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OGE Energy Is A Unique Opportunity For Energy Bulls

Summary Oklahoma utility holding company OGE Energy’s shares have underperformed its peers by a wide margin YTD, as investor sentiment has turned negative due to its exposure to oilfields. The company’s unique status, as both a regulated utility and a stakeholder in an MLP, has allowed it to finance rapid dividend growth via distributions. The company will struggle to meet its future dividend targets, if sustained low energy prices cause the MLP distribution growth to cease and Oklahoma’s economy to stagnate. The company’s share valuations have fallen sharply, however, and do not reflect the benefits provided by its unique position. While a sufficient margin of safety is not available for conservative investors, aggressive investors, who expect energy prices to remain above their earlier lows, should consider it as an investment. Investors in Oklahoma utility holding company OGE Energy (NYSE: OGE ) have seen their holdings underperform the broader Dow Jones Utility Average by a significant margin in 2015 YTD, as the company’s shares have declined by 25%. Worse, unlike many of its peers, it has been beset by slow growth over the last five years, having achieved an EBITDA increase of a mere 1% over the entire period. More recently, the market has expressed skepticism over the company’s ability to achieve its ambitious dividend goals, given its direct and indirect exposure to the financial health of domestic oilfields. This article evaluates OGE Energy as a potential long-term investment in light of these conditions. OGE Energy at a glance Headquartered in Oklahoma City, OGE Energy is comprised of two segments. The primary segment is Oklahoma Gas & Electric (OG&E), which is a regulated electric utility generating, transmitting, and distributing electricity to 819,000 customers, primarily residential and commercial, in central Oklahoma and a small part of western Arkansas (Arkansas only contributes to 7% of the company’s rate base, with Oklahoma contributing the rest). OG&E owns and operates 6,800 MW of electric generating capacity and enough transmission and distribution lines to supply a service area, including Oklahoma City and the surrounding area, covering 30,000 square miles. OG&E’s generating capacity consists of 54% coal, 35% natural gas, and 11% wind power. While it recently began operating a pilot 2.5 MW solar PV installation, by 2020 it expects its fuel mix to be 50% coal, 37% natural gas, and 13% wind. OG&E operates within a moderately favorable regulatory scheme that includes a 11.1% allowed return on equity and a 56% equity ratio. This combination has supported rapid and accelerating dividend growth by its parent OGE Energy since FY 2011, most recently in the form of a 11% YoY increase, and the company is targeting a 10% annual growth rate through FY 2019. The high allowed return on equity has also led to above-average debt ratings for OG&E of ‘A1’ from Moody’s and ‘A-‘ from Fitch. In addition to OG&E, OGE Energy also owns a 26.3% limited partner stake and 50% general partner stake in MLP, Enable Midstream Partners LP (NYSE: ENBL ). With $11 billion in assets, Enable gathers and processes natural gas from a number of South Central gas fields, including within Oklahoma, that it then pipes to destinations both within the region and outside of it. Distributions from Enable in recent quarters have equaled only 16% of OGE Energy’s total cash flows, or 20% of OG&E’s cash flows, although the parent company’s management expects them to increase by 6% to 8% annually. Q2 earnings report OGE Energy reported Q2 revenue of $549.9 million (see table), down 10.1% YoY and missing the analyst consensus estimate by $68 million. The decline and miss were the result of the utility’s electric sales volume falling by 5.3% YoY, partially offset by a 1.1% increase to customer numbers over the same period. The reduced demand was in turn due to the prevalence of cool temperatures in May and June that allowed the company’s customers to avoid using their air conditioners, with the average number of cooling degree-days over the quarter coming in 10.7% below the previous year’s average and 2.4% below the long-term average. OGE Energy financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 549.9 480.1 526.2 754.7 611.8 Gross income ($MM) 339.0 268.5 289.2 449.4 340.9 Net income ($MM) 87.5 43.2 58.4 187.3 100.8 Diluted EPS ($) 0.44 0.22 0.29 0.94 0.50 EBITDA ($MM) 237.5 170.2 202.4 367.6 251.7 Source: Morningstar (2015). OGE Energy’s gross margin declined slightly YoY from $340.9 million to $339 million, as its cost of revenue declined by 22% over the same period due to falling energy prices, almost offsetting the negative impact of reduced electricity demand on earnings. OG&E’s utility operating income fell to $127.2 million from $141.8 million over the same period, however, while income from distributions fell to $28.2 million from $39.3 million. The former was the result of the utility segment’s O&M and depreciation costs increasing compared to the same quarter of the previous