A Unique Geographic Position Makes Allete An Attractive Utility
Summary Midwest utility holding company ALLETE has encountered substantial share price volatility in 2015 so far due to broader utilities volatility and its own diversification efforts. Concerns about the company’s exposure to coal mining and coal-fired electricity have risen in recent months as the federal government has proposed to crack down on power plants’ carbon emissions. In the short term, ALLETE is insulated from commodities volatility since its major electricity customers supply the strengthening U.S. auto manufacturing sector. In the long term, the company is positioned to translate carbon restrictions into rate base growth and new projects for its clean energy development subsidiary. The company’s share valuation and dividend yield are already attractive. Given its recent volatility, however, potential investors will likely be able to get rock-bottom valuations by waiting a bit longer. Midwest utility holding company ALLETE, Inc. (NYSE: ALE ) has experienced an abnormally high amount of share price volatility in 2015 to date. The company’s share price set a new all-time high early in the year before shedding 24% of its value in seesaw action that has persisted until now. While some of this volatility can be attributed to the uncertainty that has impacted the broader utilities sector regarding future interest rate movements, ALLETE’s heavy exposure to coal and coal-fired electric generation assets has caused investors to turn bearish given the current federal U.S. regulatory environment. Furthermore, the company differs from most of its peers in that its primary customer base consists of a handful of large industrial facilities rather than a large number of small, residential homes. This article evaluates ALLETE as a potential long investment opportunity in light of these factors. ALLETE at a glance Headquartered in Duluth, Minnesota, ALLETE Inc. is a utility holding company that comprises six wholly-owned subsidiaries in addition to an 8% stake worth $115 million in the broader regulated venture American Transmission Co. Minnesota Power is the most important of these subsidiaries and, as a regulated electric utility, it provides electricity to 144,000 residential customers, 16 municipalities, and several large industrial customers in northern Minnesota. It generates sufficient electricity to meet the demand of its 26,000 service area via multiple sources, the largest of which (62% of the total) is coal. Another 29% is derived from power purchase agreements, of which a large fraction is also generated from coal, and hydro. In all Minnesota Power has a total generating capacity of 1723 MW. Minnesota Power operates within a relatively favorable regulatory scheme that includes a 10.4% allowed return on equity, cost and fuel price riders, and a $2.6 billion rate base. More than 50% of its electric sales are attributable to industrial customers, including five large producers of taconite, an important iron-bearing rock that is an important raw material input in the steel industry. The industry in the company’s service area has remained buoyant of late and the company expects new industrial customers to increase demand by up to 600 MW. Furthermore, the state of Minnesota borders states that have some of the most abundant wind resources in the country, and the subsidiary expects to meet at least some of this demand via investments in new wind capacity in North Dakota. Minnesota Power expects to average roughly $250 million in annual capex through 2018 in part to meet this demand growth, providing support for future rate base increases. ALLETE’s non-regulated subsidiary BNI Coal, which operates closely with Minnesota Power, owns and operates a lignite mine in North Dakota. This mine yields roughly 4 million tons of coal annually that is sold to electric coops in the area that in turn have power purchase agreements with Minnesota Power. Under ordinary circumstances, it would appear to be optimally placed, thanks in large part to the fact that its “cost plus” contracts run through 2037, to benefit from growing demand for electricity (and thus generation fuel) in Minnesota Power’s service area. This would be true if its name was “BNI Gas” instead of “BNI Coal.” Given coal’s rapid fall from grace in the eyes of federal regulators, however, the subsidiary runs the risk of becoming a burden on ALLETE’s balance sheet over the next several years. To the company’s credit, ALLETE responded to the unpopularity of fossil fuels in general and coal in particular by forming ALLETE Clean Energy in 2011. This non-regulated subsidiary is responsible for the development and acquisition of wind, hydro, solar, biomass, and shale gas (hence its use of the word “clean” rather than “renewable” in its