continue to be leaders in maintaining costs. The combination of these two, employee engagement and continuous improvement, enables us to deliver both a sustainable COGS savings track record and to consistently earn authorized returns at both of our utilities. We’re also very focused on customer satisfaction, demonstrated by our gas utility currently rating highest by J.D. Power among our peers for business customer satisfaction. Both DTE Electric and DTE Gas are ranked second in satisfaction of residential customers. Rounding out our business strategy is our dividend growth and solid credit rating. Our dividend continues to grow as we grow earnings and our goal is to maintain a strong BBB credit rating. This strategy provides for consistent 5% to 6% annual EPS growth. Slide 6 provides some highlights of progress in 2015. As I mentioned earlier at our Analyst Day, we raised our 2015 operating EPS guidance and provided 2016 operating EPS early outlook. I’ll provide a more detailed overview of guidance in a few minutes. Today we are revising our cash flow and capital guidance for 2015, and Mark will provide more details on this in a few minutes. Regarding Michigan’s energy policy, there is positive momentum for constructive legislation by the end of the year. The governor and other energy leaders have called this a major priority. There is [indiscernible] legislation that has been developed in both the House and the Senate and the more extensive hearings have now been concluded. There have been a dozen hearings in the House on the proposed legislation and eight in the Senate, so this legislation is moving along nicely. Also want to give a quick update on the various rate proceedings for our two utilities. Our electric utility self implemented rates on July 1 for our ongoing generate rate proceeding. We expect to receive a final order by the end of the year. We also implemented the new cost of service rates which resulted in rate reductions for most of our business customers at the same time of self implementation. For DTE Gas, we expect to receive an order this year for an expanded infrastructure recovery mechanism that if approved will allow us to double the annual miles of our mainline replacement program. For next gas general rate case, we are looking to file in late 2015 or early 2016. We’re finalizing our plans. We feel this timeframe is optimal time to file. As you know, we haven’t filed a rate case at our gas utility in nearly four years. We continue to make significant progress in our non-utility businesses. Let me hit on a couple of developments in our Gas Storage and Pipelines business. Millennium is currently working on 200 Mcf/day expansion, which is expected to go on service in the fourth quarter of 2017. In addition, Millennium is constructing an 8-mile valley lateral to supply 130 Mcf to a new natural gas plant in Pennsylvania. This is expected to go in service in April of 2017. We have increased our ownership in the Nexus pipeline project from 33% to 50%, which increases our planned investment to approximately $1 billion. We have executed a number of key milestones, including the contracting for the major pipe materials earlier this month. Our next key milestone on the Nexus project is the FERC filing which will happen later this year. We have commitments. We need to move forward with the construction of the pipe. We have recently signed a number of Tampa interconnect agreements that could provide potential aggregate load across northern Ohio for up to 1.4 Bcf a day. This demonstrates strong market support for the project and also strengthens the longer term earnings potential for the play. And we continue to see increasing production forecast for the Appalachian region. So you can see we have a lot of positive things going on in both our utilities and non-utilities giving us confidence to reach our earnings goals in 2015. I can move on to provide more detail on Michigan’s energy legislation, but before I do that, let me give you a quick update on Michigan’s economy. The state economic indicators are looking very strong. We show some of the actual forecasts and metrics in the appendix but I’d like to highlight Michigan’s unemployment rate for September which was 5%. This is actually lower than the national rate of 5.1%, and it’s worth noting because it’s the first time in Michigan the unemployment rate is below the national average in 15 years. So things continue to move in the right direction in our state. So now let me move on to the state energy policy reform on Slide 7. Slide 7 is a slide you’ve seen before showing Michigan’s leaders who are helping to move the state’s energy policy reform to its completion. We are definitely fortunate to have these individuals who really understand what good energy policy looks like. The governor identified the need for energy policy reform as one of his top priorities and he has not wavered from that all year. He has taken time to study and understand our industry and land on what a good policy moving forward would be. His good advisors were John Quackenbush and Valerie