year, driving a 6.4% increase to OGE Energy’s operating expenses. While management didn’t attribute this increase to regulatory lag in its Q2 earnings call , it did state that it was the result of the previous year’s capex, suggesting that rates have not kept pace. The company’s net income declined to $87.5 million from $100.8 million YoY, resulting in a diluted EPS result of $0.44 versus $0.50 in the previous year. The EPS result was in line with the consensus analyst estimate, despite the substantial revenue miss. The utility segment contributed $0.34 to the EPS result, down from $0.38 YoY, while the company also reported distributions from its stakes in Enable of $0.12, down from $0.10. EBITDA also fell from $251.7 million from $237.5 million over the same period. The company’s board opted to increase its dividend by 11% despite the overall decline to net income, exceeding its target and providing investors with a pleasant surprise in the process. Outlook Management reiterated in its Q2 earnings call that its previous forecast for OG&E to generate diluted EPS of $1.41-$1.49 and Enable to provide distributions to OGE Energy equal to an additional $0.35-$0.40 in FY 2015. An important assumption behind this forecast is that the company’s service area experiences normal weather in Q3 and Q4. Q3 temperatures were close to the average, with warmer numbers in early August and September being offset by cooler numbers in the latter parts of both months. Q4 is currently on track to be close to normal in terms of temperatures. Oklahoma is one of the few U.S. states that is not expected to experience large temperature variations resulting from the strong El Nino that has been developing over the last several months. Historical data indicates that OGE Energy’s service area experienced only slightly warmer-than-normal temperatures between October and February and slightly cooler-than-normal temperatures between April and June during previous El Nino events . This could result in higher electricity demand in Q4 (electricity demand tends to increase along with the number of heating degree-days, although not by nearly as much as natural gas demand does) and lower demand in Q2 2016, although any impacts are likely to be too small to have much of an impact on earnings. Of much greater concern is OGE Energy’s exposure to Oklahoma’s economy. The state has benefited strongly from the expansion of domestic crude and natural gas production that has developed in the region over the last five years, so much so that Forbes recently placed Oklahoma at #7 on its Best Places For Business list while CNNMoney named it #9 on its Fastest Growing Cities list. Between 2010 and 2015 Oklahoma’s unemployment rate was substantially lower than that of the U.S. while its GDP growth rate was higher. While the state’s economy has remained strong to date, its unemployment rate has begun to climb as sustained low energy prices have caused the finances of many oilfield firms to deteriorate . OGE Energy is exposed to sustained low energy prices in two ways. First, Enable’s share price has fallen by 34% YTD, as the value of many of its assets have declined, pushing its forward yield to nearly 10%. A further share price decline could cause the MLP to reduce its yield, in which case its distributions to OGE Energy will decline in absolute terms. While OGE Energy’s management has stated that it does not expect this to occur, a sentiment supported by its recent dividend increase, the company does intend to use its Enable distributions to finance both its planned dividend growth rate of 10% over the next five years as well as much of its capex, with the former resulting in an attractive dividend payout ratio of 55% by 2019. Capex in turn is expected to peak in FY 2016 at $720 million, mostly due to modernization and environmental investments, before declining to $445 million in FY 2019. Reduced distributions from Enable would not prevent this capex from occurring but it would increase the likelihood that OGE Energy would raise the capital in the form of additional debt, exposing itself to the Federal Reserve’s upcoming interest rate increase. OGE Energy is also exposed to sustained low energy prices via OG&E. 12% of the utility’s sales volume came from oilfield customers, a number that remained steady in the first half of 2015 despite declining demand overall. Crude and natural gas prices fell again in Q3, however, causing domestic production to also decline, and this weakness could show up on OGE Energy’s earnings statements later this year in the form of reduced electricity consumption by oilfield customers. Potential investors will want to keep a close eye on the company’s Q3 earnings report release next month for any such signs. Furthermore, slowing domestic fuel production will eventually cause Oklahoma’s population growth to decline if oilfield jobs growth slows or even stops. Such population growth in the first half of 2015 helped to mitigate the negative impact of mild weather in the service area on OGE Energy’s earnings, but such a buffer is by no means assured of existing in the future if energy prices remain