name) projects. Recognizing the existence of a broad resource nexus between energy and water, ALLETE also acquired U.S. Water Services, which is a small water management firm based in Minnesota, in February 2015. Finally, ALLETE owns a number of smaller subsidiaries that operate in different sectors. Superior Water, Light, & Power is a regulated electric, water, and natural gas utility that operates within a service area consisting of Superior, Wisconsin and the immediate vicinity. This subsidiary utility has an attractive allowed return on equity of 10.9%, although both its rate and customer bases are only a fraction of those of Minnesota Power, making it a small contributor to ALLETE’s consolidated earnings. ALLETE Properties is a subsidiary that owns three property developments in Florida. The incongruous nature of its operations and generation of losses of late have prompted its parent company to investigate gradual sales of the subsidiary’s assets that will allow it to exit the property sector while maximizing returns. ALLETE is also a participant in the CapX2020 initiative, which is focused on the upgrading of transmission lines. ALLETE’s consolidated operations are ultimately strongly influenced by the regulated utilities sector. Its regulated utilities operations were responsible for 88% of its consolidated revenue in FY 2014. Furthermore, with the exception of ALLETE Properties, its non-regulated subsidiaries operate closely within the regulated utilities sector, complementing ALLETE’s consolidated revenues and earnings. This has allowed the parent company to report a respectable EPS CAGR of 6.7% CAGR since 2010. Its dividend has increased by 15% over the same period even as its payout ratio has declined from 76% to 65%. Nor is ALLETE exposed entirely to Minnesota, as its regulated operations now encompass North Dakota, South Dakota, and Wisconsin as well while its clean energy operations reach as far afield as Oregon (hydro) and Pennsylvania (shale). Q2 earnings ALLETE reported Q2 consolidated revenue of $232.3 million (see table), up by 24% YoY and beating the consensus analyst estimate by $20.3 million. The increase and beat were mostly attributable to the inclusion of full quarter results from US Water Services and Clean Energy for the first time. The revenue number was also aided by the presence of a cost recovery rider and the commencement of a new power sales agreement in June 2014. The company’s retail numbers came in low, with retail electric sales in terms of kWh sold falling by 9.7% YoY, although the consolidated sales number increased by 7.2% over the same period due to power purchase agreements. The average price of regulated electricity increased by 7% compared to the previous year, offsetting the negative impact of lower retail sales volume on revenue. The presence of a fuel cost rider kept regulated revenue from increasing, however. ALLETE financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 323.3 320.0 290.7 288.9 260.7 Gross income ($MM) 179.6 187.9 203.3 200.0 177.1 Net income ($MM) 22.5 39.9 32.9 41.6 16.8 Diluted EPS ($) 0.46 0.85 0.72 0.97 0.40 EBITDA ($MM) 87.3 100.6 95.0 101.7 69.1 Source: Morningstar (2015). ALLETE’s cost of revenue increased by 72% YoY to $143.7 million due to the aforementioned subsidiary additions. Gross income remained relatively flat at $179.6 million YoY due to this increase despite the much stronger revenue result. Net income came in at $22.5 million, up by 33% from the previous year. Diluted EPS came in at $0.46 versus $0.40 YoY, missing the consensus estimate by $0.02. The EPS included acquisition fees of $0.02, without which the consensus estimate would have been matched, as well as dilution equal to $0.07. EBITDA increased from $69.1 million to $87.3 million YoY. Finally, ALLETE’s dividend in Q2 represented a 3.1% increase over the previous year. Outlook ALLETE’s management announced during the Q2 earnings call that it was increasing its FY 2015 guidance up to $3.20-$3.40 despite the Q2 earnings miss to account for proceeds from the sale of a wind farm that its subsidiary ALLETE Clean Energy is constructing. This result would represent its strongest annual earnings in more than a decade while also continuing a multi-year trend. The company’s current year earnings are due in no small part to the resilience of Minnesota’s taconite producers in the midst of a very bearish global steel market. While falling demand for industrial materials in the developing world in general and China in particular has pummeled steel indices (steel ETF prices are hovering around their early 2009 lows), Minnesota’s taconite producers mainly supply domestic steel producers that in turn supply U.S. automakers. ALLETE’s management has reported few signs of weakness among its large industrial customers