Tag Archives: utility

National Fuel Gas Is Cheap

$409 million reserve write-down for the company’s E&P segment overshadows its regulated utility and pipeline operations. National Fuel Gas offers the highest number of Marcellus acres per million dollars of enterprise valuation. On a yield basis, National Fuel Gas has not been this cheap since 2006 and 2008. National Fuel Gas (NYSE: NFG ) is three companies in one: a regulated gas utility with midstream assets and an exploration and production company with assets in California and the Marcellus. With the collapse of the oil and gas markets, share prices have followed suit, falling from a high of $72+ registered in 2013, 2014, and again this year. However, NFG’s base of regulated assets provides a cushion for the obvious volatility of its E&P business. A good business overview is offered on 4-traders.com : “NFG is a diversified energy company, which operates through the following business segments: Utility, Pipeline and Storage, Exploration and Production, Energy Marketing & Gathering. The Utility segment through National Fuel Gas Distribution Corp. is engaged in selling and providing natural gas and transportation services to customers through a local distribution system located in western New York and northwestern Pennsylvania. The utility segments services 775,000 customers. The Pipeline and Storage segment through National Fuel Gas Supply Corp. and Empire Pipeline, Inc. is engaged in providing interstate natural gas transportation and storage services for affiliated and non-affiliated companies. The Exploration and Production segment through Seneca Resources Corp. and Seneca Western Minerals Corp. is engaged in the exploration, development and purchase of natural gas and oil reserves in California and in the Appalachian region of the U.S. The Energy Marketing segment through National Fuel Resources, Inc. is engaged in marketing of natural gas to industrial, wholesale, commercial, public authority and residential customers in western and central New York and northwestern Pennsylvania. The Gathering segment through its subsidiary National Fuel Gas Midstream Corp. which builds owns and operates natural gas processing and pipeline gathering facilities in the Appalachian region. National Fuel Gas was founded on December 8, 1902 and is headquartered in Williamsville, NY.” It seems not many analysts like NFG as demonstrated by both a lack of research coverage and a low consensus timeliness rating. There were 12 analysts covering NFG in May 2014, but that number has shrunk to 7, of which four rate NFG as a Hold, two as a Buy, and one as a Strong Buy. Keep in mind, in the world of analyst-speak, a Hold usually and loosely translates to Avoid. At the heart of this dislike is the large write-off NFG took in its recent quarterly reporting . GAAP procedures call for a redetermination of oil and gas reserves every quarter, and in keeping with this process, NFG has taken $409 million write-down over the past 9 months. This creates a GAAP loss of -$2.24 a share. However, the operating results were not nearly as bad with 9-month operating results declining from $2.82 last year to $2.58. Below is a table comparing operating results per share for the first 9 months of FY2015 vs. same time last year. Source: National Fuel Gas press release, Guiding Mast Investments As shown, operating earnings are down “only” -$0.24 a share, or about 9%. However, share prices have declined by 25% this year. NFG has not been this cheap on a yield basis since 2006 and 2008, and 2006 and 2011 on a PE basis. Below is a 20-year FAST Graph chart indicating a more reasonable PE and dividend yield in line with its history. Prior to 2006, NFG did not have as extensive an E&P footprint, and traded primarily with a regulated gas utility matrix. (click to enlarge) Management announced its earnings per share guidance for FY2015 of $2.90 to $3.00, up from previous guidance of $2.75 to $2.90. Guidance was also given for FY2016 of $3.00 to $3.30. Over the years, NFG has generated acceptable and reliable returns on invested capital, with a current 3-year average of 8.75%. Below is a