By Mark Barnett
The pure-play U.S. gas utilities we cover have dramatically outperformed the S&P 500 and their U.S. electric and diversified utilities peers so far in 2014. The five - AGL Resources (NYSE:GAS), Atmos Energy (NYSE:ATO), New Jersey Resources (NYSE:NJR), Piedmont Natural Gas (NYSE:PNY), and WGL Holdings (NYSE:WGL) - have been contesting for the dubious designation of the most overvalued utility in our coverage universe. Valuations on these sleepy utilities aren't sleepy at all, and that should concern shareholders.
Gas utilities are no longer exactly slow-growing, conservative, dividend-paying grandma stocks. Growing exposure to nonregulated businesses and increased pipeline safety concerns following lethal accidents make these firms' results more volatile and more growth-oriented than they have been in years. In addition, gas utilities could benefit from the ever-increasing forecasts for midstream investment needs driven by the shale gas boom. With utilities' 3.8% dividend yields still historically attractive relative to 10-year U.S. Treasury rates, this combination of yield and growth has been an attractive investment proposition. But all key valuation metrics still point to a lot of hot air in these stocks.
Investors Beware: Already-High Gas Utilities' Valuations Continue to Expand
Regulatory backstops for cash flows and returns have long given gas utilities the reputation as safe and stable investments. More recently, this has made them the darling of the market in a zero-interest-rate-policy world. We expected these utilities to rebound strongly from the panic lows, but their performance during the past year has gone beyond our expectations. The five pure-play gas utilities we cover together have averaged a 13% return year to date, the same as the Morningstar Utilities Index but well ahead of the 7% return for the S&P 500. Excluding laggard WGL Holdings, the four pure-play gas utilities in our coverage universe have returned 16%.
The thirst for yield has led to significant multiple expansion across the sector that in our view is not sustainable long-term, as we believe in the long-term reversion to mean and the dynamic nature of fiscal and monetary policy and capital markets. We prefer a valuation outlook that captures normalized, midcycle market conditions, cash flows, and required rates of return. We also think income investors continue to flock to these names despite the fact that some of them have undergone fundamental changes in their underlying business models, relying heavily on moatless tax-advantaged investing.
Valuations across numerous metrics - price/earnings, price/book value, enterprise value/EBITDA - have expanded well above five-year post-panic averages, another gut check to back up our discounted cash flow valuations.
Gas Utilities Are Overpriced Even as Simple Dividend Machines
In addition to our DCF-based valuations, we built dividend discount model valuations for each of the five pure-play gas local distribution companies. In the DDM, we gave an equal weight to our base, bull, and bear scenarios for long-term dividend growth. This analysis supports our DCF-based valuations, providing another signal that gas utilities' valuations - and utilities sector valuations in general - have overreached.
These rich valuations could persist despite the disconnect from cash flows and returns. The yield spread between the utilities sector dividend yield and 10-year U.S. Treasury yields has widened again this year after contracting 189 basis points between the widest point at 276 basis points in June 2012 and the end of 2013. The spread is up 30 basis points this year as utility sector dividend yields hold steady near 3.8% and Treasury yields have fallen to 2.6% from 3.0% at the beginning of the year.
We think this is a key factor driving utilities' swelling valuations this year. This might make sense in the short run, but we think it could lead to long-term capital losses when Treasury yields rise. We don't pretend that we can time such a policy-driven dynamic, but neither should an investor.
Gas Utilities' Moat Trends Improving, but Nonutility Earnings Also Growing
While the yield spread is in the driver's seat, some fundamental tailwinds are helping strengthen gas utilities' economic moats and likely investor enthusiasm. AGL Resources and New Jersey Resources are set to turn in abnormally strong performances from an extremely favorable winter heating season and wacky gas supply fundamentals. We don't think the market should treat this year's earnings as a proxy for the companies' long-term earnings power despite the impressive amounts of cash they will collect. However, the performance does show some of the optionality these utilities have with their nonregulated businesses.
Fundamentally, gas utility regulation is moving in the right direction to support these firms' narrow Morningstar Economic Moat Ratings. More regulators are adopting rider-based rates or rates that adjust on a set schedule. This should help utilities be comfortable that their multi-billion-dollar investments in pipelines will produce earnings and cash flows more quickly, helping to support earned returns on equity. Increasing spending driven by safety concerns drives rate base growth and future earnings and cash flows, and the quick recovery supports returns. Low gas supply costs are helping hide the increasing costs of the system to end users, providing headroom for rate increases. This benefit could disappear if natural gas prices rise and regulators become more sensitive to utilities' earnings growth. Altogether, though, these items help utilities avoid formal rate case filings that often lead to lower allowed returns and disallowed expenses, especially in today's interest rate environment. While this is helpful in the short term, the fact that most utilities are so eager to avoid rate cases should remind investors of the give-and-take nature of regulation.
On the other side, allowed returns on equity have been falling. We believe there is fundamental support outside of interest rate considerations for lower allowed ROEs as returns become more consistent - supported by accelerated recovery - since realized returns should compensate equity investors for the investment risk they bear. Falling allowed returns work directly against growth from capital investments.
Could M&A Speculation Be Helping to Fuel the Market?
Given the gas utilities' small market caps relative to many of their electric and diversified utility peers' and the improving regulation for gas pipeline investment, larger firms might be looking to swallow up the minnows. We heard some chatter around M&A during our meetings at the American Gas Association Financial Forum in May, but several management teams shrugged off M&A discussion, saying it would be difficult to make any deal accretive given industry valuations, even using their own richly valued stock.
However, the industry is small and relatively fragmented, and we've already seen a couple of gas LDC deals thus far in 2014. In March, UIL Holdings announced a $1.86 billion offer for Philadelphia Gas Works, the largest municipal gas utility in the United States. TECO Energy is still working through regulatory approvals for its $950 million acquisition of New Mexico Gas announced in May 2013. The deal price implies TECO will pay 1.8 times New Mexico Gas' $520 million estimated 2012 rate base and 30 times New Mexico Gas' $23.2 million trailing 12-month earnings as of January 2013. Fortis also is working through regulatory approvals for its late 2013 $4.3 billion offer for UNS Energy, an electric and gas utility in Arizona. Fortis is offering $60.25 per share, a 31% premium to UNS Energy's preannouncement closing price. The price implies a 2.3 times price/book multiple and 1.5 times UNS' consolidated rate base.
We caution investors looking for an M&A tailwind that utility deals never come cheap, and synergies are often handed back to ratepayers for years following a deal. Shares can underperform for long periods, and in our view most certainly would if any cash component were included in a deal, as cash returns from the purchase would be very low. We don't rule out the possibility, but see it is a risk to AGL's valuation as a serial acquirer and a potential upside for New Jersey Resources and Piedmont Natural Gas as utilities with relatively simple jurisdictions. We don't view either of these management teams as eager sellers.