A Cautious Approach To NiSource

| About: NiSource Inc. (NI)

Summary

NiSource is a solid company operating within a heavy regulatory environment. It has so far demonstrated an ability to navigate through significant initiatives against coal.

Multiple reasons for outperformance in this security, as well as its peers, are visible which include assertive plans for growth as well as the potential for a takeover.

The market has been in the mood to bid a premium for this story.

Rationale for this Article

The performance by a number of securities in the S&P 500 utility sector since the general stock market meltdown of 2008 has been steadily and notably upwards. Examples can be seen in the charts of Atmos Energy (NYSE:ATO), NiSource (NYSE:NI), Southern Company (NYSE:SO), Xcel Energy (NYSE:XEL), and CMS Energy (NYSE:CMS).

While reasons for said behavior might include lower commodity prices and a safe haven at an uncertain time for the overall market, I have put my thoughts together to better understand NiSource and the market's attitude toward it and its sector. I chose NiSource because I am a longtime resident of Indiana as well as a previous customer of NIPSCO for a number of years.

Background - NiSource

NiSource is a mid-cap utility holding company, since its market cap is less than $10 billion after its divesting of Columbia Pipeline (NYSE:CPGX) in 2015. It is in the business of natural gas delivery, as well as electric power generation and delivery. Its fully regulated subsidiaries serve nearly 4 million customers in seven states.

Several introductory points can be seen on the 2015 10-K report pg. 6. The business of NiSource after its Columbia Pipeline divestiture is about one-third electric and two-thirds gas. Recent warm winters have challenged the gas business revenues of many utilities around the country. About 40% of NiSource revenue from its electric business is from industrial customers, which are largely represented by the steel industry with its own long-term growth challenges.

Still on pg. 6, NiSource owns three coal stations which generate in sum about 2.5 gigawatts. Together with its other natural gas and hydroelectric sources, the company is capable of about 3.3 gigawatts of power generation. In addition, as much as one-third of NiSource customer needs are met by external power purchases via monthly MISO grid auctions. As a tangential point of comparison, Consolidated Edison (NYSE:ED) purchases almost all of its power from the grid.

Background - Regulatory Environment

In the developed world, it can be easy to take residential power and plumbed natural gas for granted. This privilege was not obtained without many decades of intense push and shove between various and powerful concerned parties. The history of our utilities within this country over the last hundred years and more makes for a remarkable story.

There is a lot to think about at both the federal and state level for regulation of our utility companies. Regulation is a major issue which sets these companies apart from other commercial sectors, and the subject deserves some introduction. I will make an effort to summarize this oversized subject, but commenters are welcome to help me out, especially to understand the business environment for NiSource.

The Local Regulatory Environment

According to American Public Power Association statistics, out of 3306 utility entities in the U.S., 189 of these are investor-owned, and provide service to about 65% of all full-service customers. The remainder of these entities are categorized as cooperatives (such as REMC), federal power agencies (such as the TVA), power marketers (i.e. Calpine (NYSE:CPN), Dynegy (NYSE:DYN) and NRG (NYSE:NRG)), or publicly-owned utilities (i.e. our many small municipal utilities).

Indiana has five investor-owned utilities, all of which have been state regulated for decades. Most municipal utilities have withdrawn from state regulation by due process. The rationale for this option is that the town or the other municipal entity already has the public good in mind. See the table below for a summary of regulation status for municipal utilities in Indiana.

Indiana Municipal Utilities

Electric

Natural Gas

Water

IURC Jurisdiction

9

2

26

Withdrawn

67

17

366

TOTAL

76

19

392

Source: Indiana Office of Utility Consumer Counselor

For many years, I lived in a small town with a local municipal electric company, and which charged among the lowest electric rates in the state. One day, I walked over to the courthouse and presented my bill for $6.00. The lady at the counter looked at it, then looked at me, and said: That is a sin!

Whenever a regulated utility company wants to make a change in its rates, upgrade its facilities, etc., its attorneys make a filing in the local state utility court, where a consumer advocate attorney presents counterpoint. These proceedings are in the public record and can be reviewed by anyone. For the state of Indiana, see under here. Petition files attached to individual cases can be instructive in that they illustrate how the utility calculates its costs to support a rate change request.

