Summary Natural gas utility Atmos Energy has been one of the sector’s strongest performers over the last five years as the discovery of large domestic gas reserves has spurred its demand. The company also benefits from a diverse geographic footprint and the existence of multiple favorable regulatory schemes in its large service area. While a warm spring dampened its FQ3 earnings, the company continued to report customer growth and higher throughput in its pipelines segment. The company’s shares appear to be overvalued on a P/E basis but its outlook contains multiple drivers for future earnings growth, both near term and long term. Headquartered in Dallas, Texas, Atmos Energy (NYSE: ATO ) is one of the country’s largest natural gas utilities, handling distribution, pipeline transmission, and storage services in several U.S. states. The company has been one of the top performers over the last several years among U.S. natural gas utilities, generating a total shareholder return result that is roughly 50% higher than the average of its peers. More recently, its share price has begun to move higher following multiple quarters of underperformance compared to the S&P 500, setting a new all-time high last week before settling a bit to $59. While the recent performance of the company’s share price has been the result of the Federal Reserve’s delay of an expected interest rate hike, which broadly supported the utilities sector, Atmos Energy’s outlook has also improved over the last several months due to a combination of changing energy consumption habits, proposed federal regulation, and the development of a strong El Nino. This article considers the company as a potential long investment opportunity in the presence of this operating environment. Atmos Energy at a glance Atmos Energy is divided into both regulated and non-regulated segments that operate in eight different states on both sides of the Mississippi River. While its largest areas cover Texas, Louisiana, and Mississippi, which combined are the origin of 80% of the company’s total rate base, it also operates within Colorado, Kansas, Kentucky, Tennessee, and Virginia. Its service area covers several urban centers, providing its regulated distribution segment with roughly three million customers that are supplied via 67,000 miles of distribution and transmission pipelines. This segment’s operations are complemented by the company’s regulated pipeline segment, which transmits natural gas from many Texan shale gas basins via 5,600 miles of intrastate pipelines. Finally, Atmos Energy’s non-regulated segment provides natural gas delivery, storage, and transportation services. The regulated distribution segment generated the majority of the company’s earnings at 61% of the total in recent quarters, followed by 30% from the regulated pipelines segment and 9% from the non-regulated segment. The company’s regulated segments operate within very favorable regulatory schemes, resulting in strong allowed returns on equity compared to its peers. The regulated distribution segment has a blended allowed return on equity of 10.4% while that of the regulated pipeline segment is higher still at 11.8%. The allowed returns are further aided by mechanisms that rapidly increase rates in response to higher capex: the company reports that 91% of its capex is recouped via higher rates within six months and 96% is recouped within 12 months. Indeed, 45% of the company’s FY 2015 capex from its regulated distribution and pipeline operations is completely unlagged. 97% of its rates are further covered by weather normalization mechanisms that minimize exposure of the company’s earnings to weather-induced rate volatility, although this does not extend as far as consumption volume volatility. Atmos Energy earnings are very exposed to the utility’s operations within Texas, providing it with both an advantage and a risk. 60% of consolidated margins, 70% of its asset base, and 70% of its FY 2015 capex are linked to the state, and its distribution network serves 1.8 million customers in the state, including the Dallas-Fort Worth metro area. Of the company’s total rate base, Louisiana is second at 8%, followed by Mississippi at 6%. This exposure to Texas has provided strong support for the company’s earnings growth over the last decade due to the state’s above-average economic growth and growing exploitation of its shale gas reserves. The risk is that Texas could at some point introduce an unfavorable regulatory scheme that, because of the company’s exposure to the state, would have an outsized impact on its earnings despite its diverse geographic footprint. That said, the risk of this happening is much lower than that faced by utilities in states such as California or New York, for example. Atmos Energy has achieved 12 straight years of diluted EPS growth and 31 straight years of dividend increases. The most recent dividend hike came in the form of a 5.4% increase in the current fiscal year. Its forward yield is a relatively modest 2.6% at present, although this is more of a function of the fact that the share price has nearly tripled over the last three years than of a low dividend payout ratio. FQ3 earnings report Atmos Energy reported its earnings in August for the quarter ending June 30 that slightly exceeded the consensus analyst estimate despite the presence of warm spring temperatures. Consolidated revenue came in at $686.4 million (see table), down 27% YoY from $942.7 million. The decline from the previous year was primarily due to a 37% fall in the price of natural gas over the same period and reduced demand due to warmer than normal temperatures, although these impacts were partially offset by a customer increase of 4.6%. Atmos Energy financials (non-adjusted) FQ3 2015 FQ2 2015 FQ1 2015 FQ4 2014 FQ3 2014 Revenue ($MM) 686.4 1,540.1 1,258.8 778.7 942.7 Gross income ($MM) 381.7 520.7 423.3 337.7 359.5 Net income ($MM) 56.3 137.7 97.6 23.7 45.7 Diluted EPS ($) 0.55 1.35 0.96 0.23 0.45 EBITDA ($MM) 187.0 317.0 253.9 151.3 170.4 Source: Morningstar (2015). The company reported gross profit of $381.7 million, up from $359.5 million YoY. All three of its company’s segments reported increases over the same period, led by an increase to that of the regulated distribution segment from $257.7 million to $267 million as higher rates were only partially offset by an increase to revenue-related taxes and a decrease to demand resulting from the warm spring. The regulated pipelines segment reported a similar increase to $97 million from $87.2 million YoY as its capex spending quickly generated higher rates. Finally, the non-regulated segment’s gross profit increased from $14.8 million to $17.8 million YoY as falling natural gas prices pushed its margins higher. Adjusted net income rose to $55.1 million, or $0.54 diluted EPS, from $46.1 million, or $0.43 diluted EPS, beating the consensus EPS estimate by $0.03. The adjustment excluded an unrealized gain of $1.2 million, or $0.01 of diluted EPS. The YoY increase to net income would have been higher