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PNM Resources: Potential Headwinds Diminish A Compelling Value Argument

Summary Electric utility holding company PNM Resources has underperformed the S&P 500 in 2015 YTD due to regulatory and economic headwinds. While regulatory uncertainty is negatively impacting the company’s FY 2016 earnings estimates, its history of earnings and dividend growth provide some optimism. At the same time, however, its earning growth could be adversely affected by a slowing Texas economy and reduced energy demand in New Mexico. Potential investors should not consider initiating a long position until the company’s shares hit a 3-year forward P/E ratio low, or $21.40 based on the consensus FY 2016 EPS estimate. PNM Resources (NYSE: PNM ) is an investor-owned holding company that provides electricity to customers in New Mexico and Texas through two subsidiary utilities, PNM (in New Mexico) and TNMP (in Texas). The company’s share price grew strongly in the second half of 2014 as energy prices fell across the board but has subsequently lost almost of that ground in 2015, having fallen by almost 21% YTD (see figure). While the company’s trailing earnings have increased even as its share price has retreated, the presence of regulatory uncertainty and underwhelming electricity demand in New Mexico have weighed on investors’ minds. This article evaluates PNM Resources as a potential long investment in light of the current operating conditions. PNM data by YCharts PNM Resources at a glance The two utility subsidiaries of PNM Resources operate in different areas of the electric utilities sector. PNM (the subsidiary rather than the holding company) is a vertically integrated regulated electric utility that generates, transmits, and distributes electricity to 513,000 residential and commercial customers across New Mexico, including Greater Albuquerque. It owns and operates 2,707 MW of generating capacity and 14,800 miles of transmission lines. PNM also owned a gas utility until 2009, at which point it was sold to a competitor in New Mexico to allow the subsidiary to focus entirely on electricity generation and distribution. PNM has undergone the beginning of a transition toward lower-carbon energy sources in recent years in an effort to reduce its overall carbon footprint. This transition will involve the closure of two of PNM’s existing coal-fired generating units by 2017, a move that will reduce its total capacity by 847 MW while also bringing its greenhouse gas emissions 17% below their 2005 levels. PNM is also investing in the generation and purchase of renewable electricity, including the construction of 107 MW of utility solar capacity by 2016 for $269 million, the purchase of 102 MW of wind energy from the Red Mesa Wind Energy Center, and 10 MW of geothermal energy. One of the most notable investments is the PNM Prosperity Energy Storage Project , which is the first solar electricity storage facility to be fully integrated into the utility power grid. The project provides 500 kW of solar energy capacity and 1 MWh of electricity storage capacity. While the announcement of the Tesla Powerwall has sparked a debate into the current value of electricity storage, the placement of PNM’s project ensures that it will have the greatest feasibility available in terms of solar availability. PNM has not completely abandoned coal, however, having recently signed a coal supply agreement through 2022 with miner Westmoreland Coal (NASDAQ: WLB ) that will generate cost savings for the utility of up to 20%. TNMP is a regulated electricity transmission and distribution utility that provides electric service to customers in Texas. The electric utility in Texas is different from those in many other states in that it is unregulated at the point of generation but regulated for purposes of transmission and distribution. TNMP is regulated, therefore, but under the Texas Electric Rate program it distributes electricity to customers from competing retail electricity generators. TNMP serves 240,000 customers, including coastal petroleum facilities, via approximately 9,000 miles of transmission and distribution lines. PNM Resources has maintained relatively heavy exposure to New Mexico over the past several years, with PNM generating a greater share of the holding company’s earnings than TNMP. This has hurt its revenue of late due to weak electricity demand, the result of a combination of a weak economy and unfavorable weather conditions. The company’s revenue in FY 2014 was 16% lower than in FY 2010. Thanks to the combination of low energy prices following the widespread advent of shale gas extraction, which caused natural gas and coal prices to move sharply lower, and cost-control measures, the company has been able to maintain its gross income and operating income (see table). PNM Resources Financials (non-adjusted) Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 Revenue ($MM) 332.9 346.9 414.0 346.2 328.9 Gross income ($MM) 174.6 163.9 221.3 174.8 169.0 Net income ($MM) 14.3 19.0 55.7 29.1 12.5 Diluted EPS ($) 0.18 0.24 0.69 0.36 0.16 EBITDA ($MM) 111.7 120.7 174.9 130.5 104.0 Source: Morningstar (2015). PNM Resources has also been able to maintain a solid, if not exceptionally strong, balance sheet over the last several quarters (see table). Its current ratio has remained stable even as it has