Summary Midwestern electric and natural gas utility Ameren has seen its share price perform well YTD, with even a disappointing Q2 earnings report proving to be just a speed bump. Following years of underperformance compared to the peer average, Ameren is changing its focus so as to take advantage of demand for new transmission infrastructure. Its Illinois operations will provide it with a buffer against higher interest rates due to that state’s regulatory linkage between allowed return on equity and interest rates. While Ameren’s shares are overvalued on a forward basis, a warm winter in its service area due to El Nino could create an attractive long investment opportunity. Shares of Midwest electric and natural gas utility Ameren (NYSE: AEE ) have rebounded strongly since setting a 12-month low at the end of June, with a disappointing Q2 earnings report only providing a slight bump on the way to an 18% price increase since then. The company has not been one of the sector’s better performers in recent years as weather volatility and arbitrary regulator behavior have held it back. Its regulatory outlook has improved this year, however, in a way that will reduce its exposure to higher future interest rates. Adverse weather conditions in Q4 will provide short-term headwinds first, however. This article evaluates Ameren as a potential long investment opportunity in the context of this operating environment. Ameren at a glance Headquartered in St. Louis, MO, Ameren is a relatively large electric and natural gas utility with more than $20 billion in total assets and a market capitalization of $10.7 billion. The company operates in a 64,000 square mile service area that includes much of eastern Missouri and most of Illinois, excluding Chicago and its surrounding environs. Its operations are divided into 3 segments. Ameren Missouri oversees electric generation, transmission, and distribution plus natural gas distribution in that state’s share of the service area. It currently has 1.2 million electric customers and 127,000 natural gas customers, with the former receiving electricity generated by the company’s 10,200 MW generating fleet. Unlike many of its peers, Ameren Missouri remains heavily reliant on coal, which comprises 53% of its fuel mix (the balance is split between nuclear, natural gas, and hydro). Unlike its counterpart across the Mississippi River, Ameren Illinois only engages in electric and natural gas distribution activities. It has 1.2 million electric and 813,000 natural gas customers in the state. Much of the electricity that it uses is sourced from Ameren’s generating capacity in Missouri via the third and final segment, Ameren Transmission Company of Illinois, which operates 4,600 circuit miles of 345 kV regional transmission lines. Historically, Ameren Missouri has made the primary contribution to the company’s total rate base, reaching 63% in 2011 compared to 29% from the Illinois operations and 8% from the transmission operations. This has negatively impacted Ameren’s past consolidated earnings due to the lack of a favorable regulatory scheme in Missouri. While the state’s scheme does provide utilities with a fuel cost recapture mechanism that insulates them from the type of fuel price spikes that are not uncommon during Midwest winters, its use of historical test years result in a large amount of regulatory lag. This lag prevents Ameren from recognizing higher rates due to infrastructure investments and similar capex for roughly 2 quarters despite incurring higher depreciation, O&M, and property tax costs during the interim. The regulatory scheme employed in Illinois, on the other hand, has improved in recent years. The most substantial change has been the decision to base the allowed return on equity for electric utilities on the 30-year Treasury rate plus 580 basis points. While this formula currently results in a below-average allowed rate for Ameren Illinois, it will mitigate the impact of higher interest rates following the Federal Reserve’s planned rate hike on Ameren’s consolidated earnings. Furthermore, electric utility rates are based on a year-end rate base and provides for the recovery of “prudently incurred” actual costs, greatly reducing regulatory lag. Illinois natural gas utilities operate within a similar scheme that bases rates on future test years and includes infrastructure riders, similarly reducing lag. Finally, Ameren’s transmission operations are governed by a federal regulatory scheme that reduces regulatory lag by employing forward-looking calculations with an annual reconciliation mechanism. Ameren has reported slow but steady earnings growth since 2013, although its annual EPS results have yet to return to their pre-financial crisis highs. Its annual EBITDA, meanwhile, has remained flat over the same period, highlighting the lack of growth in its service area over the last several years. The company was hit especially hard by the 2008 financial crisis and slashed its dividend in that year. Since then the dividend has only increased by 10%, causing the company to lag significantly behind its peers. Its yield had been much higher than the sector average before the crisis and remained high even after the cut, however, and as a result, it has a forward yield of 3.9% despite this low growth rate. Q2 earnings report Ameren reported Q2 earnings at the end of July that missed the analyst consensus on both lines. It reported revenue of $1.4 billion (see table), down by 1.4% YoY and missing the consensus by $40 million. Revenue from its electric operations increased by 1.2% and provided 89% of consolidated revenue as higher demand in Illinois more than offset reduced demand in Missouri as the latter state experienced a mild early summer. Natural gas revenue fell by 18% YoY due to a 3.2% decline in volumes as Illinois experienced a warmer than normal spring, reducing the number of heating degree days. A sharp fall in energy prices over the previous 12 months also contributed to the lower natural gas revenues in particular. Ameren financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 1,401.0 1,556.0 1,370.0 1,670.0 1,419.0 Gross income ($MM) 1,049.0 975.0 880.0 1,273.0 1,031.0 Net income ($MM) 141.0 108.0 48.0 293.0 149.0 Diluted EPS ($) 0.58 0.45 0.20 1.20 0.61 EBITDA ($MM) 447.0 459.0 336.0 762.0 522.0 Source: Morningstar (2015). Gross profit rose slightly to $1.05 billion from $1.03 billion YoY despite the revenue decline. The increase was the result of the company’s cost of revenue falling by 9.3% YoY due to lower fuel prices, more than offsetting the negative impact of lower revenues. Operating income fell sharply to $237 million from $322 million in the previous year. While a large loss provision for the construction license of a new nuclear unit was the decline’s major driver, higher O&M and depreciation costs resulting from regulatory lag in Missouri also contributed. Ameren’s consolidated net income fell to $141 million, or a diluted