Brader. And with Senator Nofs and Representative Nesbitt, we have two very competent energy leaders in the Senate and the House. So we have a situation where all three entities, the administration, the House and the Senate, are clear that Michigan does need to develop new policy to control its future. There is definitely progress happening. It gives us confidence of a timely resolution to the energy policy reform. Both the Senate and the House energy committee have concluded extensive hearings on the legislative package. Nofs and Nesbitt are working with committee members who would vote in the committee possibly by next month. So I’d like to turn to some specifics on legislation that is under development in the House and the Senate with Page 8, starting with the retail open access. Leadership in both the House and the Senate realized that the current system is broken, so both are proposing reforms. Both proposals as they stand now would cap the current program at 10% but with stricter and more fair provisions. Actually the House until recently had planned to eliminate retail open access altogether, but as part of the alignment process has been now proposing to stay at the 10% cap. But importantly, both the House and the Senate would require one-time election to return to the utility, which means there will be no longer a free option to move back and forth between the marketplace and our regulated rates. To make the cost of capacity more fair and to issue a reliable generation service in the state, the Senate is proposing a three-year capacity commitment, the house is targeting a five-year capacity commitment for those customers who would like to stay on retail open access. Integrated resource planning or IRP is the second key element of legislation. The proposals enable pre-approvals, so once it’s decided on what generation this should be, there will be a process for pre-approving investments and assuring that they are prudent, and similar to our current Certificate of Need process or CON process but on a portfolio basis. This new IRP process will fit nicely into the state’s implementation plan for the clean power plan. Then finally the legislation is going to deal with a number of regulatory reforms. Both the House and the Senate are proposing a move from our current 12 month cycle on rate approvals with a six month sub-implementation, to a simple 10 month cycle. There is also work on establishing a fair net metering policy which I think is important as we head towards building more renewables. Revenue decoupling is also being proposed for electric utilities. We would like to have this option to enable recovery of the impacts of energy efficiency in between rate proceedings. So I think the state of Michigan is well-positioned to have energy legislation by year-end. That’s important so that as a state we can move on in a constructive way to make the investments that we need to transform Michigan’s energy infrastructure. So on Slide 9, this slide shows our EPS history and our target of 5% to 6% growth. As I mentioned before, we expect to grow our dividend with earnings, evidenced by our recent increase which was at the high end of our earnings growth target. The chart shows a revised 2015 guidance midpoint of $4.78 as well as the EPS guidance midpoint of $4.69 for our growth segments. The 5% to 6% future growth I mentioned is off our new 2016 early outlook midpoint of $4.93 per share. The $4.93 midpoint represents a 7% increase from the 2015 original guidance. So let me get into a little more detail on Page 10. Slide 10 shows our current 2015 EPS guidance and our 2016 EPS early outlook. I want to focus on our 2015 guidance. Our current EPS guidance range is $4.65 to $4.91 for total DTE Energy and $4.59 to $4.79 for our growth segments. You can see next to the guidance numbers arrows indicating where we think the year might play out for each segment. We have green arrows up next to all of our non-utility businesses. If these businesses have a repeat of the strong performance in the fourth quarter similar to what we’ve experienced in the first three quarters this year, then we are seeing earnings fall in the upper end of these ranges. For Gas Storage and Pipelines, we are seeing strong performance in both pipeline and gathering earnings. Our Power and Industrial Projects segment is seeing solid performance in our REF business. And we are seeing strong economic performance at our Energy Trading operations. Our Corporate and Other segment is trending towards the lower end of guidance driven by taxes. I mentioned the strong financial performance we have seen this year, so I’d like to turn the call over to Jeff Jewell to provide more details on the earnings results. Jeff Jewell Thanks, Peter, and good morning everyone. I’ll be going over quarter-over-quarter earnings results on Page 12, and on Page 13 I will provide more detail into DTE Electric’s quarter-over-quarter operating earnings variance. Now turning to Page 12, for the quarter DTE Energy’s operating earnings were $252 million or $1.40 per share, and for reference, our