still but for an increase to O&M costs over the same period from $125.6 million to $132.4 million resulting from higher maintenance capex. Outlook Based on its earnings through the first three quarters of the 2015 fiscal year, Atmos Energy’s management announced during the FQ3 earnings call that it was both tightening and increasing its annual diluted EPS forecast to $3-$3.10. This would ultimately be below the company’s target annual growth of 6-8% through FY 2018, although such a relative slowdown isn’t surprising given its 12% YoY increase in FY 2014. Management expects to support its long-term EPS growth target by maintaining its current high levels of capex, reaching around $1 billion annually through FY 2018 and resulting in a rate base CAGR of 9-10% over the same period. Most of this capex will consist of reliability spending by its regulated distribution segment; only 12% will go towards customer expansion. Atmos Energy’s outlook through FY 2018 will be most impacted by three factors: weather, interest rates, and natural gas demand. Barring an interest rate increase before the end of the year, weather will be the first factor to make its presence felt. Meteorologists now attribute a high degree of certainty to the arrival of a strong El Nino this year, with the only questions remaining relating to its ultimate strength. Previous such events have been characterized by substantially colder than normal temperatures across Texas, Louisiana, and Mississippi between January and May. Virginia and Kentucky have also experienced slightly colder temperatures during previous El Nino events, although Colorado and Kansas have experienced warmer temperatures. Given the strong influence of natural gas demand in Texas, Louisiana, and Mississippi on Atmos Energy’s consolidated earnings, however, the net impact of El Nino should be higher natural gas demand. While weather-normalization mechanisms in its service area will insulate the company from higher rates resulting from strong demand, it will benefit from higher volumes resulting from people running their heaters more than normal. Interest rates will also impact Atmos Energy’s earnings in FY 2016 and beyond. The company ended FQ3 with only $43 million on hand, making it likely that it will turn to the debt markets to finance its planned capex through FY 2018. Higher interest rates resulting from bullish Federal Reserve action will increase the company’s interest costs moving forward compared to in the past. That said, a couple of factors will limit this impact. First, 71% of its long-term debt matures after FY 2024, leaving it with breathing space. Second, its most expensive debt matures over the next few years. Finally, the favorable regulatory environment that the company operates in minimizes regulatory lag, preventing it from finding itself in the unenviable position of many of its peers when higher interest costs are not offset on the earnings statement by higher rates. The company’s longer-term earnings will likely be positively impacted by the U.S. Environmental Protection Agency’s [EPA] recent unveiling of its Clean Power Plan, which requires individual states to achieve reductions to the average carbon intensities (pounds of CO2 per MWh of electricity generated) of their power plants between 2022 and 2030. Each state’s required reduction operates as a function of its current average intensity, with those states having the highest intensities being required to achieve the largest reductions, although not necessarily the lowest ending intensities. Texas must achieve a 24% reduction by 2022, increasing to a 33% reduction by 2030, although its ending intensity can ultimately be met by employing natural gas complemented by wind. Arkansas must achieve an even larger reduction. The Clean Power Plan will ultimately drive demand for natural gas in power plant applications, both in Texas and the broader U.S., creating an additional source of demand for Texan shale gas. Atmos Energy’s regulated pipeline segment only operates at 51% of its peak capacity, leaving it with the slack to take on additional volumes at a very attractive allowed ROE. Finally, it is unlikely that the company will need to wait for the Clean Power Plan to go into effect before realizing additional natural gas demand in both its distribution and pipelines segments. The price of natural gas has fallen sharply over the past 12 months as commodity prices have broadly moved lower. This has caused natural gas consumption to move higher even as the number of heating degree-days in the U.S. has decreased, with the replacement of coal by natural gas at power plants providing a major impetus for this trend. Following the recent decline to the price of natural gas, the U.S. Energy Information Administration [EIA] is now forecasting total natural gas consumption to increase by 7% between 2013 and 2016 even as cooling degree-days decline. Texas, with its ample reserves of shale gas, can be expected to meet much of this demand, and Atmos Energy’s pipelines are available to connect the state’s gas fields with the rest of the country’s pipeline network. Valuation The consensus analyst estimates for Atmos Energy’s diluted EPS results in FY 2015 and FY 2016 have moved slightly higher over the last 90 days, the former in response to its FQ3 earnings beat and the latter in response to expectations of a cold winter in the company’s service area and the resumption of the natural gas price’s earlier trend lower. The FY 2015 estimate has increased from $3.04 to $3.07 while the FY 2016 estimate has increased from $3.23 to $3.25. Based on a share price at the time of writing of $59, the company’s shares are trading at a trailing P/E ratio of 19.1x and forward ratios of 18.3x and 17.5x for FY 2015 and FY 2016, respectively. All three of these are notably higher than their long-term historical averages of 14-15x. Conclusion Natural gas utility Atmos Energy has been a top performer from a shareholder return perspective compared to its peer group over the last several years, benefiting from its close proximity to inexpensive and abundant Texan shale gas and a diverse geographic and regulatory footprint. Its P/E ratios have moved higher over the last five years as both its earnings and dividends have moved steadily higher, and the company appears to be overvalued on the basis of these historical values. That said, its outlook contains a number of potential drivers to additional earnings growth, including the strong likelihood of a colder than normal winter across much of its service area resulting from this year’s El Nino event, increased demand for natural gas across the country in response to falling prices, and the implementation of a federal regulation that will spur additional demand for natural gas by electric utilities. While potential investors are unlikely to be interested in the company’s relatively low dividend yield, existing investors should remain in their positions despite the high valuation due to the number of potential positive catalysts on offer.