The Prospect Of A Warm Winter Hurts DTE Energy’s Short-Term Outlook
Summary Michigan electric and natural gas utility DTE Energy reported Q3 earnings that beat on EPS despite missing on revenue due to hot temperatures and low fuel prices. The company’s long-term outlook, which was already strong, continued to improve as national policy and low natural gas prices increased the value of its NEXUS pipeline project. Its short-term outlook has diminished, however, as the presence of a strong El Nino will likely result in a warm winter and a cool, early summer in its service area. The company’s shares are no longer so undervalued as to merit investment given this short-term outlook, although investors should consider selling near-the-money calls due to its weak short-term outlook. Michigan electric and natural gas utility DTE Energy (NYSE: DTE ) reported Q3 earnings last week that beat solidly on EPS despite missing on revenue. In a bullish article on the company written back in June, I noted that its operating outlook was not nearly as negative as investor sentiment was at the time, concluding that: Its shares certainly appear to be more attractive based on forward valuations than they were at the beginning of the year, a result that can be largely attributed to the prevalence of bearish sentiment toward dividend stocks in anticipation of one or more interest rate hikes by the Federal Reserve later in the year. With a 3.7% yield, an improved operating environment, and plans to increase regulated capacity while expanding its non-regulated operations, DTE Energy is an attractive long investment candidate. In the subsequent four months, the share price increased by 12%, although it has settled a bit over the last two trading days. While I continue to like the company’s long-term operating environment, the development of a strong El Nino that is now expected to last well into Q2 2016 can be expected to impact its short-term earnings. This article re-evaluates DTE Energy as a potential long investment in light of these changing conditions. Q3 Earnings Report DTE Energy reported Q3 revenue of $2.6 billion (see table), virtually unchanged from the previous year, and missing the consensus analyst estimate by $80 million. The miss came despite the presence of a hot quarter in the company’s service area, with 48% more cooling degree days occurring compared to the previous year, albeit only 4% more than the long-term average. This gain was partially offset by the presence of self-imposed reduced rates resulting from the lower energy prices during the quarter on a YoY basis. Its electric sales volume to industrial customers also declined by 2% YoY, resulting in a total volume reduction of 1% over the same period. The service area’s warm weather persisted into the end of the quarter as well, resulting in a 53% YoY reduction to heating degree days, albeit from a much smaller base compared to cooling degree days. DTE Energy Financials (non-adjusted) Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Revenue ($MM) 2,598.0 2,268.0 2,984.0 3,078.0 2,595.0 Gross income ($MM) 1,545.0 1,326.0 1,586.0 1,749.0 1,476.0 Net income ($MM) 265.0 109.0 273.0 299.0 156.0 Diluted EPS ($) 1.47 0.61 1.53 1.69 0.88 EBITDA ($MM) 678.0 466.0 715.0 832.0 578.0 Source: Morningstar (2015) The aforementioned presence of much lower energy prices during the quarter was reflected in reduced operating expense, which declined by 1% YoY. Operating income came in at $440 million, or an increase of 84% compared to the previous year, due to the presence of flat revenues and lower costs. Net income came in at $264 million, up 70% compared to the previous year, resulting in a diluted EPS result of $1.47 compared to $0.88 YoY. The EPS result included a beneficial $0.07 mark-to-market impact that, if ignored, resulted in an adjusted diluted EPS result of $1.40 that beat the analyst consensus by $0.15. EBITDA came in at $678 million, up from $578 million in the previous year. The company’s quarterly dividend was 6% higher YoY, reflecting its strong performance over the TTM period. DTE Energy’s Q3 earnings strength was reflected across almost all of its segments. DTE Electric reported a diluted EPS of $1.19, up from $0.76 YoY. The Gas Storage and Pipelines segment came in second at $0.15, up from $0.11 YoY, on strong demand for its pipeline and gathering services resulting from the presence of very low natural gas prices compared to the previous year. DTE Gas reported an EPS of -$0.06 that represented a gain over the previous year of $0.03 despite the presence of fewer heating degree days in the most recent quarter. Only the Power and Industrial Projects segment reported lower earnings, which declined from $0.21 to $0.17 YoY – a move that the company attributed to lower steel earnings. Finally, DTE Energy announced that it had increased its 33% stake in its NEXUS natural gas pipeline joint venture with Spectra Energy (NYSE: SE ) to 50%. Progress on the pipeline has continued over the last four months, and while the company’s increased stake caused its expected cost contribution to rise to $1 billion, the pipeline is expected to be in service by Q4 2017. Contracting was recently completed for the pipe itself, and the FERC filing is expected to be done in the current quarter. Outlook DTE Energy’s management felt confident after the Q3 earnings release to reaffirm its FY 2015 guidance range of $4.65-4.91 and increase the midpoint of the guidance to $4.78. While this result would represent a sequential decline from the company’s bumper FY 2014 earnings, it would still be one of its strongest on record. Furthermore, the company also released its first FY 2016 guidance with an EPS range of $4.80-5.05 – a move that it based on continued economic growth and falling unemployment in its service area. Existing investors will be pleased to know that management is also targeting dividend growth equal to EPS growth, suggesting a 3% increase in FY 2016 based on the midpoint of the guidance. While DTE Energy’s long-term outlook is very optimistic, I believe the company will struggle to achieve the midpoint of its FY 2016 EPS range. The reason for this is the development of