Increased Confidence in Atmos Energy’s Long-Term Investment Plan; Increasing Fair Value Estimate
Increased Confidence in Atmos Energy’s Long-Term Investment Plan; Increasing Fair Value Estimate
Analyst Note| by Charles FishmanUpdated Nov 20, 2020
We are increasing our fair value estimate to $108 per share from $104 due in large part to our increased confidence in Atmos Energy’s long-term investment plan. Atmos recently advanced its five-year capital expenditure plan, now ending in 2025, to a range of $11 billion-12 billion from the previous range of $10 billion-11 billion.
We think Atmos will exceed the top end of its investment target, like it consistently has over the past several years. We estimate total capital expenditures of $12.3 billion. Our estimated capital expenditures are 68% higher than the amount Atmos invested in the five years ended September 2020. We expect over 85% of this investment to be in pipeline replacement and other safety-related projects, which we have a high level of confidence will receive the support of regulators.
Our investment assumption increased EPS growth by 50 basis points, to a five-year compound annual growth rate of 8%. Our estimated EPS growth is now at the top end of management’s 6%-8% target. EPS growth has averaged 8.4% for the five-year period ended in September 2020 and that included a growth rate of only 1.7% in 2018, the year of the tragic Dallas gas explosion.
The increase in our fair value estimate was due in large part to our assumption of higher EPS growth, but also benefitted from time-value appreciation since our last update. In addition, recent financings have pushed the average interest rate on Atmos’ $5 billion long-term debt down to 3.9% with a weighted average maturity of 19 years, also benefitting our fair value estimate.
Investor concern over the future of natural gas for building space and water heating has pressured valuation of natural gas utilities. However, we believe electrification of building space and water heating has significant technical and economic obstacles, and the market’s misperception of the future of natural gas results in an attractive share price for the largest pure-play natural gas utility in the country.
Business Strategy and Outlook| by Charles FishmanUpdated Nov 20, 2020
Favorable regulatory frameworks and large infrastructure investment opportunities have driven strong earnings growth and steady dividend increases for Atmos Energy. We expect over $12 billion of capital expenditures during the next five years, above the top end of management's $11 billion-12 billion target ending in 2025. Over 85% of the total investment is for safety and reliability, replacing bare steel, cast iron, and vintage plastic pipes. We expect this level of investment to receive regulatory support and continue well beyond this decade.
We estimate capital expenditures of $2.1 billion in fiscal 2021 increasing to over $2.8 billion by 2025, representing over four times Atmos' depreciation and amortization expense. This should drive more than 11% average annual rate base growth during this period. We estimate earnings per share will grow more slowly than rate base, about 8% annually, due to the dilutive impact of almost $3 billion of equity issued over this period as the company maintains a strong balance sheet.
Atmos' board of directors was somewhat stingy with dividend increases in the past, but this changed five years ago. It increased the dividend more than 5% in 2014 and 2015, and bumped it 7%-9.5% over the next five years. In November 2020, the board raised the dividend 8.7% to $2.50 per share annualized.
Management has targeted a conservative 50% dividend payout ratio. With our earnings growth estimate, we believe Atmos' annual dividend increases have a good chance of being near the top end of management's target of 6%-8% over the next five years.
Most of Atmos' operations are ultimately regulated by the Texas Railroad Commission, a regulatory body that has historically been constructive to shareholders. We expect this constructive regulatory framework to continue. Given this and the investment and earnings growth visibility, we have a high level of confidence that the company's string of 37 consecutive years of dividend increases will continue through this decade and beyond.
Economic Moat| by Charles FishmanUpdated Nov 20, 2020
Atmos' narrow moat modestly widened following the 2017 sale of the no-moat energy marketing business. Following the transaction, Atmos' remaining businesses are now almost 100% regulated. Although regulated utilities' service territory monopolies and efficient scale dynamics remain, we are giving more consideration to utilities' ability to achieve and sustain a positive spread between earned returns on capital and costs of capital in the long run based on the fundamentals of its regulatory environment, operating history, and forecast shareholder returns.
Atmos' investment program is focused almost entirely on its regulated natural gas distribution and transmission businesses. The company is concentrating its growth expenditures in jurisdictions with favorable regulatory frameworks where utility rates provide a return of and on investment in six months or less. We don't foresee any changes to the constructive regulatory mechanisms that Atmos currently enjoys, given its recent history, particularly in Texas. This gives us confidence that Atmos can earn more than its cost of capital for at least the next 10 years, supporting our narrow moat rating.