The Federal Regulatory Environment

In the aftermath of the 1970s oil embargo, the U.S. government determined that unregulated or independent power producers ought to become part of the utility landscape. However, utility deregulation turned out to have pluses and minuses, with one widely publicized point of reference, remembered as the California electricity crisis of 2000-2001.

For a dated but useful primer on the original intent of utility deregulation, see here.

The Edison Electric Institute stock performance Q4'15 report, in its first few pages, indicates that of the 52 shareholder-owned U.S. utility companies with a defined service territory, all but three have more than 50% of assets under state regulation. I view this as a testimony to local regulation supporting lasting pricing power by utilities, and a notable statistic in view of all the effort expended in this country toward deregulation over the past 40 years or so.

Some recent and notable initiatives by the U.S. federal government for electricity regulation and deregulation include the 1978 PURPA act (providing for independent power producers); the 1992 National Energy Policy Act (allowing utilities to sell unregulated wholesale power); the 2005 repeal of the 1935 public utility holding act (allowing non-utility entities to be holding companies); the 2011 blocking by Congress of federal carbon tax legislation; the Dec. 2015 FERC Rule 745 (setting rules for demand response); and the Feb. 2016 blocking, for now, by the Supreme Court of the Clean Energy Plan (which encountered stiff resistance from industry as well as 30 states).

It turns out that nearly half of municipal utilities utilize coal for electric power generation, and were thereby motivated to join in the opposition to the federal clean power plan. In 2016, the Federal Energy Regulatory Commission (FERC) and its five members (with its single member turnover every year) appear to be ending up in line with the White House agenda.

Efforts by the FERC for natural gas deregulation include the 1978 Natural Gas Policy Act (a reason for huge oversupply during the 1980s); the late 1980s FERC Orders 436 and 500 (allowing end users to negotiate with producers and requiring pipeline companies to support this); and the April 1992 FERC Order 636 (further deregulation, which made natural gas one of the most active commodity indices on the NYMEX).

Before leaving this topic, let me mention, in a nod to our environmentalists, that my work for many years was in a heavy industrial district, which was no doubt a significant source of tax base for that city. Across the street from my company was a chemical plant which manufactured among many other products a component within mosquito repellent. Some mornings when we walked the long walk from our carpool parking spot to the office building, the air was filled with powerful fumes similar to automotive radiator fluid. There had to be sympathy for the many nearby residents of the area who had to live in this environment all the time.

Wholesale versus Retail Power Prices

The chart below, found in this document, illustrates the strong correlation between the wholesale price of electricity (for purchase on U.S. grids) and the price of natural gas.

FERC chart

Source: FERC.gov

The "spark spread" (i.e. wholesale revenue from natural gas or coal vs. cost of generation) has a direct effect on the earnings for independent power producers. The spark spread has become relatively low due to the low cost of natural gas and coal. Much of these commodity price savings are passed through to utilities which purchase power from the grid. Therefore, for state-regulated utilities, this situation provides a tailwind, in that these entities are frequently guaranteed coverage of their costs plus a profit by state regulatory commissions.

See here for how average residential prices for electricity have risen over the past 15 years. I can follow this trend at the micro level by comparing my own utility bill with its long list of "riders" with the summary list of rate cases from the state regulatory website.

I suggest that a precession by utilities to the regulated model has gained momentum with some assistance from the discovery of shale oil and gas. The result of wholesale vs. retail power price economics is that independent power producers have a tougher time making money than regulated utilities. (However, I would also suggest that the independent producer Calpine for one is too much of a wheeler-dealer to take this state of affairs without a wise reply.)

Response of NiSource to This Environment

The longstanding CEO of NiSource from the 1930s through the 1970s was Dean Mitchell. His story is one of providing leadership during his decades of management to a utility industry which he first encountered in an undeveloped state.

The California crisis of 2000-2001 brought a real shock to the utility sector, and the memory has not yet become ancient history.