one of the strongest El Ninos in the last half of a century over the last several months. These weather events are commonly associated with warmer-than-normal winter weather in the northern half of the U.S., including Michigan , and cooler-than-normal weather in the southern half. Historical records show that El Nino events are associated with substantially above-average temperatures in Michigan between October and May, in which case DTE Energy’s service area can expect to experience fewer heating degree days than normal in Q4 2015 and Q1 and Q2 2016. Furthermore, late Q2 will probably be both colder and wetter than normal, raising the prospects of a reduced number of cooling degree days during early summer. DTE Energy’s guidance already assumes that Q4 2015’s earnings will be lower on a YoY basis just due to the presence of abnormally cold weather in Q4 2014. That said, El Nino threatens to derail the company’s FY 2016 guidance by causing its H1 2016 earnings to come in below expectations. DTE Energy’s operating outlook improves after FY 2016, however, due to a combination of recent regulatory and market developments. Its Gas Storage and Pipelines segment is becoming an important contributor to earnings, and this is likely to continue so long as natural gas prices remain low relative to historical prices. The company’s JV NEXUS pipeline was already expected to provide a large boost to the segment’s contribution. Low natural gas prices will increase its expectations, however, by driving demand for natural gas as power plant fuel at the expense of coal. The recently announced acquisition of Piedmont Natural Gas (NYSE: PNY ) by Duke Energy (NYSE: DUK ) exemplified the larger trend by U.S. utilities to convert coal-fired plants to cheaper natural gas. Looking beyond just the current natural gas pricing environment, however, NEXUS is poised to benefit from two recent developments. The first is continued economic growth in Michigan, including Detroit. While the state and the city both suffered mightily in the aftermath of the 2008 financial crisis, with the latter being hit especially hard by the abandonment of high-margin SUVs and other fuel-inefficient vehicles by cost-conscious drivers, the persistent presence of low petroleum prices over the last three quarters has caused the U.S. automobile industry to stage a strong comeback. Michigan’s economy has rebounded as well, with the Chicago Fed recently proclaiming it the fastest-growing economy in the Midwest. Falling unemployment and continued economic growth will cause natural gas demand in DTE Energy’s service area to also increase, with NEXUS ultimately making further such increases possible. The U.S. Environmental Protection Agency’s recently released Clean Power Plan will increase demand for natural gas pipelines in Michigan and the upper Midwest. The Clean Power Plan requires each state to reduce its carbon intensity (units of greenhouse gas emissions per unit of electricity generated) over the next decade. Michigan must achieve a 24% reduction to its carbon intensity by 2024 and a 39% reduction by 2030. Importantly, its final carbon intensity target is very close to the carbon intensity of a gas-fired power plant, meaning that the state’s utilities can contribute by switching from coal to natural gas. This is already being done across the U.S. due to return of cheap natural gas, and the Clean Power Plan is expected to simply deliver a legal impetus to a market trend that already exists. This will serve to further increase demand for the type of service that the NEXUS pipeline will provide upon its completion. Valuation The consensus analyst estimates for DTE Energy’s diluted EPS results in FY 2015 have risen slightly over the last 90 days, while those for FY 2016 have remained stable. The FY 2015 consensus estimate has increased from $4.74 to $4.79, in line with management’s midpoint guidance, while the FY 2016 estimate has stayed flat at $4.96, slightly above the midpoint guidance. Based on a price of $82 at the time of writing, the shares are trading at a trailing P/E ratio of 16.1x on a non-adjusted basis and forward P/E ratios of 17.1x and 16.5x, respectively. All three of these ratios are higher than in June, but still low relative to their respective 3-year ranges. That said, I do expect that the company will struggle to achieve the FY 2016 consensus estimate if El Nino has a similar impact on Michigan’s winter temperatures to those that it has had in the past, in which case the shares are not clearly undervalued at this time. Conclusion DTE Energy reported solid Q3 earnings earlier this week as hot temperatures in the second half of the summer and low energy prices contributed to a large YoY earnings gain. Management was upbeat in the company’s Q3 earnings report and subsequent earnings call, outlining the rebounding nature of its service area’s economy, continued opportunities for additional future capex, and progress on its NEXUS pipeline JV. I further believe that the persistence of low energy prices and low natural gas prices in particular as well as the release of the Clean Power Plan will provide additional support for the new pipeline when it comes on-line. That is still two years away, however, and DTE Energy must first face the prospect of two consecutive warmer-than-normal winter quarters followed by a cooler-than-normal summer quarter as a strong El Nino makes its presence felt. Given the increase to the company’s share price that has occurred over the last four months and the prospect of multiple bearish quarters, I do not recommend buying DTE shares at this time. Existing shareholders who bought back in June and don’t want to incur the tax implications of a short-term sale, however, should consider selling near-the-money call options at this point to take advantage of the fact that the company’s near-term outlook is not as positive as its longer-term outlook. DTE Energy remains an attractive investment opportunity due to economic recovery in its service and its own strategic moves to benefit from rising natural gas demand, but it is not one that provides a sufficient margin of safety for me to recommend it as a “buy” at this time.