EPS of $0.58, compared to $150 million, or a diluted EPS of $0.62, in the previous year, missing the analyst consensus by $0.03. The most recent result included a $52 million boost resulting from the recognition of a tax benefit via the resolution of an uncertain tax position that the company treated as discontinued operations. EPS from continuing operations came in at only $0.40 versus $0.62 YoY. EBITDA also declined, falling from $522 million YoY to $447 million. Outlook Ameren reaffirmed its FY 2015 EPS guidance range of $2.45-$2.65 during its Q2 earnings call based on the assumption of normal temperatures in Q3 and Q4. The company’s service area did experience more cooling degree days than average in Q3, reinforcing this range. El Nino can be expected to impact its Q4 earnings, however, by bringing warmer than normal temperatures into the company’s service area between October and January. This year’s event is expected to be one of the strongest on record and previous such events have introduced warm weather in Missouri and Illinois during the quarter, reducing demand for natural gas. Ameren is unlikely to be as exposed to El Nino’s adverse weather impacts as many of its peers since the bulk of annual consolidated earnings have traditionally been brought in via its electric operations during the Q2 and Q3 summer months. Furthermore, temperatures in its service area have historically returned to normal by February during past El Nino events. Investors can expect its Q4 earnings to be lower than normal, however. Ameren’s earnings in FY 2016 and beyond will be driven by the company’s ability to utilize its planned capex in a manner that takes advantage of its regulatory environment where possible. The company expects capex to drive a rate base CAGR of 6% through FY 2019 as it invests in a combination of reliability, environmental, and new capacity projects. The latter will be the most important as they are designed to increase the share of its total rate base attributable to its transmission segment from 8% currently to 19% by FY 2019. The transmission segment will achieve a rate base CAGR of 27% over the same period, ultimately reaching $2.3 billion in total capex. The company expects that this will in turn result in an EPS CAGR of 7-10% through at least FY 2018. The company’s ability to achieve and maintain this earnings growth target will ultimately depend on how quickly the Federal Reserve implements its expected interest rate increase. At first glance, Ameren is more exposed than many of its peers to higher interest rates due to its BBB+ credit rating from S&P and Fitch (the credit ratings of its state units are higher). Interest rate spreads have widened in recent weeks as expectations of a Federal Reserve rate increase occurring by the end of the year have grown, with the largest increases occurring for lower-rated debt. At first glance, this would suggest that Ameren will be at a disadvantage to those of its peers with superior ratings. Unlike many of its peers, however, a substantial segment of the company’s operations reside within a regulatory scheme that links the allowed return on equity to interest rates. While this has kept the return on equity below the peer average during the current era of low interest rates, it will support Ameren’s ability to both finance its planned capex and mitigate the negative impact of higher interest costs on its earnings. Looking beyond FY 2016, Ameren’s Missouri operations are likely to be burdened by the U.S. Environmental Protection Agency’s [EPA] recently released Clean Power Plan, which requires individual states to achieve predetermined reductions to the carbon intensities (greenhouse gas emissions per unit of electricity generated) of their respective state utilities beginning in 2022. Illinois has one of the country’s highest carbon intensities and must achieve a 28% reduction by then, while Missouri is not far behind with a required 19% reduction . One advantage of these reductions is that they could pave the way for additional capex to convert existing coal-fired power plants to natural gas and possibly even build new, cleaner capacity. The presence of substantial regulatory lag in Missouri would contribute to earnings volatility. Valuation The consensus analyst estimates for Ameren’s diluted EPS in FY 2015 and FY 2016 have increased modestly over the last 90 days in response to warmer Q3 weather and the Federal Reserve’s decision not to increase interest rates in September, as had been widely expected by the market. The FY 2015 estimate has increased from $2.55 to $2.56 while the FY 2016 estimate has increased from $2.70 to $2.72 over the same period. Based on a share price at the time of writing of $44.10, the company’s shares are trading at a trailing valuation of 18.0x and forward valuations of 17.2x and 16.2x, respectively. The forward ratios in particular are at the high end of their respective 5-year ranges, albeit lower than they were at the end of 2014, suggesting that the company’s shares are modestly overvalued at this time. This is especially true for the company’s short-term outlook given the likelihood of a warm Q4 in its service area. Conclusion Ameren’s shares have exhibited an above-average amount of volatility in 2015 to date as the company has attempted to recover from its past history as a relative laggard in the electric and natural gas utilities sector. Recent developments have mostly been favorable, with its Illinois regulatory scheme changing to link the allowed return on equity to interest rates and the company’s own focus shifting away from Missouri’s poor regulatory environment to its growing transmission operations. This new approach will be necessary if Ameren is to bring its earnings growth closer to the sector average, let alone above it. Fortunately, the combination of new transmission projects, reliability investments, and environmental controls will provide it with large capex opportunities over the next 5 years that will be necessary to support faster earnings growth. Furthermore, its forward dividend yield of 3.9% is relatively high already. The main draw that Ameren has to offer to potential investors is its linkage between allowed return on equity for a substantial segment of its operations and interest rates, as this will offset one of the market’s major current concerns about utilities in general. The company’s shares are also overvalued on a forward basis, leaving them exposed to a substantial decline in the event that this year’s El Nino has a greater than expected negative impact on its Q4 and potentially also Q1 2016 earnings. Yield-seeking investors who wish to be insulated from higher interest rates could view such an event as a potential buying opportunity, however, and I would consider Ameren’s shares to be attractively valued in the event that its forward P/E ratio falls back to 14x its FY 2016 earnings, or $38 per share, as it has already done twice in the last 3 months.