Global Infrastructure

Stock story: Atmos Energy

The natural gas company stands out because its high earnings growth is unusual for a utility.

Stock story: Atmos Energy

October 2018

The US sources just under 30% of energy needs from natural gas whose cheaper price and environmentally friendly traits are expected to increase demand for an energy source that comes out of the ground clean, ready to use and can be easily transported to customers presuming the network is up to standard.

Natural gas, as an essential service, is regulated. The ‘regulatory compact’ is that utilities are deemed the sole provider in an area and are assured of a reasonable return on their investments (termed the ‘rate base’ in industry jargon). As such, US regulators allow gas utilities to increase the price of connections in small steps over time to compensate for the money spent on equipment. To smooth their returns, regulators allows gas utilities to pass on costs. These costs include operational and maintenance expenses and, crucially, the cost of natural gas – thus, customers bear the cost if gas prices climb but gain the benefit when gas prices fall. (In Australia, gas utilities can’t automatically pass on fluctuations in the gas price.) The certainty of returns makes US natural-gas utilities an attractive risk-reward proposition for investors.

But there’s one major issue with natural gas in the US. The network needs upgrading. Most of the pipes that transport gas across the US are old. Parts of the network could prove dangerous because leaky gas is flammable. In 2010, a gas explosion in the San Francisco suburb of San Bruno sent flames more than 1,000 feet (300 metres) high and eight people died when their homes where engulfed in fire. Understandably, a nationwide push is underway in the US to upgrade old gas pipelines. But it takes time and money.

This is the industry context in which to place Atmos Energy, the US's largest fully regulated natural-gas-only distributor. The Dallas-headquartered company that earned US$1.2 billion (EBITDA) profit in fiscal 2017 distributes gas to more than three million homes and businesses in eight southern US states via a network that is 70,000 miles (115,000 kilometres) long. Most of Atmos’s activity is centred in Texas, where the company is the largest gas distributor. In addition, the company operates one of the biggest intrastate gas transmission pipelines in Texas and manages storage assets.

Of prime importance is that Atmos is spending US$8 billion from 2018 to 2022, about 80% of which will be used to upgrade its pipelines. This means the company’s rate base is expected to nearly double over that time and regulators will be more amenable to agree to higher prices on Atmos connections. Atmos’s plan to eventually overhaul about 40% of its pipeline network make the company one of the most compelling long-term investment opportunities among utilities in our universe, which we limit to the most reliable of utility and infrastructure stocks.

The company does have its challenges. A low-risk stock with a steadily rising earnings outlook that offers income streams (a dividend stock) is more vulnerable to rising interest rates. Atmos estimates that 6,100 miles (9,800 kilometres) of its pipeline warrant immediate replacement. To emphasise the danger, leaks from the ageing pipelines earlier this year forced people in Dallas to evacuate their homes. Such incidents have fortunately been rare and serve to highlight why Atmos must make its ageing network safe and efficient. The company, which has exceptional safety record, can look forward to years of regulatory-sanctioned price increases on a larger rate base. The fact that Atmos is not exposed to shifts in gas prices or changes in demand (say, a warm winter that leads to lower heater use) makes the company a low-risk investment.

Old company, old pipelines

Atmos can trace its history back to 1906 in Texas, which holds significance for the age of its pipelines. The company estimates that 29,000 miles (47,000 kilometres), or 42%, of its network was built before 1970 when the US first passed regulations imposing minimum standards on gas pipelines. About 13,000 miles (21,000 kilometres) of Atmos’s pipelines were made before 1940.

The company operates as three arms: the regulated distribute division that delivers gas, the regulated pipeline segment the handles the transport and storage of gas, and the non-regulated division that services customers.      

Atmos’s plan to replace the ageing steel, cast iron and plastic pipelines is expected to lead to price increases that will ensure earnings growth of about 6% to 8% p.a. on a rate base that will nearly double in five years. We estimate that Atmos’s ‘rate base’ will nearly double in value from US$6.6 billion in 2017 to US$11.8 billion in 2022 due to its investment program as it replaces about 750 to 1,125 miles (1,200 to 1,800 kilometres) of old pipelines each year over the next five years.

Even after about 6,000 miles (9,600 kilometres) of pipeline are upgraded over the next five years, that will still leave about 22,000 miles (35,000 kilometres) of network to be upgraded after 2022. This suggests that the company will keep spending money to upgrade its network and generate earnings growth for at least for the next 25 years. That means investors can look forward to steadily rising profits from a company that has proved reliable for investors in recent decades.

The company has delivered 34 consecutive years of higher dividends and 15 years of growth in earnings per share. It targets annual earnings growth of 6% to 8% and a dividend yield of about 2%. The popularity of natural gas and the company’s capital expenditure are likely to add to Atmos’s record of keeping happy its investors.

Sources: Company filings and website.

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