chart, also from fastgraph.com, of 20-year history of ROIC. (click to enlarge) National Fuel Gas is the second largest landholder in the Marcellus shale, controlling over 800,000 acres, with 75% fee-owned. For example, below is a slide from the most recent investor presentation showing the location of the fee-owned 720,000 acres out of 790,000 acres controlled in Pennsylvania. Morningstar believes NFG has a 10-year footprint of over 1500 drilling locations, based on its current drilling schedule. (click to enlarge) NFG offers one of the lowest valuation of its Marcellus acreage compared to its peers. Below is a table of various net acres ownership, current enterprise value, and the number of acres owned for each million dollars of EV. Source: Guiding Mast Investments Although natural gas production has expanded from 30 MMcf in 2010 to 142 MMcf in 2014, NFG continues to expand its reserves by a factor of 3 to 5 times production levels. There is no reason to believe this trend won’t continue. Morningstar forecasts natural gas production will increase 74% between 2014 and 2019. Oil production in California has not been fully replaced, and reserves have declined 15% over the previous 5 years. In the current era of low prices, company-wide production growth has slowed to just 5% for the first 9 months of 2015 over 2014. National Fuel Gas is expanding its midstream assets of pipelines, storage facilities, and gathering. Over the next few years, transportation capacity will increase from a current 1 bcf/d to over 1.6 bcf/d. This expansion should continue to translate into higher earnings per share. Fund manager Mario Gabelli controls 10% of NFG shares. Last fall and spring, Gabelli pushed for a financial re-engineering of the company by spinning off the utility segment. Management resisted, and Gabelli called for a proxy vote on the issue, but he lost. It is interesting that according to Gabelli’s latest fund notes, NFG is still looking at some type of restructuring, but management is mum on the issue. As NFG continues to gain critical mass by expanding its midstream assets of pipelines and gathering systems, some type of financial restructuring seems inevitable. Morningstar’s even-handed analysis summary is: “Bulls say: National Fuel offers years of development potential with a reasonable margin of safety. We estimate the firm wide break-even index price to be approximately $2.45 per thousand cubic feet. This company has an impressive record of 112 consecutive years of dividend payments, and its 44 consecutive years of dividend increases should appeal to income investors. Midstream infrastructure has lagged production growth in the Appalachian region for several years, leaving NFG’s midstream businesses well positioned to capture incremental transport volumes from Marcellus producers. Bears Say: North American natural gas fundamentals could remain weak for an extended period of time. NFG will remain leveraged to this market for several years while developing its Marcellus acreage. We anticipate that National Fuel Gas will outspend cash flow in each year of our forecast, which could be detrimental to its development aspirations in the event of declining commodity prices. As its higher-risk E&P business continues to grow at a feverish pace, NFG will become less appealing to traditional income investors on the whole, as predictability of future cash flows becomes less certain.” A year ago, I penned a bullish article on NFG when it was trading at $74, and I apologize to those who took my advice at that time. I still believe in the value National Fuel Gas offers in its combined assets of a gas utility with an expanding footprint of natural gas infrastructure and an oil/gas E&P. Management announced the probability of additional reserve valuation adjustments over the next two quarters and this has weighted on share prices. Longer-term thinkers should have this value play on their radar screen. Author’s Note: Please review disclosure in Author’s profile. Disclosure: I am/we are long NFG. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

What Will Happen To Utility Stocks If The Fed Raises Rates?

