MGE Energy’s Investors Can Expect Lower Earnings In 2016 Due To El Nino
Summary Wisconsin electric and natural gas utility MGE Energy’s share price has struggled over the last three quarters in response to mild summer weather and the prospect of higher interest rates. The company’s valuations remain high despite the recent share price decline due to its impressive history of dividend and earnings increases as well as a strong credit rating. While MGE Energy is in a better position than its peers to handle higher interest rates, this year’s strong El Nino will negatively impact its earnings in FY 2016. Potential investors should wait for the impact of a warmer-than-average winter and early spring to be reflected by lower valuations before initiating any long investments in this top-performing utility. Investors in Wisconsin electric and natural gas utility MGE Energy (NASDAQ: MGEE ) saw their shares fall in value by as much as 24% in the first three quarters of the year as declining earnings disappointed investors, although the price has since recovered somewhat following the Federal Reserve’s decision to postpone an anticipated interest rate increase. The company, which boasts an impressive track record on both dividends and annual earnings growth, faces short-term headwinds with the potential to negatively impact its earnings over the next three quarters. This article discusses those headwinds and evaluates MGE Energy as a potential long investment opportunity in light of them. MGE Energy at a glance Headquartered in Madison, Wisconsin, MGE Energy provides natural gas and electric services to the Madison metro area. It also provides natural gas to parts of southwest Wisconsin. The company operates as a holding company for a number of energy-related subsidiaries. The original entity, Madison Gas & Electric, provides the electric and natural gas utility services to 143,000 electric and 149,000 natural gas customers. MGE Power owns electric generation assets, including 250 MW of natural gas-fired power plants, 137 MW of wind power assets, and minority stakes in large coal-fired plants. MGE Transco Investment owns a minority stake in American Transmission Company. Finally, the holding company owns a number of small LLCs engaged in energy services operations. The company’s utility operations are responsible for the large majority of its earnings, generating 70% of its diluted EPS in the first half of 2015, while the transmission stake contributed a further 8%. Residential and commercial customers provide the large majority of its utility revenues, with industrial customers only contributing a small share. MGE Energy has experienced strong EPS growth in recent years, with its FY 2014 result coming in 40% above its FY 2010 result following several consecutive years of increases. The company has also been a dividend stalwart, achieving a 3.6% dividend CAGR since 1909 and annual increases in each of the last 39 years. In recent years, the annual growth of its dividend has increased to 4% and, while its payout ratio has fallen from 66% in FY 2009 to 48% last year, this has been a function of the dividend simply not keeping up with rapid earnings growth rather than a declining payout amount (although current investors have been disappointed to see the industry average hold steady at 60% at the same time). Not surprisingly in light of these increases, MGE Energy’s total return has outperformed both the Dow Jones Utility Average as well as the broader DJIA over the trailing 3-, 5-, and 10-year periods. The company’s earnings and dividend growth have been made possible by large capex over the last six years that caused its electric assets to increase by 45% and its natural gas assets to increase by 25% over the period. The contribution of capex to earnings was supported by the fact that MGE Energy’s operations fall within a favorable regulatory scheme that employs both forward test years to determine rate base increases and fuel recovery mechanisms that minimize the impact of energy price volatility on earnings. Capex growth has slowed more recently, however, as electric capex peaked at $100 million in FY 2013 before falling to an estimated $62 million in the current year, although natural gas capex has partially offset this decline by increasing from $16 million to $22 million over the same period. Q2 earnings report MGE Energy reported a mixed bag in its Q2 earnings report released in August. Revenue came in at $122.1 million, down 5.2% YoY from $128.8 million. The decline was due to the presence of very mild temperatures in June especially, with the number of cooling degree-days present during the quarter coming in 31% lower YoY and 11% lower than the long-term average. The average temperature in June was 67 degrees F, down from 71 degrees F in the previous year. The cooler early summer caused electricity consumption to fall as residential customers in particular did not turn their air conditioners on as frequently, and the company reported 1.6% fewer MWh sold in the first half of the year, although the presence of higher rates over the same period offset this. Mild temperatures in early spring compared to the previous year’s extreme cold caused Q2’s number of heating degree-days to also decline on a YoY basis, however, resulting in the net decrease to quarterly revenue. MGE Energy financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 122.1 170.1 145.7 135.1 128.8 Gross income ($MM) 81.5 88.5 88.3 93.0 79.8 Net income ($MM) 13.5 18.3 15.2 23.3 14.1 Diluted EPS ($) 0.39 0.53 0.44 0.67 0.41 EBITDA ($MM) 35.0 42.7 40.1 50.5 34.5 Source: Morningstar (2015). Gross profit increased despite the revenue decline to $81.5 million from $79.8 million YoY as sharply lower energy prices reduced the company’s cost of revenue by 17%. Operating income declined YoY, however, from $24.4 million to $24 million, due to increases to both O&M and depreciation, the former by $1.3 million and the latter by $0.9 million. Net income fell by a similar amount from $14.1 million, or $0.41 diluted EPS, to $13.5 million, or $0.39 diluted EPS, as a result. There was no analyst consensus estimate due to a lack of coverage but the EPS result would have likely been a miss due to MGE Energy’s record of earnings growth and the adverse weather conditions