Summary Regulated electric and natural gas utility Empire District Electric has seen its share price fall sharply YTD in response to uncertainty over interest rates and state and federal regulations. Further uncertainty has arisen in recent months in the form of El Nino’s temperature impacts, with a warm winter in its service area likely. The company’s shares appear to be undervalued on a P/E ratio basis but this doesn’t account for the possibility of reduced natural gas demand in Q4 and Q1 2016. I encourage income investors to wait for the company’s shares to fall below $20 in response to disappointing Q4 and Q1 earnings before investing. Regulated electric and natural gas utility Empire District Electric (NYSE: EDE ) reported Q2 earnings that missed on both lines as mild weather in its service area hurt both sales volumes and margins. The company’s share price declined in the weeks following the report’s release, continuing a sharply lower trend that has been in place YTD in the aftermath of an adverse state court ruling (see figure). While the company’s share price is nearing a 5-year low, its investors are about to be confronted by additional weather-related uncertainty as well as looming federal regulations that could impact its energy generation portfolio. This article evaluates Empire District Electric as a long investment opportunity in light of these developments. EDE data by YCharts Empire District Electric at a glance Headquartered in Joplin, Missouri, Empire District Electric is a combined electric and natural gas utility, although it also operates small water and fiber optic services as well. Its service area encompasses 218,000 customers residing in 10,000 square miles of the tri-state border region of Missouri, Kansas, and Oklahoma, as well as part of Arkansas. Its electric generation, transmission, and distribution segment covers the full service area, although 86% of its revenues are derived from its Missouri operations. The natural gas service is limited to western and northwestern Missouri. Empire District Electric is a relatively small utility with a $948 million market cap at the time of writing, reflecting the sparsely populated and mostly rural nature of its service area. The company generates 94% of the electricity that it sells via 1326 MW of owned generating capacity. While its fuel source portfolio has shifted in recent years, it is mostly comprised of coal and natural gas complemented by a small amount of hydro. The balance of its electric sales are derived from 86 MW of coal and wind via power purchase agreements, bringing its total capacity to 1412 MW. Another 108 MW of natural gas combined cycle capacity is currently under construction and expected to begin operations in the first half of 2016. The electric segment is responsible for the bulk of the company’s revenues, bringing in 91% of the total on a TTM basis as well as 92% of gross income (or gross margin in the company’s parlance) over the same period. Its customers are broadly split between residential, commercial, and industrial, with residential being the largest group. The natural gas segment, which is comprised of transmission and distribution components, generated 7.5% of TTM revenue and 6% of TTM gross income, although both numbers were lower than in previous years. Finally, the water and fiber optic segments generated only 1.3% of TTM revenue and an unknown percentage of gross margin. The last several years have been rough for Empire District Electric and it underperformed the broader sector for many of them. Its annual earnings remained relatively flat between FY 2008 and FY 2012, only beginning to grow strongly in FY 2013. Unusually, for a utility, its annual dividend has actually declined and is now 12% lower than in FY 2008-2010. Reflecting the unique weather conditions in which it operates, the company had to suspend its dividend in the second half of 2011 after a category EF-5 tornado hit Joplin, destroying 7,000 houses and causing the company’s number of customers to decline by 1.5% for the year. Its ROE on a non-weather adjusted basis has largely lagged behind the sector average, excepting a period from late 2013 to early 2014 that saw it report above average returns thanks in part to large temperature swings in its service area. Empire District Electric’s earnings and share price volatility is largely due to the fact that the Missouri regulatory scheme that it operates within does not contain a weather decoupling mechanism. Such mechanisms, which are found in some regulatory schemes, establish a base rate case and then allow the regulated utility to either charge or refund customers on the basis of the difference between the case and its weather-related earnings. Such a mechanism would have a large impact on Empire District Electric given the large temperature swings that occur in its service area over the course of a year: Joplin records average highs of 91 degrees F in July and August and an average low of 25 degrees F in February, while heat index and wind chill factors make this range appear to be even larger. The company’s earnings are therefore very sensitive to abnormal temperatures since its natural gas segment is in demand in the winter while its electric segment is in demand in the summer. Missouri’s scheme does include a fuel recovery mechanism, however, to minimize