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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.

Terraform Power Can And Should Purchase Projects In 2016

Moody’s Report Provides Clarity. Invenergy Private Warehouse Will Provide Greater Clarity. Up to 4.5 billion in Purchases Possible. Yesterday’s Moody’s report for Terraform Power should help shape TERP’s financial decisions next year. Although Moody’s reaffirmed the corporate rating at Ba3, the outlook was cut from positive to stable and Moody’s said a rating upgrade is unlikely anytime soon. Terraform most certainly would like to obtain an investment grade rating. TERP has a better credit profile than many MLP’s that are investment grade, yet the nascent yieldco business model will need a lot more time to mature in Moody’s opinion. The most interesting line of the report was “TPO’s rating could be downgraded if there is a change in financial policy causing the company to target materially higher levels of leverage with a consolidated Debt/EBITDA greater than 6.5-7x.” Source: (BMP) Moody’s affirms TerraForm Power Operating’s Ba3 rating; ch anges rating outlook to stable from positive What this line implies is that TERP can go up to 6.5 to 7x leverage and not put in jeopardy the Ba3 rating. Because there is no clear path to an investment grade rating anytime soon and TERP can lever up some more without jeopardizing the Ba3 rating, TERP can and should move to higher leverage ratios. And the way to do this is project level debt with no or little unsecured offerings. Moody’s disagrees with the way TERP calculates debt to ebitda and calculates the number a little higher than TERP yet there still is ample room for TERP to issue project level debt. TERP in the July financing update shows a proforma 2016 view 2.952 billion in debt and 567 in ebitda creating a 5.2 debt/ebitda metric. TERP can comfortably take that number up to 6.2 without creating a ratings downgrade. That would allow 3 billion more in debt. How are they going to do that? With project level finance and the Invenergy Warehouse should pave the way. The Invenergy Warehouse With a high stock price, TERP management got aggressive with the Invenergy purchase. Paying 7.1% unlevered yield was steep and quite frankly sloppy. It was yet another example of sloppy aggressive purchasing by Sunedison and/or Terraform this year. The good news is that the Invenergy assets have a AA counterparty and a 19 year PPA so the contract there is about as strong as you are going to get. Abengoa, the most troubled renewable developer of all, recently priced 19 year amortizing bonds backed by a couple 50 megawatt solar(thermal) plants in Spain at 3.75% coupon. The bonds were rated BBB. Yields are lower in Europe but still that is attractive spread financing. Solarcity’s asset backed loans have investment grade ratings and priced sub 5%. For many renewable projects, if the project has a base debt service coverage ratio up close to 1.5 and a good counterparty, the ratings agencies have assigned investment grade ratings to the project finance bonds. Even recently, the NRG Alta bonds which dropped to 1.09 debt service kept an investment grade rating since S&P assumed normal wind patterns would resume and bring the debt service coverage back up to a 1.4 range. It is kind of ironic that the rating agencies will assign investment grade ratings to project finance with debt service coverage around 1.4 or so but TERP has a pro forma ebitda to interest expense over 3 with a more diverse set of projects than specific project financing yet has high yield ratings. This is strange and it leads to disconnects in the market. The insurance and pension funds buying project debt at 5% or so yields really ought to just buy the unsecured debt of yieldcos but they are probably restricted due to the need to invest in investment grade securities. So what will the Invenergy warehouse price at? BBB investment grade utility bonds are about 5% for 20 years and project finance although mostly amortizing has been pricing in that range. Since there likely will be a TERP call option associated, 6% debt may be an appropriate number for 70% of the proceeds. And then perhaps a 9% or so equity return for the remaining 30%. That would get to a cost of capital just below 7% and the unlevered yield of 7.1% covers the warehouse with TERP not having to put up cash (though there is a decent chance TERP is going to buying some of the equity portion of this warehouse). We don’t know what the debt on the Invenergy warehouse will price at but if it does price in line with other project finance debt, it sets a strong precedent for TERP going forward in the project finance market. 