low. While the precarious state of U.S. oilfield suggests that potential investors in OGE Energy should exhibit some caution, it is worth noting that the company is also competitively placed compared to many of its peers in other areas. In the short-term is its above-average credit rating strength. Even in the event that the company is forced to turn to debt to finance its planned capex just as interest rates are increasing, the fact that OG&E’s credit ratings are superior to those of its peers will enable it to take advantage of the widening spread that has already opened up in the corporate bond market. The impact of higher rates on its interest costs will be mitigated so long as it maintains its strong credit ratings. In the long-term OGE Energy is also better-positioned than many of its peers to weather upcoming federal rules on power plant carbon intensity (lbs of CO2 per MWh generated). The U.S. Environmental Protection Agency’s Clean Power Plan requires each state to develop its own mechanisms for reducing their average carbon intensity by a predetermined amount. Oklahoma, for example, is required to achieve a 21% reduction by 2024 and a 32% reduction by 2030. OGE Energy has already begun to reduce OG&E’s carbon intensity in order to meet other environmental regulations and changing market conditions, however, and expects to achieve a 30% reduction by 2020 regardless of the Clean Power Plan’s implementation. Cheap natural gas will only provide the company’s existing plans to convert coal-fired units to gas with additional impetus. Valuation The consensus analyst estimates for OGE Energy’s diluted EPS results in FY 2015 and FY 2016 have declined slightly over the last 90 days, as weak energy prices have increased the likelihood that Enable’s distribution growth slows in the future. The FY 2015 estimate has declined from $1.87 to $1.86, while the FY 2016 has fallen from $2.02 to $2.00. Based on a share price at the time of writing of $28.52, the company’s shares are trading at a trailing P/E ratio of 15.2x and forward ratios of 15.3x and 14.3x for FY 2015 and FY 2016, respectively. All three ratios are much lower than they were at the beginning of the year and are roughly in the middle of their respective historical ranges. Conclusion OGE Energy shares have performed poorly in FY 2015 YTD as the market has responded negatively to its exposure, both direct and indirect, to inland domestic oilfield production. Sustained low energy prices threaten to reduce both electricity demand from its oilfield customers and the distributions that the company earns via its positions in Enable. An especially lengthy period of low energy prices could hamper both economic and population growth in Oklahoma, depriving OGE Energy’s utility operations of expected demand growth in its service area as well. While the current investor sentiment around the company is bearish, it also presents a unique opportunity for those potential investors with a higher risk threshold. OGE Energy’s management has committed the company to a high dividend growth rate that it expects to be supported by distributions from Enable. Furthermore, management also anticipates using the distributions to help finance its planned capex over the next several years, mitigating the potential negative impacts of higher interest rates on its earnings. A rebound in energy prices from their current levels would provide investors in OGE Energy with both market-beating dividend growth and appreciating share values, the latter in particular being a rarity in the current utilities sector following several years of outsized returns. While the company’s shares currently appear to be fairly valued on the basis of their historical valuations, the prospect of future earnings growth and limited downside from higher interest rates makes OGE Energy a compelling investment for those investors who don’t expect energy prices to return to their previous lows for a sustained period.

ITC Holdings: Growth Comes At A Price

Summary Transmissions business carries less risk and higher allowed returns than other utilities. Dividend is slated to grow at a 10-15% annual pace through 2018 by management. ITC Holdings is highly leveraged and burns through cash – a change to allowed returns could be disastrous. ITC Holdings (NYSE: ITC ) is the largest electricity transmission company in the United States, operating out of the Midwest. Current operations sprawl out from the center of the country, impacting dozens of states. Unlike your typical regulated electric utility that directly produces energy to provide electricity to customers, ITC focuses fully on grid infrastructure. Electric transmission assets have been historically under-maintained, resulting in significant transmission constraints and stress on ageing equipment. To combat this, the regulatory environment has shifted to companies like ITC to fix these issues while receiving a stable, regulated rate of return. Given ITC’s estimates of $160-240B in additional necessary upgrades to infrastructure by 2030, substantial opportunity exists for utilities to earn a fair return on invested capital upgrading