as a result, with only one customer idling its facility. ALLETE’s earnings are highly sensitive to electricity demand from taconite producers, with a 1 million ton per year change to taconite production having an impact of $0.03/share on the company’s diluted EPS. In fact, ALLETE’s heavy exposure to Minnesota’s taconite production could continue to be a boon in coming quarters. Petroleum prices fell sharply in Q4 2014 and Q1 2015 and, while they have rebounded a bit from their 2015 lows, they remain well below their earlier highs. Consumers have responded by buying new, less fuel-efficient vehicles, driving demand. This month’s auto sales are expected to be the highest for October since 2001, while 2015’s numbers are expected to be 5% higher than 2014’s. Cheap petroleum should therefore support ALLETE’s earnings via Minnesota Power by keeping taconite demand high. While I do expect crude prices to rebound, especially as the finances of OPEC members are squeezed ever tighter, it will take several quarters for any reduced demand for U.S. steel to be felt by ALLETE. In the longer term, ALLETE’s earnings have the potential to be substantially impacted by the Clean Power Plan that was recently unveiled by the U.S. Environmental Protection Agency [EPA]. This new regulation requires each U.S. state to achieve predetermined reductions to the carbon intensity (greenhouse gas emissions per kWh of electricity generated) of their respective power plant sectors. Minnesota must achieve a large 24.5% reduction by 2024, while Iowa and South Dakota must achieve still larger reductions. While the EPA’s plan will not benefit all utilities, ALLETE is uniquely positioned due to the abundant wind resources near its service area and its new ALLETE Clean Energy subsidiary, the latter of which is already developing a reputation as a wind farm construction firm. ALLETE itself will need to shift away from coal towards renewables and, if this move is done properly (i.e., by building its own capacity rather than relying on power purchase agreements), it could support future capex. Beyond that, however, ALLETE Clean Energy should become a steadily larger contributor to consolidated earnings as utilities in the surrounding area also rely upon it to develop new renewables capacity. BNI Coal will suffer from weakening coal demand under this scenario, of course, and ALLETE itself could incur asset write-downs if it is required to send some of its coal-fired generation capacity into early retirement, but on balance, I expect the company to benefit under the Clean Power Plan. Valuation The analyst consensus estimate for ALLETE’s FY 2015 EPS has increased over the last 90 days in response to the resilience of its industrial customers and recent asset sale while the FY 2016 EPS estimate has remained relatively flat. The FY 2015 estimate has increased from $3.11 to $3.26 while the FY 2016 estimate has been revised slightly lower from $3.39 to $3.37. Based on a share price at the time of writing of $50.36, the company’s shares are trading at a trailing P/E ratio of 16.3x and forward ratios of 15.4x and 14.9x for FY 2015 and FY 2016, respectively. While the trailing ratio is in the middle of its historical range, both of the forward ratios are near the bottom of their respective 5-year ranges, having actually been at the bottom as recently as last month. Conclusion ALLETE’s share price has been all over the place in 2015 to date in response to the combination of a bearish sentiment in the broader utilities sector and its own diversification efforts. This latter move is the one that investors will want to pay the most attention to since it has the potential to provide the company with the type of growth options that are not available to most of its peers. The company’s heavy exposure to coal mining and coal-fired generation is a concern at a time when both activities are attracting the ire of regulators. This disadvantage is more than offset by the company’s twin advantages of close access to abundant wind energy resources and a subsidiary that contributes to consolidated earnings by developing and selling wind farms. Meanwhile, the EPA’s Clean Power Plan will support the company’s future rate bases while driving demand for ALLETE Clean Energy’s services. ALLETE is an attractive long investment opportunity at present due to its 4% forward yield and relatively low valuation. Given the volatility that has characterized utilities in recent months, however, I would encourage potential investors to wait for the company’s share price to provide an additional margin of safety by trading at 14x FY 2016 earnings, or $47.18 based on the estimate available at the time of writing, before initiating a new position. Initiating a short put position could be an attractive strategy here at this time.