During the financial crisis of 2008-2009, many utility companies bought up a large amount of their own stock at bargain prices. Since that time, assisted by traditionally oversized dividends, low interest rates, low commodity prices, and other Federal Reserve initiatives, securities for electric and gas utilities have advanced steadily, though not as rapidly as some other sectors.

In 2011, NiSource settled with the Environmental Protection Agency over emissions from its coal stations. While the EPA has quite a list of such settlements with numerous utility companies, NiSource was allowed to keep the three coal stations it wanted to keep at the cost of additional pollution equipment. Some other utilities in the EPA list appear to have encountered harsher sentences. According to the May 2015 company presentation (slide 17), NiSource expected to implement full scrubbing in its coal stations by the end of 2015.

The 2015 NiSource 10-K report pg. 98 indicates that the impact of future regulation (i.e. Utility Mercury and Air Toxics Standards Rule, Clean Power Plan, Cross State Air Pollution Rule) is not yet clear and is under study. There has no doubt been considerable strategizing under way across the utility sector in an attempt to compensate for increasingly rigorous requirements for emissions by the EPA. It would seem that NiSource will have to revisit its coal plant strategy in due time, but a lot can happen with elections, balance of power among the branches of government, court case delays, and so forth. Unfortunately, the same can't be said for our coal producing companies.

I would observe that despite its continued operation of its legacy coal stations, NiSource is somehow not a target for environmental activists, at least for the time being. By comparison, witness the root hog, tooth and nail fights experienced by several of our other utility companies against broad opposition over old coal and nuclear power plants, rooftop vs. utility solar, large and unwise investments to be paid for by retail customers, and so forth.

The real response by NiSource to the present environment in the last few years shows up in spinning off its pipeline division and undertaking a significant growth initiative in its core business. These issues are considered below.

Balance Sheet Through 2015

The 2015 NiSource 10-K report on pg. 46 reports $54.85/share in book assets and $48.75/share in tangible book assets at the end of 2015, based on 319 million shares of common (pg. 52).

10-K chart A

This is comparable with $46.30/share in total contractual obligations in existence at the end of 2015, which is categorized in the following table (pg. 27). Book value is then $8.50/share, and tangible book value is $2.45/share.

10-K chart B

The 2015 end-of-year debt/shareholder equity (pg. 47) ratio is $14770.1/$3843.5 = 3.84. The number looks to be on the high side, but it takes a lot of dough to run a major utility. The rising share price has been bringing this ratio down over recent months in a vote of confidence to the company.

On 10-K pg. 9, NiSource senior unsecured debt is rated by S&P at BBB+ (stable outlook); Fitch at BBB- (positive outlook); and Moody's at Baa2 (stable outlook), Despite steel industry challenges and recent warm winters, NiSource has been well able to pay its bondholders. While debt had been rising in recent years (10-K pg. 19), a significant amount was offloaded with the Columbia Pipeline divestiture.

The present list of bonds and notes is found on 10-K pg. 50, which adds up to just under $6 billion for debt due after one year, and carries interest rates ranging from 3.85% to 7.57% for long-term debt instruments. According to the May 2015 company presentation (slide 30), the weighted average for this debt is about 5.8% over about 14 years. No doubt NiSource has been traditionally regarded as a steady and valued customer by its creditors. The plan for disposing of this debt appears to be well thought out, given the steady payback of this debt per year over the coming years, as seen in the table above.

Strategic Capex and Balance Sheet Going Forward

(Refer to the May 2015 company presentation)

The above being said, NiSource has very significant capex plans going forward. The May 2015 company presentation calls for $30 billion over 20+ years, which obviously will require a significant amount of new money. I would expect the NiSource debt covenants (10-K pg. 91) to maintain limits on proportions for stock issuance and new debt.

Presentation slide

Utility industry analysts and market players appear to be focused on the forecasted 4% to 6% annual earnings and dividend growth, and do not appear at all to be put off by the funding needs for this effort. This is a notable departure in my mind from many cases across the S&P 500 over the last few years at least when a company announces a debt-financed acquisition, and the market expresses immediate disapproval if not dismay.