these assets. This business model has been a long-term outperformer. Looking back ten years, shares have trounced utility peers but have begun to underperform recently. Is this a healthy needed sell-off or an opportunity for investors to buy in before the next leg up in share price? Not Your Grandfather’s Utility Your typical state-regulated, power-producing utility has a tough time. Rates it can charge are set at fixed rates in between rate cases it makes with state regulators, hopefully with various riders in place that allow recovery of necessary capital expenditures or changes in commodity prices. In nearly every case, electric utilities experience “regulatory lag” – a gap between capital spending and eventual recovery. Disallowances are always a risk. Further exasperating utility management, a utility might make an investment assuming a return on equity that never materializes or an incredibly long amortization period that stretches out the timeline of recovery. Political gamesmanship between the utility, regulators, and the public that bears the costs is always present. ITC Holdings is instead governed by FERC, the Federal Energy Regulatory Commission. Working with the Feds directly avoids a large portion of the games played in the rate-making process. Regulatory lag isn’t as much of a problem as FERC rate-setting is forward-looking with annual adjustments. Further benefitting ITC is the much higher allowed returns on transmission infrastructure. Most publicly-traded utilities have seen their allowed return on equities plummet over the past decade to approximately 10%, give or take a half percentage either way. Allowed returns for transmission companies like ITC is in the 12% range depending on region. In a nutshell, this makes ITC a much more profitable business than most utility peers, with profit and operating margins that energy producers like Duke Energy (NYSE: DUK ) could only dream of. In spite of risk to drops in allowed return on equity (FERC dropped allowed return on equity on New England assets to 11.7%, setting off warning bells across transmission utilities), the company should enjoy meaningful returns above and beyond standard utilities for some time. Further cementing ITC’s advantages over electric utilities, transmission assets are simple. By and large, they are simply pole and wire assets with supporting infrastructure. The environmental and regulatory risk simply isn’t as present as it is for power-generating utilities. There is no nuclear waste requiring disposal or possible coal ash basin breaches to worry about. Operating Earnings The growth story is obvious here; you won’t find many other companies in the utilities segment growing at over 12% compound annual growth rate. Annual revenue growth is expected to continue at this pace over the next five years as ITC continues to take on projects. Operations and maintenance expenses have actually stayed relatively flat, indicative that maintenance costs are minimal for new transmission infrastructure once updated. Consistently better than 50% operating margins are stellar and more indicative of a company like Apple (NASDAQ: AAPL ) than a regulated utility. Getting a piece of these strong results doesn’t come cheap, because at more than 13x ttm EV/EBITDA, shares trade at a 30% premium to the broader utility industry. Serial Debtor Issue? If anything should concern investors, it is the rapid rise of the company’s debt. The company has breached $4B in debt compared to just $2.5B in 2010. Net debt/EBITDA of slightly over 5x has held steady as ITC’s earnings have grown as well, but this is a substantial amount of leverage as the company pours significant money into capital expenditures. Credit ratings are stable investment grade, but all ratings agencies note the risks in this heavy spending. A deterioration in the company’s regulatory or operating environment (increased regulatory lag, lowered allowed return on equity by regulators, litigation, rising interest rates) could stunt ITC’s cash flow which would hamstring further investment. Any company that perpetually issues hundreds of millions in debt year after year, especially one as small as ITC Holdings, should make investors pause and consider possible implications. Conclusion The small current dividend yield of 2.26% shouldn’t scare away investors. Per management’s 2014-2018 guidance, 10-15% annual dividend increases are to be expected. If management executes and hits the high end of this dividend growth target (as it did in 2015), your yield-on-cost would be 3.43% at the end of 2018, which would be a respectable number that you may not get by buying a slow-growing 3% yielder today. Additionally, ITC’s share repurchase program is rather unique in the utility industry, one that is most often plagued by dilutive equity issuance every few years that is never offset by buyback programs. However, the company’s high degree of leverage, price premium to other utilities, risk of more competition for projects, and uncertainty regarding future allowed returns on electric transmission infrastructure weigh heavily on my ability to issue a buy recommendation.

