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PNM Resources Eyes A Strategic Shift Amid Growing Renewables Use

Summary Southwestern electric utility PNM Resources reported yet another earnings beat in Q3 in the face of underwhelming revenue numbers as it benefited from a hot summer and cheap energy. The company reported continued weak demand in its service area in response to a shifting energy landscape that is increasingly focused on renewables. Its strategy for achieving future earnings growth by investing in its transmission and Texas operations is compelling based on the constraints faced by the region’s renewable generators. There is a good likelihood that the company’s earnings next year will be hurt by El Nino and investors are advised to wait for a better buying opportunity. Southwestern electric utility PNM Resources (NYSE: PNM ) reported yet another earnings beat on underwhelming revenues in Q3 last month as warm late summer temperatures in its service area pushed demand higher. This marked the third such combination of strong earnings amidst disappointing revenues this year, demonstrating the unique position that energy utilities are finding themselves in as energy prices are pushing for new lows. The company’s share price has moved solidly higher in response, most recently setting a 6-month high. Last June, I wrote an article on the company that highlighted the risks of slowing economic growth in its Texas and New Mexico service areas, concluding that the shares were attractively undervalued but not enough so to merit initiating a long position. While the prospect of weakening Southwestern economies in the face of low energy prices remains a concern, PNM Resources’ management discussed an important strategic realignment during the Q3 earnings call that will have important implications for earnings over the next several years. In the short term, meanwhile, the weather could provide the company with a new headwind by reducing demand for electricity in its service area. Q3 earnings report PNM Resources reported Q3 revenue of $417.4 million, up by 0.8% YoY but missing the consensus analyst estimate by $36.1 million. The annual increase was primarily the result of warm late summer temperatures in the company’s New Mexico and Texas service areas, which reported a combined 14% increase to cooling degree-days YoY and a 6% increase compared to the long-term average. Rate relief from renewables (reported by subsidiary PNM ) and transmission (reported by subsidiary TNMP ) also supported the revenue number. This result was partially offset, however, by the presence of a reduced load in PNM’s service area and generation facility outages over the course of the quarter. The number of customers increased by 0.8%, indicating that cheap energy has yet to result in a severe slowdown to the area economies. The company’s cost of revenue number fell to $124.3 million from $132.5 million YoY despite the improved revenue result due to the presence of sharply lower energy prices compared to a year ago. This allowed operating income to improve to $121.5 million from $116.8 million a year ago. Likewise, consolidated net income rose to $61 million from $55.7 million YoY, resulting in a diluted EPS result of $0.76 compared to $0.69 in the same quarter of 2014. PNM continued to be the primary contributor to consolidated earnings, and the subsidiary reported an increase to diluted EPS from $0.56 to $0.61 YoY. TNMP also increased, however, from $0.15 to $0.17 over the same period. In both cases, PNM Resources attributed the majority of the earnings increases to the presence of warm temperature during the quarter compared to the previous year, although lower expenses also contributed. Finally, the company increased its quarterly dividend by 8% to $0.20, resulting in a 2.8% forward yield. Outlook The company’s management narrowed its FY 2015 EPS guidance range from $1.50-$1.62 to $1.56-$1.61 on the basis of its consecutive earnings beats in the year. The midpoint of the new range, $1.58, is very close to the analyst consensus EPS estimate for FY 2015 of $1.59, the latter of which has increased from $1.56 over the last 90 days due to the hot summer temperatures in the company’s service area. Either result would result in YoY earnings growth of 7-8%, well within the company’s target of 7-9% through 2019. A shifting energy landscape in the U.S. has threatened in the past to derail the ability of PNM Resources to meet this targeted growth. Federal regulations on greenhouse gas emissions from power plants have caused the company to begin to phase out many of its coal-fired facilities. While the presence of cheap natural gas in the U.S. has caused many of its peers to replace its coal-fired units with gas-fired units, the abundance of solar and, to a lesser extent, wind in its service area has prompted PNM Resources to invest in renewable electricity capacity. With the exception of hydropower, however, renewables are intermittent in the sense that the capacity is not always achieving a high load when demand is also high. Furthermore, the cost of rooftop solar PV has finally fallen to the point that it is competitive on a subsidized basis with fossil fuels in sun-drenched areas such as the U.S. Southwest, causing many residential and commercial customers to become independent generators themselves rather than just consumers. Many utilities are reporting lower electricity sales volumes despite customer growth. PNM Resources has been no exception to this trend, with its subsidiary PNM reporting a YoY sales reduction of 1.7% in Q3 despite the