Summary Relative to the yield on the 10-year Treasury, utilities actually look cheap today. Based on earnings, however, they look expensive. The decline in utility prices so far this year is likely the market preparing for a rate increase. If rates do go up, the worst of the damage has likely already been done; and there won’t be a large amount of additional downside. Utilities are often thought of as a “bond substitute”. They have fairly steady earnings and usually have regulatory support to keep them healthy. Investors often think of utility dividends as a revenue source comparable to a bond’s interest payment. Ever since 2008’s financial crisis, utility valuations have been influenced by the artificially low interest rate environment the Fed created. Since the returns available from bonds have been so terrible, investors have naturally moved to utility stocks as a way to increase their income. As the Fed discusses the possibility of higher rates, investors should think about the implications for their utility holdings. You can really see how interest rates have impacted utility stocks (as measured by the Philadelphia Utility Index (UTY) since 2014 in the following chart. Chart 1 (click to enlarge) Source: FactSet In 2014, while interest rates were falling, all stocks were basically rising (as shown by the S&P 500), but the utilities seemed to be receiving an added boost. Utilities peaked early this year, and since then, as Treasury yields have risen, they have taken a fall much greater than the rest of the market. A large amount of the utility drop is likely from investors anticipating a Fed rate increase and trying to get out before a big fall. Expanding this chart to the turn of the century provides additional observations. Chart 2 (click to enlarge) Source: FactSet First off, you can see that utility dividend yields were lower than the 10-year treasury essentially until late 2002. At that point Enron, the California Electricity Crisis, and unwise investments by many players in the industry, finally took its toll, and utility values crashed. The yield on the 10-year treasury was actually falling because of the recession, but utilities performed terribly even with their “safe haven” status. Then over the next few years, as 10-year Treasury rates rose, utilities actually performed well. Utility dividend yields again were below 10-year Treasury until the 2008 financial crisis. The next thing to look at is the rise in the 10-year rate in 2013. There was a sizable initial drop when interest rates bounced off their lows, but the UTY stabilized before the upward move in rates was complete. Also, UTY components Exelon (NYSE: EXC ) and FirstEnergy (NYSE: FE ) were going through dividend cuts at this time, which may have had a bigger impact on the group’s underperformance than the rise of the 10-year. The next chart shows the ratio of the UTY’s dividend yield to the 10-year Treasury. Since the turn of the century, utility yields have been about 1.2x the 10-year Treasury. Today’s ratio is about 1.9x, which is more than one standard deviation above the average over the past fifteen years. Chart 3 (click to enlarge) Source: FactSet The above chart basically says that utilities are cheap today relative to the 10-year Treasury. You could also argue that the historical average ratio between utility yields and the 10-year is actually artificially high because of industry issues early in the century, making today’s ratio look even further cheaper compared to the “true” average. An alternative way to look at this data is to take the spread between utility dividend yields and the 10-year. This still basically leads to the same conclusion that utilities are cheap against Treasuries on a yield basis. Chart 4 (click to enlarge) Source: FactSet So if we just limited the analysis to the impact of interest rates, utility investors wouldn’t have much to worry about. Treasury rates are still so low that there will be plenty of investors looking for a way to get higher income with relative safety. Utility yields have such a cushion that as 10-year rates increase, the spread would likely just shrink from the higher Treasuries. If utility yields were to increase, it would just keep spreads at today’s extreme levels. Of course utilities trade on more than just dividends, and another big driver for valuations is earnings. Chart 5 (click to enlarge) Source: FactSet On this basis things don’t look as good for the utility group, but it isn’t a disaster waiting to happen. P/E ratios have come in a lot since they reached their peak at 18x earlier this year, but the current utility P/E of 14.8x is still above its 14.1x average over the last 15 years. If you look at the middle of the last decade, Treasury yields were 200-300bp greater than they are today, and utility P/E ratios were equal to or greater than today’s levels. So there is precedent for earnings valuations to be at today’s levels in an interest rate environment higher than today’s. This chart seems to imply that the drop in utilities this year has just been a preemptive move by the market, and if a Fed rate increase leads to higher interest rates, utilities have already made the majority of their adjustment. The post-Enron period was mentioned earlier in this article, and that is an event that could have artificially skewed the average P/E of the group below its “true” level. Of course, other unique things have happened in the past that could artificially move the average higher. For example, in the time period right before the Financial crisis, competitive power generation had a very positive outlook. It looked like these assets were only going to rise in value. Shale gas did a number on that prediction, but you could argue that