Summary Northeast electric and natural gas utility Eversource Energy reported Q2 earnings that beat on both lines by keeping its costs low even as revenue increased. The company is preparing the groundwork for long-term future earnings growth via multiple large capex projects to import additional electricity and natural gas to ease the region’s supply constraints. Its short-term outlook has been hampered by the development of strong El Nino conditions, which will likely cause Q4 and Q1 temperatures in its service area to be warmer than normal. The company’s shares are trading at low valuations, however, and they will be attractively valued if the price falls below 15x future earnings in response to a warm winter. Northeast electric and natural gas utility Eversource Energy (NYSE: ES ) reported Q2 earnings at the end of July that beat on both lines , as the company’s three major segments all reported strong YoY increases to income. Eversource occupies a unique position as a major utility in the U.S. Northeast, which suffers from a lack of natural gas supply infrastructure following the conversion of many of the region’s coal-fired power plants to natural gas. This shortfall causes the price of natural gas, which is finding increasing use in heating applications as well, to experience substantial volatility during the winter as supply is insufficient to meet both heating and electric generation demand. The utility has been undertaking large-scale transmission projects to minimize this volatility while simultaneously selling unattractive generation assets, both of which will support its planned earnings growth. Its share price has fallen YTD despite these moves, however (see figure). This article evaluates Eversource Energy as a potential long investment opportunity. ES data by YCharts Eversource Energy at a glance Formerly known as Northeast Utilities, Eversource Energy took on its current name and ticker symbol in February 2015. The changes followed the utility’s merger with Massachusetts utility NSTAR in April 2012. Headquartered in Hartford, CT, Eversource Energy provides electric and natural gas utility services to a total of 3.6 million customers in Connecticut, New Hampshire, and Massachusetts via multiple regulated subsidiaries (all of which now share the Eversource name). The company’s operations are broadly divided into three segments: electric transmission, electric generation and distribution, and natural gas distribution. Its transmission segment includes 4,270 miles of lines in all three of the states located within its service area. Likewise, its generation and distribution segment, which includes 72,000 miles of distribution lines, also operates in all three states. Finally, the natural gas segment, which includes 6,459 miles of pipeline, operates in Massachusetts and Connecticut. Massachusetts became the largest state by population in the company’s service area following the merger and it now provides for 1.4 million electric customers and 283,000 natural gas customers. Connecticut is close behind with 1.2 million electric customers and 222,000 natural gas customers. New Hampshire, on the other hand, only has 510,000 electric customers. The latter’s small number led Eversource to announce in March 2015 that it intends to sell 1,058 MW of electric generating capacity in the state. The majority of the capacity is coal- and oil-fired and the company determined that, given the relatively small customer base in the state, pending environmental regulations on power plants made their continued ownership by it unattractive. New Hampshire’s governor signed off on the divestiture agreement in July. That said, it remains to be seen whether potential buyers will find the agreement’s terms, which includes requiring the buyer to honor the existing collective bargaining agreement and keep the plants open for 18 months post-acquisition, to be too onerous. Even as it is reducing its exposure to generation (Eversource Energy will continue to distribute purchased electricity to its New Hampshire customers), the company is expanding its natural gas and electric transmission segments. Natural gas and heating oil prices moved in opposite directions following the advent of shale gas extraction, with the former falling to a fraction of the latter’s price. While the recent fall in the price of crude has offset the advantage of natural gas to a large degree, customers in the Northeast have been switching from heating oil to gas in large numbers. Eversource, for example, is targeting 16,000 new natural gas customers annually through 2023 via such conversions. This shift has coincided with a broader move by power plants to abandon coal in favor of natural gas, first due to the latter’s low price and more recently to comply with expanding federal regulations on power plant emissions. Natural gas distribution capacity in the Northeast has not managed to keep up with the combined demand effects of this increased consumption. While sufficient supply is achieved in the summer when heaters aren’t running, natural gas shortages and consequent price volatility have been frequent occurrences