returned $50-60 million in cash dividends, which have in turn grown by approximately 12% annually per share, to shareholders. The most recent such increase came last December, bringing the quarterly dividend up to $0.20 per share. While the company’s cash reserves have generally been low, this is not uncommon for regulated utilities due to their access to large lines of credit at relatively low interest rates. PNM Resources Balance Sheet (restated) Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 Total cash ($MM) 122.4 28.3 28.4 12.1 27.2 Total assets ($MM) 5,939.3 5,829.3 5,709.2 5,604.2 5,507.0 Current liabilities ($MM) 693.0 704.3 700.3 486.9 312.1 Total liabilities ($MM) 4,224.9 4,107.8 3,986.5 3,907.7 3,841.2 Source: Morningstar (2015). Q1 earnings report PNM Resources reported Q1 earnings last month that were largely in-line with expectations. The company reported revenue of $332.9 million, up 1.2% from $328.9 million in Q1 2014 and just missing the consensus estimate by $2.1 million. The company’s loads were down in New Mexico overall (residential loads were higher YoY but commercial and industrial loads were lower), marking at least the ninth consecutive quarter in which such a drop was reported in the state. This was partially offset by higher loads in all categories in Texas, however; the company also reported better-than-expected customer growth in both states as well. The presence of low energy prices and other sources of income in Q1 allowed PNM Resources to report slight operating income growth YoY from $48.8 million to $49.6 million. Net income also increased, from $12.5 million in Q1 2014 to $14.3 million in the most recent quarter, or diluted EPS results of $0.16 and $0.18, respectively. Adjusted net income, which included positive adjustments from mark-to-market impacts of economic hedges and state tax credits, rose from $14.2 million to $16.5 million YoY. Adjusted diluted EPS came in at $0.21 compared to $0.18 the previous year, beating the consensus estimate by $0.03. PNM reported the strongest improvement over the previous year, with its EPS rising from $0.11 to $0.14 as refined coal income, reimbursement for spent nuclear fuel, and half-priced leases more than offset the negative impact of reduce New Mexico loads. TNMP reported a slight EPS increase from $0.09 to $0.10 YoY, with the increase being attributed to slightly higher Texas loads and rate relief. While Q1 is historically a weak quarter for utilities operating in the Southwest U.S., it was strong enough for PNM Resources to maintain its previous guidance for adjusted diluted EPS of $1.50-$1.62 in FY 2015. Outlook PNM Resources faces a mixed operating outlook over the next several quarters. The economies of Texas and New Mexico have undergone very different recoveries in the wake of the Great Recession despite their close proximity. While New Mexico was not especially hard-hit by the recession, with its unemployment rate staying below that of both Texas and the U.S. average initially (see figure), it quickly fell behind after 2012. Texas, on the other hand, saw its unemployment rate plummet beginning the same year as it became a major producer of natural gas and petroleum, and its unemployment rate remains well below those of New Mexico and the U.S. average despite a recent uptick following last year’s energy price collapse. This has allowed PNM Resources to essentially split the difference, although its heavier focus on New Mexico via electricity generation as well as distribution has prevented strength in Texas from completely offsetting New Mexico’s relative weakness in recent quarters. Management stated during the Q1 earnings call that it is seeing early signs of “stabilization” in New Mexico’s economy, with employment rolls increasing and YoY customer growth of 0.7%. This improved outlook is partially offset by weakness in Texas, however, as energy production in that state has fallen in recent months (although customer growth there did increase by 1.4% in Q1 YoY). Potential investors in PNM Resources will want to keep an eye on economic conditions in both states. While energy prices have rebounded of late, sustained low prices for natural gas and petroleum could limit load growth in Texas in particular, hampering the company’s outlook. Texas Unemployment Rate data by YCharts Regulatory uncertainty has increased recently following adverse initial decisions at both the federal and state levels. PNM Resources recently received notice that the compliance plans it had submitted to regulators were determined to be insufficient, raising questions as to the amount and timing of expenses anticipated under them. The first initial decision relates to the company’s BART determination under the Clean Air Act. Whereas the company has proposed to retire two of its coal-fired units and upgrade two more to comply, the BART hearing examiner recommended that the negotiated proposal be rejected. While the recommendation is not final, Moody’s has indicated that an adverse final BART decision would cause it to remove its positive outlook on the company’s debt, potentially resulting in the imposition of higher interest rates. PNM Resources has also encountered difficulties with its future rate case proposal, which a hearing examiner determined was incomplete. As a regulated utility the company’s rates are determined by regulators rather than the