Description

Corning Natural Gas is the smallest publicly-traded player left in the relentlessly consolidating utility sector, yet the stock sits at a 40%+ discount to the value indicated by larger peers as well as recent acquisition multiples. We expect this discount to close as an already-settled rate increase delivers significantly higher earnings this year and next, which sets the stage for a probable sale of the company as its CEO and largest shareholder nears the age of 70.

Description and Background

The principal assets of Corning Natural Gas Holding Corporation are its namesake gas distribution utility in and around Corning, New York (“the Gas Company”) and Pike County Light & Power (“Pike”), which provides electric and gas service in the northeast corner of Pennsylvania. The holding company also owns 50% of a joint venture (Leatherstocking) that is building gas distribution networks in previously unserved parts of the region. Technically there is no debt at the holding company, but the Series A fixed-rate preferred is characterized as debt on the balance sheet and its dividends are shown as interest expense on the P&L. The Series B preferred converts to common at a 1.2 to 1 ratio, and with a conversion price of $17.29 it is in-the-money. Including the Series B preferred, there are 3.3 million fully-diluted shares outstanding, giving Corning an equity market cap of $59 million as of the last trade on Feb. 6. The company’s fiscal year ends in September.

The Gas Company dates back to 1904, but for analytical purposes we’ll join the story in late 2006. At that point, several decades of mismanagement--overly generous dividends, inadequate maintenance, dubious forays into non-regulated businesses--left Corning with a leaky pipeline system and a tottering balance sheet. Yet the company managed to hire a new CEO that would ordinarily have been out of its league. As the former president of New York State Electric & Gas and head of Southern Union’s gas distribution utilities, Mike German was attracted not so much by a paycheck--his total compensation even now is only $213,000 a year--as by the opportunity to invest his own money in Corning’s turnaround and subsequent growth.

Under German’s leadership, Corning quickly returned to profitability and embarked on a pipeline replacement program for virtually its entire system. The Gas Company’s total asset base has tripled since his arrival. That, plus the initial repair of the balance sheet and the 2016 acquisition of Pike, required nearly $50 million in common and preferred share issuance. During the same stretch we estimate German has invested about $6 million of his own funds in Corning’s common and convertible preferred shares, acquiring an 18.7% fully-diluted stake. Most of this has come through participation in rights offerings, which offered other shareholders the opportunity to avoid dilution--there were no special deals for insiders. German also brought two notable institutional investors on board: Portfolios managed by Mario Gabelli own an 18.6% fully-diluted position, while heiress Anita Zucker’s organization (a top holder of several small-cap gas utilities and a major beneficiary of 2017 go-private deals for Delta Natural Gas and Gas Natural) holds 10.5%.

Today the Gas Company still accounts for roughly 70% of total assets and earnings, but the aforementioned Pike acquisition adds a bit of diversification as well as more than $0.10 a share in annual earnings accretion. When Consolidated Edison put this subsidiary-of-a-subsidiary up for sale, it aimed to dispose of the legal entity and its fixed assets, but the workers, trucks, and supplies would stay with Con Ed. With few bidders given these terms, Corning bought Pike not for a massive premium but a small discount to the regulatory value of its assets, booking a $1.2 million bargain purchase gain in 2016 as a result. The flip side was a fair amount of “sweat equity” on the part of management, but the fully-staffed and -integrated Pike now earns roughly $900,000 a year after taxes for Corning, nicely ahead of the $562,000 in annual dividends on the preferred stock that financed the equity for the deal.

Valuation

We have no doubt that the persistence of low interest rates has inflated market values for regulated utilities over the last decade while eroding both allowed and realized returns. On the other hand, the fundamental appeal of gas utilities is hard to deny: Regulation delivers moderate but highly consistent profits without much regard to recessions, commodity price fluctuations are passed through to customers, and--in contrast to electricity in some places--gas does not face imminent displacement by renewables.