presence of hotter temperatures on the same basis. While TNMP did report higher sales, the company expects PNM to report flat-to-negative growth which, given its outsized contribution to consolidated earnings, is important. Management’s response to this changing landscape has been to shift its planned future capex away from new generating capacity, which is no longer as essential (and therefore less likely to be part of a compelling rate case increase argument), in favor of new transmission capacity. Contrary to conventional wisdom, new solar and wind capacity in the Southwest can only be sited in limited areas due to constraints such as ecological protection, resource availability, and proximity to high-demand areas. This latter in particular is a major constraint since renewables built away from high-demand areas must be connected via lengthy transmission lines. The recently-announced Clean Power Plan, which requires utilities to reduce the carbon intensity (greenhouse gas emissions per kWh of electricity generated) of their power facility fleets over the next decade, provides a strong incentive to replace existing fossil fuel units that are located near population centers with renewable units that can be several hundred miles away, further raising demand for transmission capacity. PNM Resources stated in its Q3 earnings call that it has already signed 400 MW of transmission agreements that will send electricity generated at wind farms in New Mexico to California, which has very ambitious renewable electricity targets. The company’s transmission lines have an impressive allowed ROE of 10% and it has established a goal of increasing its transmission rate base by 53% between 2016 and 2019; by comparison, the company expects to increase its PNM retail rate base by only 4% over the same period. While ambitious, I believe that the former target is very likely to be met given the increased demand for transmission capacity that will result from the Clean Power Plan. This will more than offset a lack of retail growth, allowing PNM Resources to achieve steady earnings growth over the next several years despite reduced retail sales. While the company’s long-term outlook is attractive, its short-term outlook has weakened over the last six months as one of the strongest El Nino events on record has appeared over the U.S. Past El Ninos have caused the northern half of the country to experience warmer-than-usual winters even as the southern half experiences more cold than normal. While this winter appears set to continue this trend, PNM Resources doesn’t receive much benefit from cold winters, having sold its natural gas subsidiary utility several years ago. As an electric utility, it is very sensitive to summer temperatures, however, given the heavy reliance on air conditioning in its service areas. Texas and New Mexico are expected to experience fewer cooling degree-days in Q2, with colder-than-normal conditions lasting through June. Q2 is historically one of the company’s strongest quarters from an earnings perspective, only being surpassed by Q3 in terms of diluted EPS and often equaling the combined EPS of Q4 and Q1. A cold early summer in the company’s service areas is likely to have a sizeable impact on its earnings as a result. While PNM Resources has released a rather broad EPS guidance range for FY 2016, allowing some flexibility as temperature data comes in, the consensus analyst estimate of $1.65 has not changed over the last 90 days and is significantly higher than the lower end of the company’s range. Based on a share price at the time of writing of $28.84, the company’s shares are trading at a forward P/E ratio of 17.5x, in the top half of their historical range. If the company’s bottom guidance value of $1.50 is achieved, on the other hand, which the current weather forecast suggests is very possible, then the company’s shares are trading at the still-higher valuation of 19.2x. The company’s share valuation has tended to be quite responsive to weather conditions in the past despite their historical nature, suggesting that the share price will decline in the first half of next year if El Nino’s impact on the service area is similar to its historical impacts. Conclusion PNM Resources continued its recent streak of beating on earnings despite missing on revenues in Q3 as hot temperatures and continued customer growth more than offset lower retail sales volumes. The company’s management recently outlined its strategy to prevent falling demand in the service area of its primary subsidiary PNM by focusing instead on TNMP, where demand remains strong, and its transmission operations. I believe that this latter focus in particular will allow the company to secure several years’ worth of earnings growth since the Southwest’s focus on renewable electricity will encounter siting issues, thereby increasing demand for transmission capacity and delivery agreements. While its path forward looks secure, the market appears to be underestimating the impact that this year’s strong El Nino event will have on the number of cooling degree-days in the company’s service areas in Q2 of next year. Shares of PNM Resources are overvalued if El Nino’s past weather impacts in the Southwest occur again during the current event. Based on this, then, I encourage investors to wait for its share price to fall below $24, or 16x the lower end of management’s FY 2016 guidance, before initiating a long position. A compelling earnings growth case should not prevent investors from being in an even stronger buying position in the first half of next year.