in the Northeast during the winter months, especially during the type of exceptionally cold winters seen in 2014-15, for example. In an effort to offset increased demand for natural gas by its customers, Eversource Energy is building the high-voltage Northern Pass Transmission [NPT] line that will connect its service area’s electric grid to the Quebec province by way of New Hampshire. The $1.4 billion will construct 187 miles of new transmission lines that will run the length of New Hampshire and, in the process, connect the service area to 1,200 MW of Canadian hydroelectric capacity. The project is still several years away from completion, with the company stating that it doesn’t expect it to be in service until the first half of 2019, assuming that construction begins by the end of 2016. Complementing the Northern Pass project is a natural gas pipeline that Eversource announced late last year in partnership with Spectra Energy (NYSE: SE ). The $3 billion project is actually an expansion of pre-existing pipelines in the Northeast that supply natural gas to 60% of the region’s natural gas-fired power plants. When completed, the Access Northeast project will supply 5,000 MW of gas-fired electric generation capacity with natural gas from the Utica and Marcellus Shale regions, further helping to alleviate the Northeast’s natural gas shortages in the winter. The full expansion is expected to be in service as early as November 2018. Q2 earnings report Eversource Energy reported Q2 revenue of $1.8 billion, up by 8.3% YoY (see table) and beating the consensus estimate by $70 million. The increase came despite lower retail sales across its segments, with electric distribution sales down 0.1% YoY and natural gas sales down 1.2% YoY. Total operating income rose to $412 million from $294 million YoY as operating expenses failed to increase by the same amount as revenue. The company’s O&M costs fell as well, helping to offset an increase to purchased power costs over the same period. Eversource Energy financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 1,817.1 2,513.4 1,881.1 1,892.5 1,677.6 Gross income ($MM) 1,131.9 1,351.4 1,538.8 1,057.2 950.7 Net income ($MM) 207.5 253.3 221.6 234.6 127.4 Diluted EPS ($) 0.65 0.80 0.70 0.74 0.40 EBITDA ($MM) 588.6 667.0 594.3 606.0 451.7 Source: Morningstar (2015). Net income rose to $209.5 million from $129.2 million YoY, resulting in a diluted EPS of $0.65 versus $0.40 over the same period and beating the consensus estimate by $0.09. The strong earnings result was due to a number of factors related to both the company’s core operations and regulatory changes. Its electric generation and distribution segment fared best, reporting earnings of $121.6 million compared to $83.4 million in the previous year. The gain, which the company attributed to rising revenue and lower O&M expenses, occurred across all of the segment’s subsidiary entities. The electric transmission segment generated earnings of $80.4 million, up from $43.9 million YoY. The gain was almost entirely due to a FERC charge that was accounted for in the company’s Q2 2014 earnings report and was not repeated in the most recent quarter. Finally, the natural gas distribution segment had a slow quarter due to seasonal issues, although its earnings more than doubled from $2 million to $5.3 million YoY as a result of cold weather early in the quarter that resulted in a larger number of heating degree-days. Of Eversource’s total $0.25 YoY gain to diluted EPS, $0.11 was due to the previous year’s FERC charge and $0.10 was due to higher revenues in the most recent quarter. The Q2 earnings were in line with management’s earnings expectations and the company reaffirmed its estimated FY 2015 EPS range of $2.75 to $2.90 during the Q2 earnings call . The company also increased its quarterly dividend by 7.7% YoY to $0.42, resulting in a forward yield of 3.6%. Outlook Eversource Energy’s outlook has been dampened over the last year due to adverse regulatory decisions. The first of these was a decision by Connecticut state regulators to limit the company’s ROE to 9.17% , with 50/50 earnings sharing for the 100 basis points over that amount. This ROE was less than the company had expected and relatively low compared to those permitted for its industry peers. Second, federal regulators recently reduced the company’s transmission ROE from 11.14% to 10.57% . This latter decision in particular is a negative for Eversource given its large investment in new transmission assets. I am also concerned about the weather outlook for the company’s service area over the next six months. This year’s El Nino event is now expected to be one of the strongest on record even if it doesn’t actually set a new record. Previous El Ninos of similar strengths have been characterized by warmer-than-normal winter weather across the northern half of the U.S. that, as far as the eastern seaboard is concerned, pushes as far south as Washington D.C. This year’s event is expected to last into the spring, meaning that Eversource Energy’s service area is likely to experience fewer heating degree-days than normal (and certainly fewer than last year’s bitter winter) during its traditional high-earnings quarters of Q4 and Q1. It should be noted that El Nino’s impacts are not as severe on the eastern seaboard as on the western seaboard and, just as importantly, the forecast is still quite uncertain. That said, investors should not be surprised if the company reports YoY declines for the period from October to March. Eversource Energy’s longer-term outlook is improved by its heavy planned capital expenditures, especially on natural gas pipelines and electric transmission lines. In addition to providing a basis for future rate case increases, the capex is also intended to serve a more fundamental purpose by reducing the Northeast’s notorious natural gas price volatility, particularly in the winter months. As discussed earlier, the widespread replacement of coal in power plants and heating oil in homes by natural gas leads to shortages when temperatures turn colder, resulting in wide price swings in states such as Massachusetts that aren’t reflected by the Henry Hub price (see figure). In addition to being onerous for consumers who find their heating and, more recently, electric bills spiking each autumn and winter, this volatility threatens long-term consumption trends by encouraging consumers to find alternatives. Massachusetts Natural Gas Citygate Price data by YCharts While Eversource’s proposed capex is intended to lay the groundwork for long-term earnings growth via both rate and volume growth, potential investors should be aware that, as a regulated entity, many of these plans are dependent on the support of multiple regulated entities. The Northern Pass project has encountered numerous instances of NIMBYism in sparsely-populated New Hampshire that have driven up its costs by requiring some of the line to be buried, for example, and despite its relatively advanced stage, the company doesn’t expect final permits to be received until the end of 2016. Likewise, while the Access Northeast pipeline has political support due to the history of natural gas shortages in the region, there is always the potential for a combination of NIMBYism and environmental concerns to cause delays and additional expenses. Valuation The consensus analyst estimates for Eversource Energy’s diluted EPS in FY 2015 and FY 2016 have remained relatively flat over the last 90 days as its Q1 and Q2 earnings have largely met expectations. The FY 2015 estimate has increased from $2.85 to $2.87, near the top of management’s expected range, while the FY 2016 estimate has remained flat at $3.04. Based on a share price at the time of writing of $47.47, the company’s shares are trading at a trailing P/E ratio of 16.5x and forward ratios of 16.5x and 15.6x for FY 2015 and FY 2016, respectively. All three of the ratios are near, but not quite at, the bottom of their historical respective ranges since the beginning of 2012, having fallen substantially since the beginning of the year (see figure). ES PE Ratio (TTM) data by YCharts Conclusion Electric and natural gas utility Eversource Energy reported Q2 earnings earlier in the summer that beat on both lines, as its cost-saving efforts offset slight declines to retail volumes. The company is in the midst of a strategic shift following its recent merger that will see it move from electric generation and distribution to electric transmission and natural gas distribution. This is a forward-looking move that, in addition to providing the company with years of large capex to support future rate cases, is aimed at mitigating the natural gas shortages that affect its service area on an annual basis. Furthermore, unlike some logistics projects (the Keystone XL pipeline being the most visible example), neither the Northern Pass nor the Access Northeast projects are likely to be especially offensive to the environmentally-conscious residents of the region, with the former in particular connecting the company’s service area to zero-emission electricity. NIMBYism and opposition to natural gas do create some regulatory uncertainty regarding both projects’ futures, of course, but these are more likely to increase their costs rather than result in their cancellations. The company’s share price is trading at low valuations in terms of both trailing and future earnings. The only thing that prevents me from buying its shares today is the presence of an especially strong El Nino, which increases the likelihood that the company’s service area will experience warmer-than-normal temperatures in Q4 and Q1 2016, especially on a YoY basis. Disappointing earnings results in one or both quarters could cause the company’s shares to fall a bit further, especially if such an announcement follows on the heels of an expected interest rate increase by the Federal Reserve at the end of 2015. It has been more than three years since Eversource Energy’s share price has remained below 15x future earnings for a lengthy period of time, however, and I consider its shares to be an attractive long investment opportunity in the event that they decline below $45.60, or 15x FY 2016 earnings at the time of writing.