reported earnings were $1.47 per share. You can find the reconciliation of the third quarter reported to operating earnings on Page 27. For the quarter, our growth segments operating earnings in 2015 were $75 million or $0.40 per share higher than 2014. The Electric segment was higher by $79 million. This favorability was due to warmer weather, self implemented rates and lower storm expenses in 2015. I’ll provide more detail on Page 13. DTE Gas was higher by $5 million. This was primarily driven by reinvestment spend in 2014 and increased revenue associated with the infrastructure recovery mechanism surcharge. Gas Storage and Pipelines earnings were $7 million favorable to the prior year. This increase was primarily due to increased volumes on the Bluestone pipeline and increased investments in our gathering assets. Our Power and Industrial Projects segment was lower by $6 million versus 2014, due primarily to timing of major coke battery maintenance project expenses and a steel related installment sale contract that ended in the second quarter of 2015. Our Corporate and Other segment came in unfavorable by $10 million versus last year. This variance was mainly due to timing of federal and state tax accruals. These items were considered in our year-end guidance. Again, the overall growth segment results for the quarter were $253 million or $1.40 per share. Energy Trading posted a $1 million operating loss for the quarter and economic net income of $14 million. Both the power and gas business lines contributed to these results. Please refer to Page 25 of the appendix to review the Energy Trading standard reconciliation page which shows both economic and accounting performance. Overall, DTE Energy’s operating earnings were $252 million or $1.40 per share for the quarter. Now let’s turn to Page 13 to discuss our Electric performance. Electric segment earnings were $79 million higher quarter over quarter. The variance was driven by three major contributors, increased rates, return to near normal weather, and lower storm O&M. DTE Electric self implemented a rate increase on July 1 as part of its ongoing rate case. This was partially offset by increased rate base growth due to investment in the generation and distribution operations. The next major contributor was weather. If you recall, summer weather in 2014 was much cooler than normal while this summer was near-normal. This resulted in increased sales of approximately 700 gigawatt-hours when compared to the same period last year. Please refer to Page 24 of the appendix for sales variance detail. Finally, we experienced lower storm activity in the third quarter of 2015. This is a significant decrease when compared to 2014 where we saw multiple storms including the storm in September of 2014 that impacted more than 400,000 or 20% of our customers. In conclusion, for the quarter, DTE Electric’s operating earnings were $79 million higher than 2014. That concludes the update for our earnings for the quarter. I’d like to now turn the discussion over to Mark who will cover cash flow and balance sheet metrics. Mark Rolling Thanks, Jeff, and good morning everyone. In addition to the solid earnings results, our cash flow and balance sheet are strong and continue to support our long-term growth plan. Slide 15 lays out our cash flow and CapEx through the third quarter. Cash from operations is $1.5 billion and we saw strong performance across all business units, putting us a little ahead of our plan for the year. We invested $1.7 billion of CapEx through the third quarter, and on the right side of the page you can see the breakout by business unit. DTE Electric is up due to higher operational investments and higher new generation spend with the acquisition of a gas [indiscernible] back in the first quarter, partially offset by the timing of some wind investments between years. And year to date, the non-utilities are on pace with last year. To fund this CapEx program and the refinance maturing debt, we issued $1 billion in long-term debt this year. Let me turn now to Slide 16 and the revised cash flow and CapEx guidance that Peter touched on. As I mentioned a moment ago, we are seeing strong cash flow this year and therefore we are increasing our cash from operations guidance by $100 million. We’re also making a small change to our CapEx guidance, and on the right side of the page you can see the breakout of capital spending by business unit. We still expect to spend a little over $1.8 billion at DTE Electric and $280 million at DTE Gas, and we expect our non-utility businesses to invest $350 million for the year or about $100 million lower than the low point of the original guidance. Now this change captures the timing of some of the growth progress upon industrial and will have no effect on the growth plan that we provided at our Investor Day last month. This brings our total CapEx to nearly $2.5 billion for the year, which is up more than 15% over last year. And back on the left side of the page, we have reduced our debt financing needs to correspond with this $200 million increase in