Con Ed Catalysts Can’t Overcome Structural Burden

Con Ed is the 6th largest producer of solar power and aggressively moving into the solar + storage markets. Con Ed has little exposure to traditional solar “losers”. 90% of earnings are derived from its regulated activates and will be the major driver of future performance. Free cash flow has a 7-yr average of +$475 million a yr, demonstrating conservative cash management. ED offers stability of earnings and dividends, but not much growth. Founded in 1880, Consolidated Edison (NYSE: ED ) is one of the original electric utilities in the US. Serving New York City and surrounding areas, ED offers a stable outlook and adequate dividend yield, just not very exciting future growth prospects. With over 90% of its earnings derived from regulated activities, ED can be considered a more “pure” utility than others of its size. Con Ed operates electric, natural gas, and steam networks servicing about 4.9 million customers, 3.6 million electric and 1.2 million natural gas. In addition, ED invests in transmission projects and solar power generating systems. ED is the 6th largest generator of solar power in the US. At the end of 2014, Con Edison Development had a total 446 MW of solar and wind generation in operation. The company is in development stage of a combined residential solar and storage pilot project. As of June 2015, Consolidated Edison Company of New York, Inc. CECONY represented 95% of combined EBITDA, and ED’s stock performance is tied to the performance of CECONY. Investors should be aware CECONY is under a base rate freeze through the end of 2016. Fitch offers a great recap of allowed return on equity and rate case issues in their Oct 2015 review: Relatively Restrictive Regulation: Authorized returns on equity ROEs continue to be below national average, and an increasing use of regulatory deferrals and rate freezes to limit pressure on customer retail rates has somewhat constrained Fitch’s view of New York regulation. That being said, CECONY and Orange and Rockland ORU enjoy several mechanisms that Fitch considers to be supportive of credit quality including forward-looking test years, multi-year rate plans, trackers for large operating expenses, and a revenue decoupling mechanism that isolates net margins from variations in retail sales. Those mechanisms do support the utilities’ long-term financial stability. Base Rate Freeze Manageable: The 2015 rate order that extended a base rate freeze at CECONY one additional year through 2016 will pressure credit metrics over the next two years but some mitigating factors lessen the adverse effect on operating cash flows and help keep the utility in line with the existing rating level, albeit at the lower range of the ‘BBB+’ rating category. CECONY will be allowed to continue the use of a revenue decoupling mechanism and trackers that provide recovery of fuel, pension and property tax expenses, and storm costs, including collection from customers on an annual basis of $107 million related to Superstorm Sandy. The rate order reflected an authorized ROE of 9%, which is significantly below the national average and below the 9.2% ROE authorized in CECONY’s previous rate order. However, the 9% authorized ROE is consistent with those received by utility peers ORU and Central Hudson Gas & Electric in their recently settled rate cases. Pending Rate Case Filing: Management has announced publicly that it intends to file a rate case in the first quarter of 2016 for new rates that would become effective in early 2017. Given the prolonged rate freeze, CECONY’s rate request to recover spent capex could be sizeable, and as a result, lead to heightened regulatory risk. Under Fitch’s rating case scenario that assumes CECONY operating under a 9% ROE over 2017-2019, the utility’s credit ratios modestly improve from weaker 2015-2016 levels. Fitch’s rating case also assumes that CECONY can continue to effectively control O&M to support the financial profile. ED has very little power generation and is mainly a distribution company. The majority of generation is wind and solar with a combined total of 446 MW, about equal to a medium-size natural gas combined cycle plant. The company is test driving a solar + storage platform for better utilization of its residential solar customers. In July, ED announced a demonstration project to develop a combined residential solar and storage program to better control the availability of intermittent power. The goal is to generate 1.8 MW of capacity and aggregated energy of 4 MWh. While small in comparison with the total needs of its customer base, this could be a footprint for further development not only in NYC but elsewhere. A good description of the solar + storage project is offered in an article on capitalnewyork.com: The final, and perhaps most sci-fi of the projects, is called the Clean Virtual Power Plant , which envisions a constellation of homes equipped with solar and storage, essentially large batteries. The homes would be wired together so they could act both as source of power for individual homes or be conducted by the utility like a symphony, with power dispatched to wherever it is needed on the grid or even sold into the state’s energy marketplace. The marriage of storage and solar is a crucial element for renewable energy as it allows power from the sun to accrue for use when it is cloudy or when it is dark. Con Ed writes