that contributed to the YoY decline. EBITDA did rise from $34.5 million to $35 million over the same period, however, demonstrating the impact that depreciation had on the EPS decline. While the company’s sparse earnings report did not go into detail, earnings declines resulting from higher O&M and depreciation costs commonly signify the presence of regulatory lag, as a lack of such lag causes higher rates to offset the cost increases via additional revenues. Outlook U.S. utilities are currently faced with two short-term and one long-term events that are likely to have a notable impact on their future earnings. The first of these, and the one that has received the most public attention, is the looming interest rate increase by the U.S. Federal Reserve. Most utilities drive future earnings growth via large capex amounts that are ultimately recovered in the form of rate increases. This capex is in turn financed largely by debt, making utilities very exposed to changes in interest rates compared to other public firms. The Dow Jones Utility Average swooned in the second half of August, falling by more than 10%, as spot interest rates for utilities began to escalate in anticipation of a rate hike by the Fed, leading investors to fear an imminent negative impact on utility earnings. The Average then recovered most of the lost ground after a worsening domestic economic outlook caused the Fed to postpone the hike until at least later in the year. While the inevitable rate hike will result in higher interest costs for MGE Energy, the utility is better positioned than most of its peers to handle higher rates. First, its leverage in terms of debt-to-capitalization has declined [pdf] from 43.5% in FY 2009 to 38.1% in FY 2014. More importantly, 80% of its long-term debt matures after FY 2019, providing it with flexibility in terms of when to refinance. Finally, the company is top among investor-owned utilities in terms of its credit ratings, boasting strong ratings and stable outlooks from both Moody’s and S&P. Credit spreads have increased sharply over the last 12 months, with the gap between AA- and BBB-rated yields growing by nearly half over the period. Maintaining its strong ratings will therefore minimize MGE Energy’s interest costs, both in absolute terms as well as relative to its peers, as interest rates move higher. The company’s short-term outlook moving into FY 2016 is also diminished somewhat, however, by the development of a strong El Nino event in recent months. The event, which is now forecast to be among the strongest on record, will bring cooler temperatures to the southern half of the U.S. but, counter-intuitively, warmer temperatures to the northern half, including MGE Energy’s service area. Historically Wisconsin has experienced substantially warmer than normal temperatures between October and May during years in which El Nino has been present. As Wisconsin residents know all too well, natural gas demand is quite high during the same period, making it very likely that the company’s natural gas utility segment will report weak retail sales over the next three quarters, especially on a YoY basis. MGE Energy’s long-term regulatory outlook recently shifted following the U.S. Environmental Protection Agency’s release of its Clean Power Plan, which requires each U.S. state to draft and implement plans for achieving preset reductions to the carbon intensity (i.e., pounds CO2 emitted per MWh of electricity generated) of their electric generation portfolios. Wisconsin’s electric sector continues to rely heavily on coal and the state is required [pdf] to make very large intensity reductions of 26% by 2022 and 41% by 2030. The ultimate reduction can largely be achieved by simply utilizing natural gas in place of coal and MGE Energy’s carbon intensity is cleaner than that of the state. I would not be surprised to see the large coal-fired plants that MGE Energy holds minority stakes in be placed on the chopping block as Wisconsin drafts its compliance plan, however, in which case the company will need to find alternative power providers. Ideally, this will take the form of rate-boosting in-house generation rather than power purchase agreements, although it is too soon to hazard a guess other than to say that the Clean Power Plan does inject uncertainty into the company’s long-term outlook. Valuation The analyst consensus for MGE Energy’s future diluted EPS results has remained unchanged over the last 90 days, although since only one analyst covers the company, the estimate should be viewed accordingly. The FY 2015 estimate is $2.25 and the FY 2016 estimate is $2.35; while the former would represent a slight YoY decline, the latter would represent a new high (albeit by only $0.03). Based on a share price at the time of writing of $41.90, the company is trading at a trailing P/E ratio of 20.6x and forward ratios of 18.6x and 17.8x for FY 2015 and FY 2016, respectively. All three of these ratios are quite high compared to both their respective historical ranges as well as those of the company’s peers. Conclusion MGE Energy’s share price has recovered since the beginning of September in response to the Federal Reserve’s decision to delay its anticipated interest rate increase, reflecting broader optimism in the utilities sector as a whole. While there is no denying the company’s stellar record in terms of both dividend as well as earnings growth, potential investors should approach it cautiously despite this price rebound. The company is well positioned to handle higher interest rates due to its excellent financial position but at the same time is exposed to El Nino-induced warm weather over the next three quarters, a period in which natural gas demand in its service area is normally high. Meteorologists’ forecasts of El Nino’s likelihood and duration have only strengthened over the last few months and I believe that MGE Energy will have a difficult time avoiding its second consecutive annual earnings decrease in FY 2016 as a result. The company’s shares are already overvalued on the assumption of earnings growth as it is. I encourage potential investors to wait for El Nino’s likely negative impacts to be reflected in the company’s share price before considering a long position in this otherwise excellent utility.