free cash flow. Now I’ll move to Slide 17 with a look at our balance sheet metrics. Our balance sheet remained strong and we project ending the year within our targeted range for both leverage and FFO to debt. We issued $200 million of equity back in the first quarter and that fulfilled our equity needs for this year. At our investor event last month, we disclosed modest equity needs of $800 million from 2016 through 2018. Earlier this year we renewed our credit facility through 2020 and we ended the quarter with $1.8 billion of available liquidity. As we outlined at our Investor Day, we have a financial planning approach that will continue to rely on the strength of our balance sheet to fuel our long-term growth plans. And now I’ll hand the discussion back over to Peter to wrap up. Peter Oleksiak Thanks Mark. Let me finish the presentation with a quick summary on Slide 19, and then we can open the line for questions. We had three solid quarters so far this year and we are confident that this year’s performance will allow us to achieve our 2015 EPS guidance. We also anticipate constructive outcomes this year in both utility regulatory filings as well as the Michigan’s energy policy reform. Our balance sheet and cash flow metrics remain strong and our investments in our utility and non-utility businesses support our target 5% to 6% EPS growth going forward. I thank you all for joining our call this morning and I hope to see many of you at the EEI conference in a couple of weeks. Gerry Anderson will be giving a formal presentation on November 10th that will be Webcasted on our Investor Relations Web-site. So we hope you all can join us. Now I’d like to open up for questions that you have, so Kyle, you can open up the line for questions. Question-and-Answer Session Operator [Operator Instructions] We’ll take our first question from Michael Weinstein with UBS. Julien DuMoulinSmith It’s actually Julien here. So quick first question, perhaps obvious, given the trailing 12 months, what are you thinking here in terms of the fourth quarter and implied results, it seems perhaps it could even be potentially down year-over-year, is there something about reinvestment, [indiscernible] et cetera, you might imagine? Peter Oleksiak I’d like to reiterate that we are kind of confident with the earnings guidance that we’ve put out there. The electric utility in particular last year was in a lean mode. That’s really, if you’re looking quarter over quarter, kind of a fourth to fourth, that’s what you’re seeing emptying there. Julien DuMoulin Smith Got it. So does that actually mean that there is added strength or more of a tailwind that you are reinvesting in fourth quarter into 2016, or perhaps as you just alluded, was in more of a 4Q 2014 phenomenon such that this is more of a normalized pace in 4Q 2015? Peter Oleksiak It’s more the latter, the last year’s fourth quarter phenomenon. Julien DuMoulin Smith Got it, excellent. And then perhaps secondly, just of late any developments on the gathering front with Southwestern? Peter Oleksiak Our gathering business is going very well, and as you know, our raising of guidance in that segment in particular was with the volumes associated with the gathering with the Southwestern Energy. So the well performance is great, the drilling program continues to be strong in that region and our gathering earnings are flowing nicely there. Julien DuMoulin Smith Great. All right, I’ll leave it there. Thank you. Operator We’ll take our next question from Daniel Eggers with Credit Suisse. Dan Eggers Just on the legislation in Michigan with the hearings done, do you guys have a read in when something can get formalized or resolved between the House and the Senate and vote where this finally gets cauterized, is there something that we can look forward or a schedule that you guys see right now? Peter Oleksiak It is not a firm schedule, but as I mentioned, the extensive hearing process is done, and as you know, you mentioned that as well. There’s some finalization of language that will happen both in the committee and the House and then they’ll move it, both the Senate and the House, and from there there’ll be reconciliation. We are anticipating that will start happening as early as next month, early next month, but going more likely into the month of December. Dan Eggers So a conference next month between the House and the Senate and a vote in December seems realistic at this point? Peter Oleksiak Right, yes, that’s a possibility. Dan Eggers Okay. And then I guess your second question, when you think about the – it looks like you’re going to the idea that Choice has to get a firm capacity kind of somewhere between three and five years, is that something that you guys would look at providing or are you not going to be in the business of offering capacity to those customers? Peter Oleksiak No, we are not in the business of offering capacity to those customers. We’ll offer to our customers. Dan Eggers Okay. What is the year to date weather benefit on that after the good third quarter? Peter Oleksiak Jeff, if you have