4.5 billion in purchases in 2016? It is highly unlikely but I will lay out a scenario that is not too far fetched. Since there is no chance of TERP becoming investment grade anytime soon and Moody’s stated TERP could lever up to 6.5 to 7x without creating a downgrade that is exactly what TERP should do if project finance permits. 8.5% unlevered yields on projects are out there for purchase. The Sunedison First Reserve and Goldman warehouses seem to have cost of capital somewhere around 8.5% so much better to have TERP calling projects from those warehouses at 8.5% than projects staying in the warehouses (JP Morgan warehouse seems to be much better than those two). If SUNE projects are 10% IRR projects than still 17-18% gross margins for SUNE on 8.5% unlevered calls by TERP from project warehouses. But if TERP is going to acquire 8.5% unlevered projects it needs a cost of capital close to 7.5%. That isn’t going to happen with 50/50 unsecured debt/equity these days. If TERP were to package existing projects and/or built call right projects into project finance bonds, there is a good chance a 5.5% debt rate could be had, at least for amortizing bonds. If 5.5% project debt can be used for 65% of projects, then the 35% equity portion needs to be at 11.2% to generate a 7.5% WACC. If TERP were to acquire 4.5 billion of projects with 65% project debt/ 35% equity all at 8.5% unlevered yields, debt would rise to almost 6 billion. 382 of unlevered CAFD would be added. Debt service would be .055 x 3 billion so 165 million. Probably makes sense to assume about 10 million of extra expense to cover backfilling amortizing portion of debt with higher cost debt and perhaps to cover extra various fees. 382 million of unlevered CAFD minus 165 million of interest and 10 million extra expense leaves 207 million levered CAFD(assuming no taxes here which perhaps there should be an assumption for some). 207 divided by 1.5 billion of equity issuance is 13.8% equity yield, certainly accretive. Levered CAFD of 207 million would actually be growth of about 60% on the 320 million of pro forma CAFD that TERP is projecting for 2016. 320 million plus 207 million leads to 527 million of CAFD. Assuming 1.5 billion of equity comes at a $20 stock price (8.75% 2016 dividend) that is 75 million more shares to add to the 140 million outstanding. 527 million CAFD * .85 is 448 million CAFD to distribute. Even with IDR’s, a 15% dividend increase from $1.75 would be possible for 2017. Do I think that scenario is going to play out? No, I don’t. But I do think the private project finance numbers out there do support something more than a dead in the water TERP in 2016. TERP needs to move into the project finance market in a big way. And some less than ideal equity issuances may make sense to give investors confidence dividend growth is still alive. With added confidence that TERP can grow its dividend in difficult times, the dividend yield should move lower and allow for more even debt to equity funding in future years. One may question with a movement to project finance in the renewables space vs. corporate level finance why Sunedison would even try to feed a yieldco vs. creating its own project finance vehicles to keep ownership. A yieldco was supposed to allow corporate level finance in addition to project level finance so finance could be attacked from all angles at reasonable rates. Although not ideal, TERP still has better funding characteristics than SUNE. No projects are going to be 100% debt financed and even with suppressed yieldco equity prices, I do believe a yieldco has a better chance of consistently raising even small amounts of equity at reasonable prices vs. Sunedison. Plus, there may be a need to do small unsecured corporate level debt issuances and that is still better done at TERP than SUNE. In addition, it is very possible the yieldco market does improve with maturity and yieldcos can once again finance at the corporate level with attractive rates. Besides, TERP has a call right list so Sunedison has to offer projects to TERP. TERP paying even a little lower than what others will pay still makes sense for Sunedison due to IDR’s and residual ownership value. However, Sunedison won’t sell projects from the warehouses much lower to TERP than to the private market so TERP needs to quickly establish project finance initiatives. Management of TERP and SUNE has touted their creative finance ability in the past and it is time for TERP management to do just that in a difficult 2016. Playing dead and hoping the market improves to once again issue significant amounts of corporate equity and unsecured debt is not good enough management and equity owners deserve better. I am long SUNE and short covered calls. The firm I work for is long GLBL and TERP.

