Atmos is a stable producer in an uncertain world (NYSE:ATO)
Finding stocks that offer protection during a period of rising interest rates and economic uncertainty is a difficult task with many companies trading at cyclical or valuations that leave little headroom. of error with the 10-year Treasury close to 4%. Atmospheric energy (NYSE: ATO) may constitute an exception, given its regulated economic model and a now reasonable valuation. It can be an effective safe haven in times of high volatility.
For those unaware, as you can see below, Atmos operates in the south-central United States with 63% of its operations in the state of Texas. Atmos transports natural gas. Approximately 68% of its business consists of distributing natural gas utilities. 66% of these companies serve residential consumers, with the remainder being commercial and industrial customers. The distribution unit has three million customers. The remaining 32% of its business is a pipeline and storage business that provides services in the Texas gas shale formations.
As with most utility companies, Atmos’ operations are regulated. 98% of its operations are in locations that encourage the use of natural gas, creating a favorable environment for the business. In its distribution business, ATO is allowed to achieve a return on equity of up to 9.8%. Its pipeline and storage business has an allowed return on equity of up to 11.5%. It is important to note that revenues are based on tariffs rather than commodities, which means that the ATO receives a fixed amount for transporting gas, regardless of its price.
The fact that Atmos does not take commodity risk – it is simply paid for natural gas transmission and distribution service – and that it receives regulated returns on equity and rate increases in Friendly States has been a very stable performance pattern. The company has increased earnings per share for 19 consecutive years, and it has 38 years of dividend growth, including an 8.8% increase to $0.68 this fiscal year. While this track record validates its business model, as investors we are focused on the present and the future, not the past. Will Atmos be able to continue this steady growth momentum? It seems so.
In the company’s fiscal year third quarterit made $0.92, up 18% from a year ago. Revenue rose $211 million to $816 million. Much of this increase was due to the $162 million increase in natural gas costs, with the remainder due to increases approved by regulators. As stated above, ATO does not take commodity risk in its business. It is paid for the distribution of gas and receives a fee for this service, passing on increases or decreases in costs to customers. Natural gas moves can create or hurt revenue growth, but they wash out the bottom line.
For the full year, the company is expected to earn between $5.50 and $5.60 and spend approximately $2.45 billion in cap-ex. The company recorded $175 million in regulatory gains that boost operating profit with an additional $145 million pending at the time. September 9. In all of 2021, there were $186 million in increases. Thus, the stable and supportive regulatory environment remains intact. I would point out the importance of its cap-ex spending. These capital expenditures increase the “rate base,” or the assets from which the business is able to derive revenue. Securing regulatory approval for capital projects is critical to generating earnings and dividend growth.
Indeed, as you can see below, the company’s goal is to generate EPS growth of 6-8% by FY2026. This plan is based on a cap-ex budget of 13 to $14 billion, providing significant rate base growth. It is important to note that Atmos begins to generate income on these capital expenditures within 6 months 90% time.
It is essential to have the authorization to carry out projects and to start making income from them quickly, because we think about the impact of inflation on the company, because it is something of a double-edged sword. To some extent, inflation is actually positive for the business. In the distribution business, for example, ATO gained 9.8%. So if a project requires $100 of equity, ATO will earn $9.80. If the regulator approves $110 for the project because the building materials are more expensive, he would now earn $10.78. It is important to note that there are no significant mismatches between projects and benefits that increase the risk of cost overruns against the approved rate increase. In a world with higher inflation, the $13-14 billion worth of viable projects the ATO sees could turn into $15-16 billion, creating an opportunity for incremental growth.
Now, inflation is not a panacea, as I said, it’s a double edged sword. In addition to getting more revenue from cap-ex projects, ATO may also get rate increases from annual cost increases, but these cost increases may not always keep pace with inflation. This year the company gets credit for 3-3.5% O&M inflation, so if a 6%+ inflation environment were to persist for an extended period of time and not be reflected in the future increases, this could pose some margin risk. If ROE deviates too far from the target levels of 9.8% and 11.5%, there could possibly be faster O&M increases in the future to catch up with Atmos.
Ultimately, to achieve its goal of $7.20 EPS by 2026, Atmos will need to meet these cap-ex plans. Fortunately, most of its capital program is aimed at safety measures. For example, it aims to replace half of the steel piping in its network by 2025, a program that has been underway and has received regulatory approval since 2012. It is adding wireless meters and taking steps to reduce methane emissions by 15-20%, a key priority to help the energy sector meet its carbon targets. The nature of its capital program, improving and modernizing operations, should increase confidence that it receives approval.
Also, aside from the favorable regulatory environment, I see Atmos’ presence in Texas as a clear positive. As you can see from the chart below, Texas’ population growth has consistently outpaced that of the country as a whole. Population growth means more potential customers, more investment opportunities, more cash flow and more dividend capacity.
Now, to finance its investments, Atmos relies on a combination of debt financing, operating cash flow and a market share program. Due to the company’s persistent issuance of shares, its outstanding shares have increased by 6.1% over the past year. As an investor, I never like to see the number of shares increase because it dilutes my stake in the company. That said, Atmos does it reliably. Atmos enters into futures contracts to give it certainty about the price it will receive for the stock. Based on the relative attractiveness of debt versus equities, this may change the mix somewhat. By pre-agreeing on a price, the risk of the shares falling, with Atmos still having to issue shares, and by turning what would have been accretive capital into a dilutive program is greatly reduced. So far this year, it has issued $675 million in equity at around $94, as well as $800 million in debt.
Atmos has entered into futures contracts that give it $701 million of available equity that it can sell at $108.71 in Q4 2023. Since the stock is now below $100, this is of an attractive exercise price that management has obtained. Importantly, Atmos has locked in low interest rates on much of its debt with an average maturity of nearly 20 years, significantly reducing its sensitivity to higher interest rates.
Over time, Atmos aims for an equity to capitalization ratio of 50-60%. It now stands at 62%, excluding the winter storm securitization of Winter Storm Uri. The 2021 storm caused significant damage and cost to Atmos; Texas allows all of these costs to be recovered through a surcharge for customers, who fund a separate portion of the debt – this cost recovery again speaks to the favorable regulatory environment. With its equity weighting above the high end of the target, I expect the ATO to direct funding capital for the next two years toward debt to reduce equity dilution.
After increasing the dividend by 8.8% last November to $0.68, I expect another single-digit increase in November. In the end, ATO has very little economic sensitivity. Because it receives a regulated rate of return, Atmos will never generate explosive earnings growth, but it also won’t see business drop much during a recession. Atmos is well positioned to steadily grow revenue as it expands its rate base through a credible multi-year investment program. Given its ability to pass on higher construction costs and with annual cost escalations, ATO is also relatively resilient to inflationary pressure.
Over the next 12 months, Atmos is expected to gain close to $5.80 to $6, giving the stock a forward multiple of around 17x, and assuming a $0.05 dividend increase in November, it has a prospective dividend yield of approximately 2.93%. Atmos shares won’t double or triple, but they can perform well during a time of enormous uncertainty and accumulate steadily over time to help you generate growing dividend income. I think the stock can get back into the $110-120 zone or a 20x multiple given its very predictable cash flow. Atmos could be an effective way to generate stable, non-economy sensitive income in your portfolio.