that? Jeff Jewell Ask that one more time, just make sure we’re answering what you’re looking for. Dan Eggers How much year-to-date weather benefit have you guys gotten? You gave the quarter, I don’t know if you have the year handy. Jeff Jewell So for the full year, if you go back to Page 24 in the pack, I think that’s what you’re asking, so I’ll just guide you back there. So the first is – I’m on the left-hand side there in the middle, DTE Electric 2015, you can see what that was for the quarter and we talked about that. And for the year to date, you can see it’s at $12 million. Dan Eggers Got it, thank you. I should’ve [looked it up] [ph] myself. Jeff Jewell [Indiscernible] was down negative $17 million for the year. Dan Eggers Okay. And my last question just on the pipeline tap-ins now that you’re 1.4 Bcf of potential customers, when do those start converting either into contracts or something more substantial and what should we be tracking other than just kind of these quarterly updates? Peter Oleksiak That will happen over time as the pipe gets built. That 1.4 Bcf is non-binding but we do anticipate that a number of that will potentially turn into nice investments for us, lateral or gathering couple of opportunities. They are more likely – that will happen once we are done with the construction of the pipe. Dan Eggers Okay. Thank you, guys. Operator We’ll take our next question from Matt Tucker with KeyBanc Capital Markets. Matt Tucker Just wanted to follow-up on the guidance and the full year guidance kind of implying that the fourth quarter would be down year-over-year, you already commented on some reinvestment at Electric. It looks like the non-utility segments, the guidance also implies earnings would be lower year-over-year. Could you talk about what might be driving that or should we kind of expect that the Electric reinvestment could offset some of the earnings there? Peter Oleksiak The electric utility, I mentioned I’m feeling comfortable with the guidance range we have out there. There was a phenomenon last year fourth quarter around lean. We’re in a normal investment cycle this year in the fourth quarter. But our non-utility businesses are performing strong. On a year to date basis, there is strong performance, and if that strong performance continues in the fourth quarter, those businesses will more likely end up in the upper end of those ranges. Matt Tucker Great, thanks. And just hoping you could provide a little more color on the change in timing in the CapEx at Power and Industrial Projects. Peter Oleksiak Mark, you want to take that one? Mark Rolling Sure. So that as you mentioned is timing related. When we did our original guidance for the year and we provided a range this year on the non-utility businesses, recognizing that those businesses and the timing of the project show-up has some variability. As we are close to the year-end, we have better visibility as to what’s going to occur here in late 2015 versus what may occur early in 2016. So it’s a timing related item at Power and Industrial. Specifically, if you step back and look at our early outlook for 2016 and our growth plan that we provided at our Investor Day, this has no impact on any of that, it’s really the timing item. Matt Tucker Got it. And is there any specific projects that you did highlight there? Peter Oleksiak I’ll add just a little commentary to Mark’s comments. Power and Industrial Projects in particular, we do have an acquisition strategy there where if opportunistic we’ll acquire small on-site related projects, and they have the tendency to be kind of lumpy in terms of when they show up, and when they do show up – we had one back a few years ago with the Duke project on the on-site project. So there, I don’t want to be too concerned. When they do show up, sometimes they show up and they are relatively sizable. We like to have a placeholder in with a capital for that business unit in particular. So it’s really just timing related to these small acquisitions related to in the Power and Industrial segment. Matt Tucker Understood. Thanks guys. Operator [Operator Instructions] We’ll take our next question from Jonathan Arnold from Deutsche Bank. Jonathan Arnold I just wanted to revisit just timing of the legislature. I know you’ll lay that when you know the steps, you see it. Are there some deadlines that we need to hit in order for this to be all accomplished in calendar 2015, when do the session end and at what point would we need to see it out of conference, how much wiggle room is there I guess? Peter Oleksiak It is not a firm schedule. The augment deadline was before they moved to the holiday break and which would be the back half of December, but the momentum we are seeing right now with the hearings being concluded, they said there’ll be some tweaking of the language in both the House and the Senate, and then at that point a reconciliation. The good thing is both the House and the Senate, essentially with Aric Nesbitt’s move to move a bit closer to where Mike Nofs is at, I see that process hopefully happening relatively quick