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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.

PNM Resources: Priced Just Right

Summary Management has made significant steps in past five years to improve profitability. Margins are up, energy generation mix is improving. Dividend has followed suit. Heavy interest expenses and overhang of the company’s large ageing coal plant concerns me. PNM Resources (NYSE: PNM ) is a holding company operating two regulated utilities, one in New Mexico and Texas. The company had a rough go of it from 2007-2011; exiting from non-regulated businesses at great cost focus on only serving regulated customers. Management may not have known what they were in for, as the next few years of regulatory environment were tough, with harsh allowed returns and strict oversight. PNM Resources was forced to heavily cut the dividend in between 2007 and 2009 as wholesale electricity prices plunged, chopping it nearly in half from $0.91/share to $0.50/share. The dividend remained stagnant at those depressed levels until a 2012 hike. This marked the start of a company revitalization as PNM Resources has bumped the dividend significantly, averaging 15% per year since then, as operating results recovered. Shares have responded to the flood of good news, rallying off lows near $10/share in 2010 to nearly $30/share today, recovering most of their losses from 2007-2010. Is there more upside for shares? Business Overview The company operates a diversified portfolio of over 2,500MW in generation capacity. Like many utilities, PNM is reducing its reliance on coal, instead shifting to natural gas. However, the largest generation facility for PNM Resources remains its San Juan Generating Station in Waterflow, New Mexico. This plant used to be much larger, but the company was forced to retire 900MW of capacity on regulator and environmentalist pressure – or face heavy capital expenditures related to mandatory upgrade costs. It is likely that this plant will continue to see aggressive treatment by regulators as coal continues its slow-and-steady decline as a source of power in the United States. Investors should expect continued power generation and compliance costs with the overhang of possible additional restrictions on aged coal-fired facilities like this one. PNM Resources expects to keep remaining capacity here online until at least 2022 given the recent contract extension with a local coal supplier for fueling needs. Operating Results (click to enlarge) While 2011 was a much bigger revenue year for 2011, that doesn’t tell the entire story. 2011 was a turning point year where many changes went into place at PNM Resources. The company exited its non-regulated businesses in Texas in 2011 ($329M in proceeds), using the proceeds to pay down debt and repurchase shares. This divesture followed the exiting of New Mexico Gas in 2008 as the company struggled to stay afloat, facing mounting losses in wholesale energy where the company simply couldn’t compete. Tough choices were made and SG&A expenses were cut as well as PNM Resources streamlined its operations. All told after a lot of work, all these changes have resulted in much better operating margins from 2012 forward. (click to enlarge) PNM Resources has run cash deficits as we can see from above, which has been paid for by more than $500M in net long term debt issuance since 2011. Like I feel with most mature utilities, I really want to see these numbers temper. Continued weakness here means no cash flow available for increased dividend payments without increasing leverage through long term debt or dilutive common stock issuance. Interest expense already eats 40% of operating income, well ahead of most other utility businesses I’ve looked at in the past. Conclusion At around 16x 2016 earnings estimates, shares aren’t the most expensive utility shares out there, but they don’t appear to be the cheapest either. The current dividend yield of 2.85% is in-line with historical averages. Management has guided towards 8% dividend growth, which I think is achievable assuming capital expenditures come down and demographic trends continue to be favorable in New Mexico and Texas. The heavy interest expense and lack of operational cash flow concern me. Shares are likely fairly valued at current prices, but investors who are looking to pick up shares of PNM Resources are best served by playing the waiting game and entering around $25.00/share, a spot where shares have tested and experienced solid support over the past year.

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.