the unique situation inflated the historical group average. (And maybe utilities with competitive assets are entering another period with increasing values. See here for more on that possibility.) Since there are reasons to adjust the average utility P/E up or down to get a “true” number, this article just uses the 14.1x based on the historic values. Another thing to note from chart 5 is that during the rising rate period of 2003-2004, when utilities made a substantial upward run, P/E ratios started much lower than today’s levels. This should wipe out any hope that a rise in rates today would come with an increase in utility stocks similar to 2003-2004. That was really a unique situation that doesn’t currently apply. This year’s move from an 18x P/E to a 14.8x P/E means about an 18% drop in utility stocks. If the P/E were to fall to the 14.1x historic average, this would require a further drop of 4.7%. If the group were to really get hit hard, and P/E ratios went to 13x, then the group would have to drop 12% from today’s level. If utility P/E ratios started going much lower, you would expect value investors to start moving into the space and prevent a freefall. Of course, when thinking of P/E ratios we also need to think about how the group compares to the market in general. The following chart shows the P/E of utilities compared to the P/E of the S&P 500 over time. Chart 6 (click to enlarge) Source: FactSet Based on this chart we again have a situation where utilities are trading a little rich compared to historical averages, but not outrageously so. Treasury yields have been more than 200bp higher than today’s level with utility P/E ratios compared to the S&P even higher than today. There could be some downward pressure on utilities based on this metric, especially if P/E ratios in the S&P 500 contract, but there is no reason to think things will go back to the way they were at the turn of the century. One last area that will be mentioned in this note is the impact of higher rates on utility earnings. Regulators set utility rates based on an allowed return on equity. As interest rates have been falling, these allowed ROEs have been falling as well. Chart 7 (click to enlarge) Source: SNL A Fed increase in rates should slow down this drop in utility ROEs, and help support utility earnings in the future. So a rate increase is not all bad news for utility investors. Conclusion While a rise in interest rates is not a good thing for owners of utility stocks, a tightening by the Fed in the near future should not lead to a disaster in these names. Right now it seems that low interest rates have increased demand for utilities by attracting investors looking for yield. As these investors have come into the space they have driven up P/E ratios in the sector, and investors focused on this valuation metric have likely stayed away. As rates rise, the balance between these two forces should gradually shift. But rates are starting at such a low level that utility yields will still be attractive to people looking to juice up the income in their portfolio, so there shouldn’t be a mad rush out from dividend-focused investors. The Philadelphia Utility Index has already fallen almost 18% off of its peak earlier this year. Utility P/E valuations were extremely high at that time, and it is likely the drop was in anticipation of interest rates falling later this year. Utilities would have to fall about 5% to bring their P/E back to this century’s average of about 14.1x, and they would only have to fall 12% to get down to 13x. If valuations start reaching these lower levels, then value investors would likely start moving back into utilities. The other thing to remember is that a rate increase is not all bad news for utilities. Higher rates should be beneficial in utility rate cases, allowing them to earn higher returns. So, even with a Fed increase, interest rates are likely to remain low and income investors will still want to own utilities for the added income. If too many income-driven investors leave and utilities go down by more than 12%, earnings valuations should start to look cheap, and it would put a floor under these names. Also, higher rates should help utilities in their rate cases, benefiting future earnings. So while you should expect a decline from the utility group if rates go up, it shouldn’t be a giant one. Housekeeping Items I am making the assumption that an increase in rates by the Fed will lead to a general increase in all Treasury rates. In theory, there are scenarios where you could say a rate increase at the Fed might lead to lower rates elsewhere in the financial world. (Maybe the Fed’s increase signals increased confidence in America’s economy, and money floods into US Treasuries lowering rates.) I’m not going to get in any type of complicated repercussions from a Fed increase. This analysis makes the simple assumption that if the Fed increases rates, Treasury rates will also increase. Historic utility performance was based on the Philadelphia Utility Index. The current components of the index are: AES Corp. (NYSE: AES ), Ameren (NYSE: AEE ), American Electric Power (NYSE: AEP ), CenterPoint Energy (NYSE: CNP ), Consolidated Edison (NYSE: ED ), Covanta (NYSE: CVA ), Dominion Resources (NYSE: D ), DTE Energy (NYSE: DTE ), Duke Energy (NYSE: DUK ), Edison International (NYSE: EIX ), El Paso Electric (NYSE: EE ), Entergy (NYSE: ETR ), Eversource Energy (NYSE: ES ), Exelon, FirstEnergy, NextEra Energy (NYSE: NEE ), PG&E (NYSE: PCG ), Public Service Enterprise Group (NYSE: PEG ), Sourthern Company (NYSE: SO ), Xcel Energy (NYSE: XEL ). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

SCZ: Do You Need Some International Small-Cap Companies For Your Portfolio?