once it starts. Jonathan Arnold Okay. Thank you, Peter. That was it. Operator We’ll take our next question from Shar Pourreza with Guggenheim Partners. Shar Pourreza Just one question on the decoupler, I know it’s a little bit preliminary, but Peter, are you looking for a full decoupler which takes any kind of load out of your earnings mix or sort of more of a partial decoupler that accounts for energy efficiency in DSM? Peter Oleksiak We’ll explore all the options. First is to kind of get that option for the electric utility to have a decoupler in legislation. That’s being proposed right now. So we like that to give us that option of flexibility. As we are thinking about it, we really would want it fully focused on the energy efficiency, that’s our early thinking at this moment. Shar Pourreza Got it. Okay, so you have some potential leverage to macro probably, okay. And then just on the pipe, 1.4 is non-binding, it’s a little bit preliminary, but is there any indication that you could reach that to laterals and compressors from a demand side or it’s too early? Peter Oleksiak The overall pipe we are putting in is 1.5 B, that’s expandable to 2 B with compression. The major market when this pipe first was put in was Dawn, and Michigan is Michigan, goes from a coal plant to gas plant conversion. So it’s really nice. Actually this Ohio market is actually showing up as well that wasn’t originally anticipated. We kind of knew that when we placed this pipe, we deliberately placed it in the Northeast Ohio around these industrial centers. So we are hoping that this 1.4 B, a portion of that gets converted over to this industrial load, which then once we [indiscernible] to get a lateral in gathering, but we feel comfortable right now that we’ll be able to expand the pipe to meet that. It will be a nice problem to have. Shar Pourreza Yes, exactly. Thanks Peter. Operator We have no further questions in queue at this time. I would now like to turn the call back over to management for any additional or closing remarks. Peter Oleksiak I’d like to just thank everybody for this morning joining us on the call, and once again we’re going to be at EEI and hope to see many of you there. Have a great day. Operator This does conclude today’s conference call. Thank you all for your participation. You may now disconnect.

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.

NorthWestern Corp. Looks Cheap, But It Will Likely Look Even Cheaper Later

Summary Electric and natural gas utility NorthWestern reported Q2 earnings that beat slightly on adjusted EPS, despite missing big on revenue. The company has expanded its renewable energy capacity in recent years to take advantage of its service area’s abundant hydro and wind resources. The company’s share price has also declined YTD even as its acquisitions have supported its earnings. While NorthWestern’s shares appear to be undervalued, there is a substantial risk that a strong El Nino will reduce hydro output and natural gas demand in its service area. I recommend that potential investors wait for adverse weather impact to provide a more attractive buying opportunity before initiating a long investment in NorthWestern. Northern Plains electric and natural gas utility NorthWestern Corp. (NYSE: NWE ) reported Q2 earnings in late July that beat slightly on EPS despite missing substantially on revenue. The company’s share price has largely declined in 2015 to date after racking up six straight years of steady gains (see figure). Interestingly, the company’s earnings haven’t slowed even as its share price has, suggesting that bearish investment sentiment resulting from a looming interest rate hike by the Federal Reserve is the cause of the latter’s poor performance. NorthWestern has been investing heavily in renewable energy in recent years, acquiring hydro and wind capacity in Montana and South Dakota, respectively. These acquisitions have coincided with falling energy prices and the prospect of weather-related disruptions to supply, however. This article evaluates NorthWestern as a potential long investment in light of these broader macroeconomic and weather conditions. NWE data by YCharts NorthWestern at a glance Headquartered in Sioux Falls, South Dakota, NorthWestern operates electric and natural gas segments that serve utility customers in Nebraska, South Dakota, and Montana. Its electric segment utilizes a mixed portfolio of coal, natural gas, hydro, and now wind to generate electricity that it transmits and distributes to 416,000 customers in all three states. The electric segment has been expanding its renewable generation capacity of late, purchasing 633 MW of hydroelectric capacity in Montana in late 2013 and agreeing to purchase 80 MW of wind power in South Dakota last July. The recent wind purchase, which is expected to close in Q3 with a price tag of $143 million, also includes the rights to a co-located 50 MW expansion site. These acquisitions will allow NorthWestern to easily meet the renewable portfolio standards in Montana and South Dakota, the latter of which is non-binding. Roughly