market, making the final decision an important one for the company’s earnings. While the hearing examiner’s decision is not final, its finalization by the state regulatory commission would delay the implementation of new rates by several months, negatively impacting the company’s earnings for one or more quarters. The company has already receive approval for transmission rates equaling a 10% ROE so an adverse decision would not negatively impact all of its operations, but it would still cause the company’s FY 2016 estimated earnings to be revised lower. Valuation Analysts have revised their estimates for the company’s earnings FY 2016 earnings lower over the last 90 days in response to slowing economic growth in Texas and the possible delay in the implementation of new rates for the year. While the consensus estimated EPS for FY 2015 has remained flat at $1.56, the consensus for FY 2016 has fallen from $1.85 to $1.65. Both results would reflect a positive trend on an adjusted basis that has been in place since at least FY 2010. That said, based on the company’s share price at the time of writing of $24.74, this earnings growth has not outpaced the company’s share price. The current share price results in a trailing P/E ratio of 16.3x, which is roughly in the middle of the company’s 3-year range (see figure). The forward P/E ratios for FY 2015 and FY 2016 of 15.9x and 15.0x, respectively, are near the bottom of their respective 3-year ranges, although ratios of 13.5x and 13.0x for FY 2015 and FY 2016 would represent true bottoms (as well as a share price of $21.40, or a discount of 14% to the current share price). PNM PE Ratio (NYSE: TTM ) data by YCharts Conclusion PNM Resources has seen its share price fall substantially since the beginning of the year in response to slowing economic growth in its service areas, regulatory uncertainty at both the state and federal levels, and broad bearish sentiment with regard to dividend stocks in light of anticipated interest rate increases by the Federal Reserve. While the company appears to be undervalued on the basis of earnings estimates for FY 2015 and FY 2016, I believe that potential investors in the firm should require an additional discount to the current share price to compensate for the risks of a slowing Texas economy resulting from low energy prices and the prospect of adverse regulatory actions later in the year. I recommend that potential investors wait to initiate a long position until the company’s shares set a new 3-year low on the basis of forward valuations, or a share price of $21.40 based on current EPS estimates. While the company’s reliable earnings and dividend growth and current 3.1% dividend yield are attractive, the prospect of regulatory and economic headwinds should give potential investors pause. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Adoption Of VXUP As A Hedging Instrument Could Transform Investment Management

VXUP is revolutionary. VXUP could become a key hedge for non-correlated portfolios. VXUP deserves to become a billion-dollar ETF. Spot CBOE VIX Up Class Shares (NASDAQ: VXUP ) could transform investment management. While I am very empathetic to the notion put forth in yesterday’s article that the daily movement of the ETF currently lags the responsiveness of the raw VIX index, the recognition, appreciation, and acceptance of VXUP’s benefits should dramatically increase its trading volume. In turn, the increase in VXUP’s trading volume should make it much more responsive to changes in the raw VIX index. And this increased responsiveness to the raw VIX index will further increase the ETF’s value as a hedging tool, in a virtuous cycle. The general acceptance and adoption of VXUP as a hedging instrument should transform investment management in a variety of ways which I will specifically illustrate. Indeed, I believe that the investment community will quickly realize the immense profitability of promoting a very healthy level of liquidity and AUM in VXUP. Yesterday’s article did an excellent job of explaining VXUP’s mechanics, along with that of its inverse ETF VXDN (NASDAQ: VXDN ). I will not recreate the wheel here. However, I will point out numerous examples of strategies which could be vastly improved by the use of VXUP as a hedging component. Indeed, as a hedging instrument, it is totally irrelevant whether VXUP is perfect. What matters to the investor is whether or not VXUP is a drastic improvement over every other ETP hedging alternative currently available. I will argue forcefully that VXUP is vastly superior. The ZOMMA Index Master Sheet is an exhaustive list of ETP strategy indices and their variations that we have published on seekingalpha and sometimes in books. I forcefully argue that for any of the strategies which use iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA: VXZ ), iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ), or ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) as a hedging component, that the performance of those strategies could be vastly improved over multi-year periods by replacing the use of VXZ, VXX, and UVXY with VXUP. Theoretically, there are very short, discrete time periods where backwardation could benefit the use of VXZ, VXX, or UVXY. However, it has been definitively illustrated by dozens of studies that over longer times frames, persistent contango tends to cause