that its peak load usually comes after 5 p.m. The connection of multiple homes as one “plant” hews closely to a central idea of the R.E.V. in that it upends the traditional flow of power from a fossil-fuel plant through a transmission line to customers and instead manages energy traveling in multiple directions. “The project is designed to demonstrate how aggregated fleets of solar plus storage assets in hundreds of homes can collectively provide network benefits to the grid [and] resiliency services to customers,” the utility wrote. It is interesting Con Ed could be on the forefront of developing residential solar + storage networks, and has little exposure to the potential “losers” of power plants and transmission assets. The solar + storage network could potentially flow into micro grids currently being reviewed by the Department of Defense for several installations. In 2013, I penned an article for SA titled, Micro Grids Don’t Have To Be the Death Knell for Electric Utilities , and Con Ed could become an prime example of a regulated utility moving in this direction. While Con Ed’s exposure to the solar + storage and micro grid potential could be intriguing, I don’t think it will be sufficient to offset some of its structural problems with being 95% controlled by the fate of CECONY. These include the current rate freeze and its low allowed return on equity. The New York Public Service Commission has historically been tough on Con Ed’s rate structure. The current 9.0% allowed return on equity is lower than the recent national average award of 9.5% to 9.8%. Below is a graphic from the company’s investor presentation of PSC rate decisions since 2006, and the downward trend should be obvious. (click to enlarge) With one of the highest cost of living areas in the world, Con Ed is under constant pressure to keep utility costs low for residents and commercial customers. Real estate tax increases have historically been automatically included in rates decisions. However, as real estate taxes become more of a burden in the NYC area, there is movements within the community to remove its automatic inclusion. In 2014, Con Ed paid about $1.4 billion in real estate taxes, and $1.8 billion in total taxes other than income taxes. This represents 19.7% of total operating expenses and 27% of all non-fuel related operating expenses. In addition, a fatal gas explosion in Manhattan in 2014 and another one in this past March have led to added scrutiny of the utility from regulators. It is estimated legal issues and fines could total upwards of $1 billion. Con Ed and NYC have been pointing fingers at each other over who’s to blame, but Con Ed was just officially condemned by the New York Public Service Commission for the loss of life and property. The unflattering headlines will have a negative effect on the relationship between ED and state regulators, and the final resolution will take years of court proceedings. The state regulators have established reliability performance standards for every electric utility in the state, and levies a fine for non-performance. According to consulting firm Brattle, Con Ed could be exposed to a maximum of 0.90% reduction in its allowed ROE from its performance evaluations. So far, Con Ed has been levied only minor fines for non-performance, however, as of 2012, performance issues are included in future rate decisions, keeping the pressure on Con Ed to control costs while increasing reliability to its customers. ED current stock valuation could be considered as fairly valued based on its history. Below is the fast graph of the previous 20 years. (click to enlarge) Con Ed’s return on invested ROIC has been falling recently, but has hovered around the 6.0% mark, with is better than the industry average of 4% to 5%. According to ThatsWACC.com, ED’s weighted cost of capital WACC is 3.8%, making ED’s hurdle rate around 1.4% to 2.0%, and is better than many peers who do not generate ROIC in excess of its WACC. Below is a 20-yr history of ROIC, also from fastgraph.com. (click to enlarge) Dividend increases have been small, with a 5-yr growth rate of 1.3%, a 3-yr growth rate of 1.6% and a 1-yr growth rate of 2.4%. These numbers would hardly move the needle for dividend growth investors. On the plus side, ED has raised its dividend every year since 1974 and its payout ratio is a comfortable 73%. Since Jan. 2009, management has generated positive free cash flow demonstrating a conservative cash approach. During this 7-year timeframe, ED generated in excess of $3.2 billion in free cash, very admirable in a capital intensive industry. On a trailing twelve month basis, ED’s free cash flow was $471 million. Driving earnings higher will be Con Edison’s multi-year capital expenditure budget. The company plans on spending $13.9 billion capital in 2015-19, and should increase its 2014 regulated asset base of $24.0 billion. Compared to many of its top peers, Con Ed has offered below average total return performance. Below is a 10-yr total return chart from morningstar.com for ED and four of its peers, demonstrating this underperformance of a $10,000 investment. (click to enlarge) While ED has an interesting exposure to solar power, storage networks, and the potential of moving into the micro grid markets, investors should look elsewhere for either higher yield or higher growth – or both. Author’s Note: Please review disclosure in Author’s profile.