Avista Is An Excellent Stock For The Defensive Portfolio

Avista Corp. pays a very consistent dividend with a current yield of 3.96%. It also has very stable customer base that provides protection in any bear market. AVA is trading at a reasonable price with a forward p/e of 16. The company grew revenue by 8% YoY for the most recent quarter. While there’s nothing sexy about owning a small utility company operating in the northwest region with a market cap of only $2 billion, Avista Corp. (NYSE: AVA ) is a great dividend paying stock for the defensive investor looking to preserve capital during a bear market while collecting a 4% yield. AVA has consistently raised its dividend over time, even during the depths of the financial crisis. One of the great things about companies offering services that everyone needs is that they usually outperform the market during recessions. By protecting capital while most of the market is losing it, you have a larger base from which to grow when the market eventually turns positive. This is exactly what Warren Buffett’s portfolio did during the great bull market of the 1990s that eventually went bust. Everyone thought Buffett was crazy for staying out of tech stocks during the now famous record breaking run the sector was having for those few years. While everyone was saying “this time is different,” Buffett knew that a market with an average p/e over 50 could not sustain that level of growth and that it would not end well. Of course he was correct, and many companies not only lost most of their value when the bubble popped, but a great number of high flying growth companies simply went out of business. Buffett’s portfolio on the other hand just kept chugging along, building wealth. How did AVA do doing this period? In October, 1999 AVA was trading at $18 a share. After the bubble burst and many were losing their shirts and swearing off stocks forever, AVA was trading even higher than its pre-crash price of $18 a share. In October 2000 after the market crashed, AVA was trading at $22 a share. This example clearly illustrates the power of investing in stable dividend paying stocks during bear markets, but in terms of psychology, which of course is a large part of investing, I would argue that it also makes the case for owning this type of stock during all kinds of market conditions. AVA has solid fundamentals. At a p/e of only 16 and YoY quarterly revenue growth of 8%, the company can not be said to be overpriced. Dollar cost averaging into this company would be a logical strategy because with such a stable p/e ratio, you can buy it at almost any time and know that your capital will be safe and growing over the long term. AVA is currently trading at only 1.4 times book value. This means that the company’s shares are only trading at a slight premium to the value of the company’s tangible assets. So in the event of a severe market crash, the company could literally sell off its assets and pay shareholders back. This is highly unlikely to happen, of course, since a utility company as strong as AVA will most likely perform very well in a severe bear market, which history has shown to be the case for this type of stock. Again, notice how well AVA performed during the huge crash of 2000 when the internet bubble burst. AVA was no worse for wear after the crash, and in fact, was trading at a higher price while most of the rest of the market took years to recover. One of the greatest factors that AVA has going for it is that, like many utility companies, it basically has a monopoly in its region. This translates to a huge moat, as the barriers to entry into this market are basically insurmountable. It would cost billions of dollars to attempt to supplant this market leader in the region where it operates (the northwest), and for that reason it simply isn’t worth the attempt for another utility provider. So AVA has stable earnings, a very strong moat, a high dividend, and is trading close to book value. These factors include most of what any value investor is usually looking for in a conservative investment. This strategy has the benefit of letting us sleep well at night, knowing that no matter what happens, our capital will be safe and we will at least be earning some income from the dividend while we wait for better market conditions to prevail. We accept the fact that we will not build as much wealth as others during bull markets, knowing that we are still accomplishing our long-term investing goals while not losing years of our lives being stressed out about when the next recession will hit. It’s a simpler strategy too. When you invest in stable dividend paying companies that offer products and services that investors need, you don’t have to worry about timing the market or looking at a million charts and using complicated technical analysis to try to predict the future. You just invest money when you have it in your defensive portfolio and let the power of compounding do its work. In the meantime, you can enjoy your life and let others’ hair turn gray trying to time the market (and usually failing). In conclusion, AVA is a great addition to the defensive investor’s portfolio due to its history of stable dividend growth and solid earnings. There may be companies in other industries that pay a higher yield than 4%, but you won’t find an industry or company that is more defensive than a utility company that is the market leader in its region. AVA will be raising its dividend and slowly growing for the next 50 years. If you have a long time horizon, you could do a lot worse.