half of the company’s total generation capacity is either renewable or in support of renewable capacity. The company’s natural gas segment transmits and distributes natural gas to 276,000 customers across its service areas. The segment is unique in that it also produces much of the natural gas that it distributes to its customers. It produces enough natural gas to meet 25% of its needs in Montana, for example, and is investigating potential acquisitions in the current low-price energy environment that will allow it to increase this share to 50%. Q2 earnings report NorthWestern reported Q2 revenue of $270.6 million, up 0.1% YoY and missing the analyst consensus estimate by a substantial $45.8 million (see table). The company attributed its low numbers to the presence of warm weather during the cold part of the quarter, which reduced its natural gas retail volumes by 14% compared to the previous year despite an increase to its customer numbers over the same period. Higher temps were prevalent across its service area, with the company reporting 16% fewer heating degree-days in total. These factors ultimately caused the natural gas segment’s revenue to decline by 15% compared to the previous year. The electric segment offset some of this decline, reporting a 7.5% YoY increase to its own revenue on higher retail rates and customer numbers. NorthWestern Corp. financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 270.6 346.0 312.9 251.9 270.3 Gross income ($MM) 191.0 233.6 204.9 157.3 157.8 Net income ($MM) 31.0 51.4 37.2 30.2 7.8 Diluted EPS ($) 0.65 1.09 0.85 0.77 0.20 EBITDA ($MM) 97.9 119.7 88.7 61.0 55.5 Source: Morningstar (2015). The company’s gross income came in at $191 million, up from $158 million YoY, as its cost of revenue declined by more than revenue on lower energy prices (see figure). The natural gas segment reported a 9.4% YoY decline to gross income, as the presence of reduced demand and its reliance on own production to meet much of this demand limited the decline to cost of revenue. This was more than offset by the electric segment, however, which reported a 31% YoY increase to its own gross income. Much of this increase was the result of generation from its Montana-based hydroelectric capacity showing up on its income statement; the segment’s gross income remained flat if this income source was excluded. The segment’s gross margin (gross income/operating revenues) did increase from 58% to 71% over the same period, however. Henry Hub Natural Gas Spot Price data by YCharts NorthWestern’s net income rose to $31 million from $7.7 million in Q2 2014, resulting in a diluted EPS of $0.65 versus $0.20. Much of the increase was the result of an insurance settlement payout, without which the company’s net income was $23 million on an adjusted basis versus $9.8 million YoY. Adjusted diluted EPS came in at $0.48, up from $0.25 over the same period and slightly beating the consensus estimate of $0.45. The company increased its quarterly dividend by 20% to $0.48 on the strength of its performance (resulting in a 3.8% forward yield), which also saw its free cash flow increase to $26.3 million from -$48.0 million YoY. Finally, management also took advantage of a favorable interest rate environment to refinance $150 million of debt due in 2016 with $200 million of 10- and 30-year mortgages at a substantially lower rate. Outlook NorthWestern’s decision to add wind capacity should prove to be a smart investment moving forward. The North Plains is one of the windiest places in the U.S. on a sustained basis (see figure) and has been home to much of the nation’s rapid wind farm growth over the last decade as a result despite its plentiful access to cheap natural gas and small population. The company’s service area overlaps with abundant wind resources and I wouldn’t be surprised to see it take advantage of the additional 50 MW capacity option in the event that Congress extends wind’s Production Tax Credit. Wind energy has been one of the few resources to prove competitive with fossil fuels in recent years and NorthWestern has additional backup natural gas capacity available to support such an expansion. In the shorter term, it remains to be seen how accretive the acquired capacity will be to the company’s earnings, as this will ultimately depend on South Dakota’s rate case decision that is due by the end of 2015. Source: EIA (2012). The company is also pursuing $100 million of additional natural gas investment so that it can supply 50% of the natural gas that its customers in Montana consume. It expects to incur roughly $1.5 billion in additional capex through the end of 2019 that will support future rate increases. The majority of these expenditures will be spent on infrastructure maintenance and upgrades. One area that investors should keep an eye on is the state of the economy in the company’s service area. The large fall to the price of energy that has occurred across the board since the second half of 2014 has negatively impacted the Northern Plains’ economy in the form of higher unemployment rates (see figure), which