the impacts of the kind of energy price volatility that the U.S. has experienced over the last year. Q2 earnings report Empire District Electric reported Q2 revenue of $134.5 million, down by 10.2% YoY and missing the consensus estimate by $17.1 million. The presence of mild weather during the quarter compared to both the previous year and the long-term average as well as the presence of a fuel cost refund of $1.4 million resulted in the decline. This was partially offset by a $3.5 million increase resulting from customer growth and the implementation of a previously approved rate increase. Mild weather also reduced natural gas demand for heating purposes in the early part of the quarter, although the fact that the quarter is generally slow for the segment meant that this had only a small negative impact on the revenue result. Gross income (or margin) came in at $93.3 million, up slightly YoY from $92.7 million. The electric segment’s margin increased by 1% YoY as lower fuel costs and higher consumption by its commercial and industrial customers offset lower revenue overall and reduced consumption by its residential customers. The natural gas segment’s margin remained flat YoY and, as with revenue, only made a small contribution to the company’s total result. Net income came in at $6.8 million (see table), down from $11.2 million YoY. This resulted in a diluted EPS of $0.15 for the most recent quarter, down from $0.26 in the previous year and missing the consensus analyst estimate by $0.09. Both the decline and miss were almost entirely the result of higher O&M costs and depreciation expenses, both on a YoY basis. The negative impact of the former, which was the result of a planned major maintenance outage, on the company’s FY 2015 earnings should be offset by lower O&M costs in the rest of the fiscal year. Empire District Electric financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 134.6 164.5 151.4 171.5 149.8 Gross income ($MM) 65.7 75.6 67.3 86.0 65.1 Net income ($MM) 6.8 14.6 11.1 23.9 11.2 Diluted EPS ($) 0.15 0.34 0.26 0.55 0.26 EBITDA ($MM) 39.8 48.2 39.7 56.1 41.6 Source: Morningstar (2015). The depreciation increase, on the other hand, was the result of an air quality control system that the company had installed at one of its power plants in order to bring it into compliance with U.S. Environmental Protection Agency [EPA] restrictions on power plant emissions. Existing investors are already familiar with such costs, which are the result of a structural lag in Missouri’s regulatory scheme that prevents utilities from rapidly recouping capex in the form of a rate base increase. Instead, capex such as the control system purchase and installation negatively impact the company’s earnings in the form of higher depreciation costs and property tax payments before (hopefully) being offset by a rate base increase several months later. The company’s management has indicated in previous earnings calls that it does not expect for this lag to be eliminated anytime soon, further increasing its share price volatility. Outlook Investors should be aware of three major developments set to occur over the next twelve months that could have a substantial impact on Empire District Electric’s earnings results. The first of these is the prospect of higher interest rates for the utility sector resulting from a rate increase by the Federal Reserve. Utility capex has been bolstered over the last several years by the presence of historically low interest rates, allowing them to increase maintenance, replacement, and new capacity spending without negatively impacting earnings via substantially higher interest costs. While the market has been expecting such an increase to occur in 2015, a decision by the Fed not to implement an increase at its most recent meeting and a weak October jobs report has caused expectations of a 2015 rate hike to fall sharply. The utility sector has been one of the market’s stronger performers over the last several weeks as a result of this delay. When the inevitable hike does occur, however, Empire District Electric is unlikely to be as severely impacted as many of its peers due to the fact that most of its debt does not come due until after 2030, while recent borrowings have achieved a roughly 4% interest rate. Investors can expect Empire District Electric’s earnings to smooth out somewhat over the next year since the company expects its capex spending to decline sharply through FY 2017 following a large increase in FY 2014. As a result of this decrease, it is only forecasting a 4% rate base CAGR in 2014-2019. Furthermore, customer growth in its electric segment is expected to remain quite low, averaging less than 1% annually over the same period. This latter expectation is surprising given the robust economic strength of its service area’s economy. For example, the unemployment rate in Joplin and the surrounding area recently fell to 4.3% as compared to 5.6% in Missouri more broadly (see figure). The Joplin housing market has also been growing at a faster rate than Missouri’s (see second figure) following a brief downturn in the wake of the 2011 tornado strike. While the service area’s economy is strong, however, the region does not have any of the population growth drivers found in either metro areas or rural areas (a latter example being the Dakotas up until