Summary SCZ has over 1500 holdings across the globe which appear to give it great internal diversification. The term “across the globe” might be overly optimistic since over 50% of the holdings are in two locations. The weakness for SCZ is that SCHC and VSS both offer materially lower expense ratios and more holdings for enhanced diversification. Since SCZ has a beta higher than 1, it has to be expected to generate fairly substantial returns. On top of the high beta raising required returns, SCZ also needs to be able to beat out SCHC and VSS to justify the high expense ratio. One of the funds I analyzed for exposure to international markets is the iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. By reducing risk at the portfolio level investors can get their best shot at producing alpha. Expense Ratio The expense ratio for SCZ is .40% for both gross and net expense ratio. That may not seem bad for international small-cap equity and an ETF with 1555 holdings. However, investors should be aware that they also have options in the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) and the Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA: VSS ). SCHC has an expense ratio of .18% and 1645 holdings. VSS has an expense ratio of .19% and 3352 holdings. It should be no surprise that I see SCHC and VSS as the strong front runners for this kind of portfolio exposure. In the interest of full disclosure, while I don’t have a position in any of these ETFs yet, I do have a pending limit-buy order on SCHC. That order is quite a ways under the current share prices and is only intended to activate if share prices start falling hard again. Geography The geography of the exposure is important in considering international equity options. The chart below demonstrates the exposure for SCZ. Japan and the United Kingdom only represent over 50% of the market capitalization of the holdings in SCZ. I’d like to see more exposure around the globe. This is international and I’m okay with excluding China since I’ve been bearish on their market for months, but I’d like to see a few more continents included. Aside from the concentration being so heavily focused on the top two options, I don’t see any other problems there. Sector Exposures The following chart has the sector exposures within the ETF: I’m not seeing this as a huge problem, but it seems interesting that the exposure is so heavily focused on a few categories again. If it were reasonably possible, I’d like to see better diversification across the industries as well as across the globe. International ETFs are usually plagued by having fairly high levels of volatility and more diversification within the sectors might reduce that volatility some. On the other hand, when financial markets exhibit significant stress factors, it is common for correlation levels to increase throughout international markets so even more diversification in the holdings might not make a material difference in the volatility. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to high yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully investors will be keeping at least a material portion of their investment portfolio in tax advantaged accounts. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for longer term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. The iShares U.S. Utilities ETF (NYSEARCA: IDU ) is used to create a significant utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard’s Vanguard S&P 500 ETF (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion SCZ is the most volatile investment in the portfolio when viewed in isolation as it has a volatility level of 18.7%. That problem is compounded by the high correlation between SCZ and the S&P 500. The combination leads SCZ to having a beta of 1.06% which is unfavorable. Under modern portfolio theory the only way to get risk adjusted returns on SCZ is for it to be outperforming the S&P 500 over the long run since it is increasing portfolio volatility. Will it outperform the S&P 500? I have no idea. The better question would probably be: “Will it outperform SCHC and VSS?” In that regard, I’m skeptical. It certainly could happen but SCHC and VSS have an advantage from having materially lower expense ratios which allow more of the returns to reach shareholders. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.