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Atmos: A World-Class Business At A Too-High Price

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About: Atmos Energy Corporation (ATO)
by: Josh Arnold
Josh Arnold
Long/short equity
Summary

Atmos has rallied hard this year.

While I think the business is outstanding, its valuation is untenable, even after a pullback off the highs.

I like Atmos in the mid-$90s or below.

Texas-based natural gas utility Atmos Energy (ATO) has seen its shares rally immensely in the past couple of years. We all know that recent years have seen dividend-focused stocks perform well given that interest rates - and, therefore, alternative investments to dividend stocks - have decreased in terms of attractiveness, meaning that dividend stocks, in general, have been bid up. This has certainly occurred with Atmos, and while I really like the business and the fact that shares are starting to come off their highs, I still think Atmos is substantially overpriced. As such, to my eye, investors should wait for a better entry price.

A stable, growing platform

Certainly, part of the appeal of utilities, in general, is that they tend to have predictable, rising earnings over time. This is, of course, due to the fact that utilities are highly regulated, and while that means they have to ask for pricing increases, it also means that they generally have monopolies in their service areas. This is a highly attractive business model that affords the companies the ability to pay out large portions of their earnings to shareholders, and thus makes them great dividend stocks.

Atmos provides natural gas to more than three million homes and businesses in the southern US. The company's history is over a century long, and it has managed to grow itself into a nearly-$13 billion market capitalization today.

Source: Q4 investor presentation

The company's operations span a wide swath of the southern US with a sizable portion of its customers in Texas, where it is based. In this way, Atmos is a bit more diversified than most smaller utilities that have narrow service areas, adding to the attractiveness of Atmos.

Atmos also has a pipeline and storage business, in addition to the distribution area seen above.

Source: Q4 investor presentation

Atmos has scale in the natural gas distribution business that no other utility can rival. It sports about 70,000 miles of distribution and transmission mains, but as mentioned, it is heavily leveraged to the Texas market. In addition, its pipeline and storage business is over a third of its earnings, derived through five storage facilities and 5,700 miles of intrastate pipeline. The pipeline and storage business has a substantially higher allowed return on equity so that business is quite attractive not only as a diversifier away from natural gas distribution to customers but also because its returns are much higher.

Atmos has posted outstanding growth numbers in the past, with the recently completed fiscal 2019 being the 17th consecutive year of earnings per share growth. That is a track record that very few companies can match, even when accounting for utilities' stable business model; so again, Atmos ticks all the boxes.

Looking forward, Atmos believes it can grow EPS at a rate of 6% to 8% annually through focused, intense capital investments.

Source: Q4 investor presentation

Atmos' rate base was just over $9 billion in fiscal 2019, but it reckons it will see closer to double that amount by fiscal 2024. That's a huge amount of growth but Atmos says it will significantly boost both of its lines of business via $10-11 billion in capital investment in the next five years, with the overwhelming majority of that spent on safety improvements. The company's capital investments also pay back very quickly, with most of it being recovered in less than six months. All told, Atmos sees $5.90 to $6.30 in EPS for fiscal 2024, representing strong growth over last fiscal year's $4.35.

As if that wasn't enough, Atmos is also an exemplary dividend payer, having increased its per share dividend for a staggering 36 consecutive years after accounting for mergers and acquisitions.

Source: Q4 investor presentation

This is a big part of the appeal of Atmos stock for yield-starved investors who are wary of lending their money to sovereigns for little or no interest. The company's stable business model, reliable cash flows, and willingness and ability to perpetually raise its dividend make it very attractive.

However, there's a problem

The stock has rallied hard, as I mentioned above, and that has created a situation where I find the valuation to be untenable. Below, I've charted the stock's historical PE ratios and yields in order to give us some context on the current situation.

Source: Author's chart using company data

Today's PE ratio is 23 based upon estimates from analysts, assuming $4.65 in EPS for this fiscal year. That puts the stock at a staggering 23 times earnings, and as you can see, that's nearly the most expensive valuation shares have ever had on a normalized basis. The stock was slightly more expensive a few weeks ago at the highs, but for annual PE ratios, Atmos has never seen valuations like this.

Its ten-year average PE ratio is 17 times earnings and the most recent five years saw an average of 19.6. In other words, there is simply no way to justify a valuation anything like what we're seeing today given that Atmos' earnings growth hasn't accelerated and isn't expected to in the next five years according to the guidance discussed above.

The yield is telling the same story as Atmos began the past decade with a yield well in excess of 5%. However, that has dwindled to just over 2%, meaning that what was once a very strong income stock is basically sporting a market average yield at this point. On both of these valuation measures, then, it seems Atmos is far too expensive.

Finally, this company loves to issue common stock to fund growth and other things, as we can see below.

Source: TIKR.com

The company's share count is more than double what it was in 2004 and has steadily climbed higher over time. While Atmos isn't issuing catastrophic numbers of shares, it is a steady headwind to EPS each year as the company's earnings are spread over more and more shares on an annual basis. This is another reason why I think investors should be more cautious on Atmos than they are today.

The bottom line

Atmos is a fantastic business, and there is simply no other way to look at it. The company sports a captive consumer base with built-in revenue increases, it produces reliable and ample cash flows, and it has increased its dividend more than most companies in the world. However, all of this goodness comes at a massive price, and despite the fact that shares have sold off of late, I still think Atmos has further to go before it is a buy.

I see fair value around 20 times earnings, which would equate to a share price of $93 on this year's EPS of $4.65. That's another ~$14 lower than where shares trade today, which sounds like a lot but keep in mind, shares traded below that at the end of 2018.

As great as this company is, the stock has rallied essentially unabated for most of this year, and it is very expensive as a result. Atmos is a buy, but only under in the mid-$90s or below.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.