an uncomfortable amount of performance drag when using these instruments as hedges. On one hand, I have argued that all of the strategies illustrated in the master sheet should no longer be used due to their correlation to long bonds. On the other hand, reducing the size of TMF, and making VXZ, VXX, or UVXY larger percentage allocations in an effort to reduce the strategies’ long bond correlation and diversify hedging sources kills upside performance due to contango lag–equally unacceptable. VXUP would solve this problem elegantly, allowing larger volatility-related hedges, which could reduce the correlation of the strategy indices to both stocks and to bonds, while eliminating contango lag. I have argued forcefully that the nightmare scenario for the financial markets is for both stocks and bonds to crash simultaneously. On 3/11/2015 , I wrote: The sad joke of financial markets is that they are driven by long term interest rates, which set the discount rate for all other asset classes. And indeed, dropping interest rates have made speculators of every stripe look brilliant. Imagine a high jumper who is constantly buoyed by a dropping force of gravity. His athletic prowess appears to be improving, but instead, the force of gravity is becoming weaker. And conversely, rising gravity, or interest rates, cause moving objects to drop to earth more quickly. Moving objects like stock prices, bonds, real estate, and even gold. Every asset class will be affected by rising rates. Since then, the TLT ETF has dropped from $127 to a touch below $117. Imagine a nightmare scenario is which both stocks and long bonds dropped by 50%, due to a spike in interest rates. In such a scenario, it is almost facile and axiomatic to point out that volatility would skyrocket. A hedge like VXUP would be absolutely essential to reduce a portfolio’s correlation to both stocks and to bonds during such a nightmare. Moreover, if stocks and bonds do not simultaneously collapse, a lower correlation to both asset classes will not hurt the investor seeking an authentically non-correlated return stream during more normal regimes. So returning to the issue at hand, the use of VXUP as a hedging tool potentially allows the serious investor to reduce a portfolio’s correlation to both stocks and to bonds without the continuous contango that a VXZ, VXX, or UVXY position would entail. And without contango, the new VXUP volatility hedge could be comparatively larger without the associated drag of pre-existing alternatives. So it is largely irrelevant to the serious investor whether or not VXUP perfectly mirrors the raw VIX index. No hedge is perfect. There are merely hedges which are far better than any available ETP alternative! And VXUP is that far better hedge. As the investment community realizes it and volume in the VXUP increases, ironically, the VXUP should better mirror the raw VIX and even further outpace the competition as the most serious tool in the hedger’s toolbox. The portfolio manager’s dream has always been a continuously traded put option of sorts, which can serve as a shock absorber to a portfolio, without the drawbacks of a put option’s time decay or a volatility future-based instrument’s contango (which some would call synthetic time decay). The VXUP should become that continuously traded put option. Nothing else which has been introduced in the ETF world comes close to the VXUP in achieving that goal. I am not an expert in ETF design, but the goal that VXUP seeks to achieve is exceedingly shrewd. I would argue that increased volume, AUM, and acceptance will make the instrument more robust, useful, and demanded. Disclosure: I am/we are long VXUP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Pepco-Exelon Merger: OPC-DC’s Position Raises Questions As To Agency’s Effectiveness, Relevancy

Summary The D.C. Public Service Commission is reviewing the Pepco-Exelon merger; regulatory approval is the final step in the process and if granted, the transaction should close shortly thereafter. Pepco shareholders will receive $27.25 per share in cash plus a pro-rata dividend; the D.C. AG and the Office of People’s Counsel D.C. have voiced opposition to the proposed merger. A closer look at the OPC-DC’s brief in opposition to merger reveals flawed reasoning and a motive of preserving the agency’s existence and relevancy to the detriment of D.C. consumers. We are approaching the conclusion of the regulatory review of the Pepco-Exelon merger which was announced on April 30, 2014. Pepco Holdings Inc.’s (NYSE: POM ) stock now trades ex-dividend (from June dividend) but there remains upside at its current price of $26.75 per share. At closing shareholders will receive $27.25 per share in all cash and a pro-rata dividend of $0.002967 per share per day after June 10th and until the merger closes as we discussed in early-June . We continue to hold our position in Pepco and expect that Exelon (NYSE: EXC ) will close the transaction in July with the expectation that the Public Service Commission of D.C. will grant its approval of merger. (click to enlarge) (Source: Nasdaq.com) The Office of the People’s Counsel of D.C. Is Taking the Wrong Approach to the Merger In anticipation of the Public Service Commission of D.C. vote to approve the proposed transaction, the Office of the People’s Counsel of D.C. filed a brief outlining their views and opposition