Service territory monopolies and efficient scale advantages are the primary moat sources for regulated utilities such as Atmos. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and of the capital they invest to build, operate, and maintain their distribution networks. In exchange for regulated utilities’ service territory monopolies, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.
This implicit contract between regulators and capital providers should, on balance, allow regulated utilities like Atmos to achieve at least their costs of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing.
Fair Value and Profit Drivers| by Charles FishmanUpdated Nov 20, 2020
We increased our fair value estimate to $108 per share from $104 due in large part to our increased confidence in Atmos' long-term investment plan. Atmos recently advanced its five-year capital expenditure plan, now ending in 2025, to a range of $11 billion-12 billion from the previous range of $10 billion-11 billion.
We think that Atmos will exceed the top end of its investment target, like it consistently has over the past several years. We estimate total capital expenditures of $12.3 billion. Our estimated capital expenditures are 68% higher than the amount Atmos invested in the five years ended September 2020. We expect over 85% of this investment to be for pipeline replacement and other safety-related projects, which we expect will receive the full support of regulators.
Our investment assumption increased our EPS growth forecast by 50 basis points, to a five-year compound annual growth rate of 8%. Our estimated EPS growth is now at the top end of management’s 6%-8% target. EPS growth has averaged 8.4% for the five-year period ended September 2020. That included 1.7% growth in 2018, the year of the Dallas gas explosion. We believe low natural gas prices will allow Atmos to continue its capital expenditure acceleration over the next five years with limited pushback from regulators.
Our weighted average cost of capital assumption is 6.8%, higher than Atmos' regulated utility peers. The higher cost of capital, reducing our fair value estimate, is due in large part to Atmos' conservative balance sheet, which uses more equity than most of its peers.
We assume a 7.5% cost of equity, lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio because of Atmos' lower sensitivity to the economic cycle and low degree of operating leverage. Our long-term pretax cost of debt assumption is 5.8%, incorporating a normalized long-term real rate environment and normalized credit spreads. A 2.25% long-term inflation outlook underpins our capital cost assumptions.
Risk and Uncertainty| by Charles FishmanUpdated Nov 20, 2020
The primary uncertainty is Atmos' ability to achieve timely, constructive regulatory rate adjustments, though the size and breadth of its distribution operations preclude any one regulatory decision from having a drastic impact on earnings. Still, lower allowed returns or political pushback on Atmos' favorable rate mechanisms would cause the company significant pain, especially in Texas, its largest service territory. Overpaying for acquisitions is also a risk given the company's acquisitive past, although management insists it is now focused on internal growth opportunities.
Stewardship| by Charles FishmanUpdated Nov 20, 2020
Our stewardship rating is Exemplary. The company sold its no-moat businesses and distribution systems in jurisdictions with less favorable regulatory frameworks. In addition, management has improved the regulatory framework in most of its existing jurisdictions.
Since PG&E's San Bruno, California, gas pipeline explosion in 2010, Atmos management has done an excellent job of working with regulators and government officials in its service territories to embark on replacing all bare steel, cast iron, and vintage plastic pipes in its system. The result of this collaboration is a investment program requiring billions of dollars in investment. Although Atmos has accelerated its pipeline replacement programs, we still expect this will remain a 20-year endeavor.
The good news for investors is that Atmos worked with regulators to modify existing regulatory frameworks such that these investments are quickly recovered in rates. Today, about 90% of capital expenditures are recovered in rates within 6 months following the test year-end. This significantly reduces regulatory lag and, combined with strong customer growth, allows Atmos to consistently earn above its allowed returns. These regulatory frameworks are some of the best in the industry and demonstrate management's commitment to stewardship of shareholder capital, warranting our Exemplary rating.
In addition to capital expenditure trackers, Atmos has weather-normalization mechanisms that now cover over 95% of distribution margins, significantly reducing earnings variability. These changes to its regulatory frameworks reduce earnings variability and has allowed Atmos to increase its dividend at a faster rate. We expect these dividend increases to last well into the next decade and think they also demonstrate Exemplary stewardship of shareholder capital.
On Aug. 7, 2019, Atmos announced CEO Mike Haefner would retire early because of health issues. He was replaced by Kevin Akers, previously executive vice president, on Oct. 1, 2019. Atmos indicated that this was consistent with its long-planned succession plan and Akers has been president of the Kentucky/Midstates and Mississippi divisions. Kim Cocklin, CEO before Haefner, remains executive chairman. We expect the transition to go smoothly, but these events are always a concern, especially with the exceptional operational and financial performance under Haefner.