has benefited in recent years from the exploitation of unconventional fossil reserves. While NorthWestern’s customer numbers have yet to reflect this recent weakness by declining, multiple quarters of low energy prices could ultimately cause these numbers to plateau or even fall, offsetting some or all of the positive impact of rate increases on the company’s earnings. Montana Unemployment Rate data by YCharts Weather factors present the largest headwinds to NorthWestern’s earnings over the next few quarters, however. The West Coast drought that has been capturing headlines over the last year has also been appearing as far east as Montana. As of this month the western half of the state is classified as either “Moderately Dry” or “Severely Dry”, while much of the eastern half of the state is classified as “Slightly Dry.” Management stated during the Q2 earnings call that the drought conditions weren’t affecting its hydro operations in the state yet due to the fact that its capacity is widely distributed across the state. The drought conditions are of concern, however, because they are likely to grow worse over the next two quarters. NOAA recently announced that an especially strong El Nino is developing and, given its magnitude, it is now expected to last through the spring. Past El Nino events have resulted in reduced precipitation in Montana, as the winter storm track has been pushed into the south half of the U.S., with levels falling to an average of 75-80% between November and March of those experienced in normal years (see figure). Reduced river levels resulting from lower snowpack development can cause hydro generation to fall sharply, much as is already occurring in California. This, in turn, leads to higher average variable power costs that limit EPS, especially if not offset by higher rates. Source: NOAA . Compounding the potential impact of El Nino on Montana’s hydro generation this winter and spring is its impact on winter temperatures in NorthWestern’s service area. Past El Ninos have resulted in higher-than-normal temperatures in Montana, South Dakota, and north Nebraska, reducing the number of heating degree-days experienced during the winter and early spring. Montana has historically experienced the warmest temperature increases during El Nino events, especially in Q1. The impact of El Nino on NorthWestern’s earnings could be significant, as Q4 and Q1 have historically been when the company has earned the large majority of its annual earnings (see figure). Weak winter and spring demand for natural gas resulting from a historically strong El Nino would likely cause the company’s earnings to fall on a YoY basis, especially if it coincides with higher average variable power costs resulting from reduced hydro generation. NWE EPS Diluted (Quarterly) data by YCharts Valuation The consensus analyst estimates for NorthWestern’s earnings have remained relatively flat over the last 90 days. The consensus an analyst estimate for diluted EPS in FY 2015 has fallen slightly from $3.17 to $3.16 while the estimate for FY 2016 has increased slightly from $3.38 to $3.41. Based on a share price at the time of writing of $50.80, the company’s shares are trading at a trailing P/E ratio of 19.2x on an adjusted basis and forward ratios of 16.1x and 14.5x, respectively. The forward ratios have fallen significantly since peaking at the beginning of the year and are approaching multi-year lows (see figure). Even accounting for bearish sentiment on utilities resulting from a likely interest rate hike by the Federal Reserve before the end of the year, NorthWestern’s shares appear to be undervalued at present on the basis of the consensus analyst earnings estimates. That said, the estimates for FY 2016 in particular have not fallen over the last 90 days even as meteorologists have increased the expected strength and duration of the El Nino event in Q4 2015 and Q1 2016. NWE PE Ratio (TTM) data by YCharts Conclusion NorthWestern Corp. reported Q2 earnings that beat slightly on EPS despite missing big on revenue. The news briefly interrupted a steady decline to the company’s share price, although it has since re-approached its YTD low. Meanwhile, the company’s earnings have marched steadily higher, as it has invested in new capacity while also benefiting from reduced energy costs, resulting in share valuations that are approaching multi-year lows. While it is tempting to recommend the company as a long investment on those grounds alone, potential investors should be aware that meteorologists expect this year’s El Nino to be historically strong through spring. Historically, weather conditions in the company’s service area have been both warmer- and drier-than-normal during past El Nino events, indicating that there is a strong likelihood that both hydro output and natural gas demand will be reduced during the important Q4 2015 and Q1 2016 earnings periods. I encourage potential investors to wait for potentially disappointing earnings in the coming quarters resulting from adverse weather conditions to provide a better buying opportunity.