to the merger. We are surprised that the OPC is taking strong stance against a sound merger that will result in a more efficient company with greater resources to provide reliable and low cost service to the people of D.C. Even more surprising is that their arguments against the proposed transaction are inconsistent and in many instances directly contradict past statements made by and official views of the OPC. We believe if Pepco continued as a standalone company over the long-term, Pepco’s already attenuated financial position may worsen due to the company’s substantial indebtedness, and capital expenditure requirements for further investments in infrastructure improvements. OPC has even agreed that this was true prior to the Exelon-Pepco merger. In Mayor Vincent Gray’s annual letter for OPC in 2013 he starts off by discussing how Pepco has struggled significantly with service reliability and minimizing power outages: (click to enlarge) (Source: OPC-DC 2013 Annual Report; opc-dc.gov) With such an unfortunate experience in service reliability, we would think the OPC would like to a see a service provider with greater financial strength, greater resources to invest in improved infrastructure, and an experienced and talented management team. This does not appear to be the case. In fact, OPC would like the opposite. We look to OPC’s brief on the merger and surprisingly the office now claims that “PHI/Pepco do not need Exelon” and “Direct Benefits to Ratepayers are Inadequate, Overstated, and Will Be Fully Realized (if at all) Only After Many Years.” Suddenly and inexplicably (actually we will get to our explanation below), Sandra Mattavous-Frye, the head of the OPC, in the brief put her full support behind Pepco CEO Joseph Rigby’s statement of service reliability: (click to enlarge) What could possibly explain this sudden shift in the OPC’s view toward Pepco? The OPC-DC relies upon power outages, unreliable service to its consumers and over-billing among other issues in order to litigate and justify its existence within the D.C. government. A standalone Pepco will allow OPC to continue to pursue litigation against Pepco and take advantage of power outages and poor service for political gain. For example, Sandra Mattavous-Frye states that in response to several consumer complaints against Pepco and other energy suppliers: “We took a novel approach to a traditional problem. We petitioned the Commission to investigate the matter, educated and informed consumers about their rights, and negotiated a global settlement with the provider. The end-result was an unprecedented settlement that addressed the needs of some 500 aggrieved customers and led to the creation of a $100,000 low income energy grant fund.” Apparently suing Pepco is a “novel approach.” But this is what the agency relies on and the agency continues to pursue litigation against Pepco and others when the opportunity arises. Any improvement in the underlying problems by more efficient and low cost service providers would disrupt the agency’s mission. Therefore, in an effort to maintain the status quo, the OPC has come out against the merger with populist views of how the merger is driven by greedy management and shareholders at the Illinois-based Exelon. Politically, this stance grabs headlines and gets strong support from a solid segment of the population but in the end, we think it is bad public policy for D.C. consumers and will not withstand the objective review of the D.C. Public Service Commission. We expect the D.C. Public Service Commission to approve the merger. (click to enlarge) (Source: Exelon Presentation April 30, 2014) In Our View, the Transaction Would Undoubtedly Be an Overall Positive for D.C. Consumers We believe the OPC’s vocal stance against the merger is driven by the agency’s self-interest as the merger will in effect render this inefficient, bureaucratic agency irrelevant. Consumer complaints will almost certainly decline and overall service reliability will improve post-transaction. (Source: OPC-DC.gov; 2013 Annual Report) Exelon’s establishment of a Customer Investment Fund and a commitment for enhanced reliability will improve the service for D.C. consumers over the status quo. Post-transaction, the agency’s role in advocating consumers will be greatly diminished and the D.C. government may take a close look at this agency to determine if it is even necessary to continue to spend significant and valued taxpayer dollars on such basic tasks when consumers are receiving low cost and reliable service from the new Exelon-Pepco entity. Will History Repeat Itself? In our view and final analysis, the Office of People’s Counsel DC provides very little, if any, substantive value to DC consumers. The agency represents government bureaucracy at its worst despite its claim that its overall budget is revenue neutral. (click to enlarge) (Source: OPC-DC.gov) We find that the agency is over-staffed and under-delivering on its mission to educate, advocate, and protect consumers because the agency is squandering its resources in pursuing misguided political activism at the expense of DC consumers. The office which was eliminated once before in 1952. After being reestablished in 1975, we think now in 2015 the agency’s effectiveness and relevancy has passed it by. Disclosure: I am/we are long POM. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.