I would expect that the increased debt going forward is justified by the promise of growth in an ultra low interest rate environment with the umbrella of regulation to guarantee a reasonable profit.

The above picture seems reminiscent to me of how our master limited partnerships have traditionally grown in order to stay relevant to the investment community.

Earnings and Funds from Operation

FastGraphs chart

Courtesy: FastGraphs.

The above chart indicates earnings for NiSource over the last 20 years compared to its stock price (black) and average valuation (NASDAQ:BLUE). The spinoff of Columbia Pipeline in the summer of 2015 makes comparisons between 2013-2014-2015 more difficult. The FastGraphs chart concept recognizes that the balance sheet and other intangibles can significantly color the overall investment picture; however, a takeaway from the chart is that the pre-spinoff as well as post-spinoff stock price is on the high side.

From the cash flow table in 10-K pg. 48, and using 319-316-314 million shares at end of year for 2015-2014-2013 (10-K pg. 52), cash flow per share is $4.6/share in 2015; $4.2/share in 2014; and $4.6/share in 2013.

Dividends per share (10-K pg. 19) are 0.83, 1.02, and 0.98 for 2015-2014-2013. Basic or diluted earnings per share (10-K pg. 44) are 0.90, 1.67, and 1.70 for 2015-2014-2013. Forward guidance for the 2016 payout ratio is projected in the NiSource May 2015 presentation at 0.62/1.00 to 1.10 = 60% to 70%. My rule of thumb threshold for a safe dividend is payout ratio <70%.

From the previous section (Strategic Capex and Balance Sheet Going Forward), I would expect the capex to cash flow ratio for the next three to five years to be more than 70%, which would exceed a separate rule of thumb threshold for heavy borrowing needs.

Ownership Profile

According to exchange records, out of 321 million NiSource shares outstanding, about 83% of these shares are held by 443 financial institutions of various types. The short interest is at less than four days to cover. Insider sales have occurred over the past several months. It has not been a money-making trade to short NiSource or some of its peers for a long time.

Mood of the Market

In 1Q'16, the market seems to have placed a premium on safety, bidding up the securities of companies with solid balance sheets and solid dividend payout ratios. This can be seen in the stock charts for other companies such as: VZ and T; O; TSN; KO; and so forth.

The timing of the Columbia Pipeline divestiture seems to have occurred at an advantageous time for NiSource, i.e. during 2015 when the MLP sector faced significant concerns due to low oil and gas commodity prices; concerns over counterparty risk; and a departure by many investors from the junk bond sector. However, the recent acquisition announcement for Columbia Pipeline by TransCanada (NYSE:TRP) is a testimony to the value of the pipeline entity.

It may appear that the wholesale price of natural gas will stay low for years to come, as a tailwind for the regulated utility business model. I do find worthwhile this link from BTU Analytics, which proposes U.S. demand to become greater than supply by 2018. Although the wholesale price of natural gas is theoretically passed through to the consumer, I would not put it beyond the stock market to take such commodity price behavior as an excuse for a correction in the gas utility sector.

The real reason for the rapid rise of the NiSource stock chart has been suggested to be in anticipation as a takeover target, in that the natural gas regulatory environment is more favorable than the electricity regulatory environment, with the result of better growth and income. One such article is here.

Apart from a long-term safe growth story and/or a potential takeover scenario, many utilities have historically been viewed as relatively safe places to park cash which pay better than the local bank. I can understand domestic or foreign financial institutions bidding up this U.S. sector as an alternative to U.S. Treasuries in our long term ultra low interest rate environment.

Conclusion

The utility sector at present seems overbid and due for at least a moderate pullback. The chart has entered a faster pace of increase since the beginning of 2016.

Far be it from me to stand in the way of a market that has decided to bid up a sector seemingly without bounds, reminiscent of 30-year treasuries, but it also isn't my style to try to participate. I hold a small long dated put position, and may add to it if a clear top becomes visible. I will not pursue but can understand the case for anticipating a better entry point within its trading channel, with intent to scale in and DRIP an investment in this active company as opportunity permits, with standard put insurance as an additional consideration.

Disclosure: I am/we are long LONG-DATED PUTS.

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.

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