$100,000 Investment Into Yearly Income: The Southern Company Example

Summary A dividend strategy is essentially turning investment into a yearly income stream. Boring utilities stocks can help you generate great levels of wealth. Here is the way it can work for you. In the article “Can A $100K Investment Produce A $50K Yearly Income? Walking The Model Step By Step” I introduced a model to generate an ongoing income steam through initial investment of $100,000 and by reinventing the net dividend flow. There were many comments and feedbacks to this model and I thank all commentators for their good inputs. One key concern that was raised was that achieving a $100,000 worth of savings is almost an impossible challenge these days. Well, I will fool you not. Getting to a significant amount of wealth is not an easy task. It requires both discipline and setting straight the priorities. There is no magic here. In order to achieve significant amount of savings one must put aside a portion of his income. These amounts can be either fixed or it can change from week to week or month to month. Nevertheless there should be constant contribution. In order to achieve something there must be a goal. A goal should be set realistically based on the ability to routinely contribute to the accumulated wealth. In the next example I will continue to use the $100,000 as the goal. After we set our mindset straight and agreed to take responsibility over our spending and savings, and after we set up a goal that is reasonable to achieve, how can we generate wealth using dividend investing strategy? The example of The Southern Company I decided to use The Southern Company (NYSE: SO ) as an example as it is conceived as a boring type of investment. It is less exciting from the growth machines out there but it can definitely fit to our purpose of generating wealth. SO is a holding company that operates in the South East counties of the U.S. It owns Alabama Power Company, Georgia Power Company, Gulf Power Company, and Mississippi Power Company, each of which operates as a public utility company. SO is the 16th largest utility company in the world, and the fourth largest in the U.S. It serves more than 4.5 million customers in Alabama, Georgia, Florida, and Mississippi. The company was founded back in 1945 and began paying quarterly dividends in 1972. SO never had a dividend cut and has been steadily increasing its dividend since the year 2002. An investor who decided back in November 2005 (ten years ago) to regularly invest in SO, to routinely invest $450 per month and buy more shares. And alongside during this period, each quarter he reinvested the dividends after tax to buy more of SO’s shares he could have reached the $100,000 goal by the end of 2014. Even after the 2015 correction in the Utilities’ stock prices he would have reached the goal again by the month of September 2015. It means that based on these particular assumptions the goal was achieve after nine years. Let’s see how it worked in more details. The investment Since SO paid a quarterly dividend through the assumed period, the investment is built out of two elements: the first one is the monthly contributions of a fixed $450. That means yearly contributions of $5,400 each year. The second element is the dividends net of 25% tax rate which have constantly grew from year to year. The higher dividends together with the higher number of accumulated shares delivered an everlasting growing purchasing power to buy more shares. As we can see in the next graph, during the recent years the dividend became a significant portion of the yearly investment and by 2014 it was about 40% of the $8,568 yearly investment. The shares accumulation The monthly contributions allowed to constantly increase the amount of shares but the accumulation was highly dependent on the share price. The next graph shows the yearly stock price average during the recent ten years alongside the accumulated number of shares during each period. At times of high stock price the accumulation power was lower. The situation of the zero interest rate brought the stock price to recent highs and by that reduced the buying power of the routine contributions. In a scenario of a hiking interest rate we might see SO’s stock price going down and by that a fix accumulation will allow to purchase more shares. The total investment value: The dividend yield went down from the levels of 6-7% in the years 2005-2009 to the levels of 5% in the recent years due to the stock price hike. But this exact hike also drove the holding value to higher levels and led the total value to exceed $100,000 by December 2014. If indeed the interest rate hike will arrive soon (and it depends how high it would reach in the next couple of years) the value of the portfolio will be highly volatile and might go down in value. The income: Which brings us to the last piece. The accumulated holding at the value of $100,000 generates in 2015 a yearly net income of $3,566. As this machine will continue to work it would grow its income power even higher. Even if the stock price will go down due to a FED’s action the power of time and reinvestment will allow to accelerate the income machine even faster (as lower stock price allows to accumulate more shares). If you are interested in the excel model behind this example you can find it here . Conclusions: Even a boring type of investment like SO can serve well the patient investor to generate wealth using a sound dividend investment strategy. Dividend strategy cannot depend on a sole stock and should be based on a diversified portfolio. The monthly contributions should be aimed towards high quality stocks that face temporary headwinds but have long and proven history. Nowadays this list may include companies like Chevron (NYSE: CVX ), ConocoPhillips (NYSE: COP ), Deere & Company (NYSE: DE ), Eaton (NYSE: ETN ), Johnson & Johnson (NYSE: JNJ ), HCP (NYSE: HCP ) and other names from the Industrial sector. A consistent strategy of constant contributions and dividends reinvestment will allow to obtain sound results overtime. There would be those who would criticize the length of the time required to achieve the goal at it was shown in this example. As mentioned earlier: there is no magic here. In order to accelerate the accumulation and reduce the length of time the monthly contributions should be higher. For example, a monthly contribution of a $1,000 would have reduce the time by ~40% allowing the goal to be achieved in early 2011 or after six and a half years. There are highly subjective decisions to be made and it will vary from one person to the other, but if the mindset should be set to take responsibility over your financials, a sound goal should be set and the only thing left is to execute the strategy. Happy investing.