a year ago). While the economy will prevent customer growth from turning negative, then, the fact that southwest Missouri and the tri-state area have few major draws will prevent it from increasing by much either. Missouri Unemployment Rate data by YCharts Joplin, MO House Price All-Transactions Index data by YCharts I do expect the company’s earnings to falter a bit in Q4 and Q1 2016 as the effects of this year’s especially strong El Niño are felt. Historically, the company’s service area has experienced warmer than average temperatures between October and March during previous El Niño events, raising the prospect of similar mild conditions and consequent reduced natural gas demand over the next six months. While long-range weather forecasting is by nature an inexact science, the probability that this year’s event will remain strong have only increased over the last several weeks, boosting the likelihood that Empire District Electric’s earnings will be weaker than expected when it reports in January and April 2016. Finally, potential investors should be aware of a recent federal regulatory development that has the potential to impact Empire District Electric’s longer-term operations, although the timing of the impacts will be difficult to predict. In August, the White House and EPA, making good on its previous threats to respond to Congressional inaction on greenhouse gas [GHG] emissions by wielding federal regulations, announced a Clean Power Plan that will require each U.S. state to reduce the carbon intensity (e.g., unit of CO2-equivalent emissions per unit of electricity) by a predetermined amount over the next 15 years. Missouri is required to achieve an especially large reduction . While each state will be allowed to draft its own plans for achieving its individual reduction and, in the case of Missouri, this likely will be accomplished in consultation with the state’s utilities, in practice the plans will almost certainly take one of two forms: either coal-fired power plants will be replaced by natural gas-fired plants or large investments in new renewables capacity will be made. It is worth noting that Missouri can achieve its required reduction by phasing out coal in favor of natural gas, a process that is especially attractive in light of other recent EPA regulations restricting other types of coal-related emissions from power plants. Such a scenario would likely result in higher capex for Empire District Electric as it improved the efficiency of and converted its existing coal-fired plants, thereby supporting long-term rate base increases despite a lack of customer growth. The Central Plains region is host to a large amount of potential wind energy , however, and it is also possible that Missouri would focus on minimizing electricity prices and simply require the utility to purchase wind-derived electricity from independent producers of renewable power. Alternatively, the state could also opt for distributed generation, such as the residential PV installations that were the subject of the aforementioned state court decision. These latter scenarios would not support the company’s capex to nearly the same extent. Valuation The consensus analyst estimates for Empire District Electric’s diluted EPS results in FY 2015 and FY 2016 have held steady over the last 90 days despite its share price volatility. The FY 2015 estimate remains at $1.39 while the FY 2016 estimate remains at $1.51. Based on a share price at the time of writing of $21.69, the company’s shares are trading at a trailing P/E ratio of 16.7x and forward ratios of 15.6x and 14.3x for FY 2015 and FY 2016, respectively (see figure). The forward ratios in particular have declined sharply since the beginning of the year and are approaching their respective 5-year lows. I do believe that a warm winter will cause the company’s FY 2015 EPS to come in under the analyst consensus, ending up near the bottom end of management’s range of $1.30-$1.45. In this case, the company’s shares appear to be fairly valued at present on a historical basis. EDE PE Ratio (TTM) data by YCharts Conclusion Empire District Electric’s share price has fallen sharply YTD as abnormal weather conditions and an unfavorable regulatory structure have helped to produce more volatility than normal. While the company’s forward P/E ratios have fallen to levels that would normally suggest undervalued shares, the analyst consensus for FY 2015 and FY 2016 have remained flat over the last 90 days even as the likelihood of higher than average temperatures occurring in the company’s service area in Q4 and Q1 has grown. That said, I do believe that recent federal regulations on power plant emissions could present the company with an opportunity for long-term capex growth, although this will depend on how the state of Missouri decides to adapt to the recent Clean Power Plan. As attractive as Empire District Electric’s 4.8% forward dividend yield is, I would prefer to see a larger margin of safety in the form of undervalued shares to compensate potential investors for a lack of near-term capex growth and customer growth. While that margin is not available at present, I would consider purchasing the company’s shares in the event that the share price falls below 15x its FY 2015 earnings, or $20/share at the time of writing, in response to warm winter weather.