However, our purpose here isn’t to make a case for gas utilities in general. Since the long-term earning power of a regulated utility is mainly a function of invested capital and allowed return, our primary yardsticks are price/tangible book and a related statistic, enterprise value/tangible capital, that normalizes for variations in leverage (and can be thought of as a GAAP-derived proxy for enterprise value to regulatory rate base). On this basis we compare Corning to other U.S.-domiciled members of GICS’ Gas Utilities sub-industry classification, excluding those members that are predominately non-regulated (AmeriGas Partners, UGI, National Fuel Gas, etc.). In a relentlessly consolidating industry, we might not expect to find the smallest publicly-traded player trading at a steep discount, but that’s where we find Corning--well below the bottom end of its larger peers.

Corning looks just as underpriced measured against recent M&A transactions as well, with EV/tangible capital ratios ranging from 1.5x to 2.2x (median 1.9x).

• In 2017, Delta Natural Gas--despite negative customer growth in its rural Kentucky service territory--sold itself for 2.0x tangible capital in 2017 and 2.9x tangible book.
• Following its 2015 acquisition of AGL Resources (at 1.85x tangible capital and nearly 4x tangible book), in 2017 Southern Company sold AGL’s Elizabethtown Gas and Elkton Gas subsidiaries to South Jersey Industries for about 2x tangible capital, net of estimated tax benefits to SJI.
• In 2017, WGL Holdings sold to AltaGas for 1.8x tangible capital, 2.7x tangible book.
• Vectren’s pending sale to CenterPoint Energy was struck last year at 2.2x tangible capital, 3.8x tangible book.
• Even the barely profitable Gas Natural, whose balance sheet included several economically stranded assets, fetched 1.5x tangible capital and 1.8x tangible book in its 2017 sale to an infrastructure fund.

Valued at the same price/tangible book ratio as its median publicly-traded peer, Corning would be worth north $31 (2.86x its Sept. 30 book value of $10.87 a share; we note also that if the Series B were fully converted, tangible book value would rise 5% to $11.40 a share). Similarly, the peer median enterprise value-to-tangible capital ratio of 1.77x would place Corning’s equity at $32 a share. Both metrics suggest that Corning offers upside potential of roughly 70% from its recent price range--a truly rare opportunity for a regulated utility, let alone one that isn’t even distressed. Meanwhile there’s a 3.1% dividend yield while we wait, and even that is a relative bargain compared to the peer median of 2.6%.

Why does Corning trade at such a large discount? The stock may be illiquid and largely ignored; the company doesn’t even publish quarterly press releases. But the company is still an up-to-date SEC filer, so it’s not as though financial performance has been or will be invisible. Instead, we suspect that if the current valuation reflects anything other than the dividend, it is a backward-looking reflection of several weak years for earnings that are about to resolve to the upside.

Earnings

In the last four years, Corning’s earnings (excluding the aforementioned bargain purchase gain in FY16) have been stuck at about $0.60 a share with ROE running around 6%--an objectively weak showing even by the capital-intensive standards of regulated utilities.

This slump is mainly the result of “regulatory lag”--the delay between deploying capital into utility infrastructure and the recovery of a return through higher rates. Fortunately, our analysis of the Gas Company’s earning power indicates a long-awaited breakout year for profits is already under way.

In 2017, the Gas Company and New York state regulators settled a general rate case with a $4.7 million increase in revenues, based on both the company’s cumulative and planned capital investments and a 9.0% targeted return on equity (sharing with customers starts to kick in above 9.5%). Since the cost of gas is passed directly through to customers, expected gross profit rises by an equal amount. This increase should have been front-loaded with more than $3 million falling in year one, but in order to cushion the impact on customers, the increases were split into three annual increments of about $1.6 million each, with the first taking effect on June 1, 2017. Then, due to the vagaries of the ratemaking process and the associated accounting, most of the first year’s benefits were eaten up by higher property tax and pension expenses--items that had previously bypassed the P&L as separate surcharges on customer bills. Accounting adjustments caused by the late 2017 corporate income tax reduction dented profits as well in FY2018. So even as customer rates did rise--a fact visible in gross profit as well as operating cash flow--after-tax income for the Gas Company rose only to $1.705 million from $1.456 million in FY17.

The good news is that there are no comparable drags on the horizon for FY19 and FY20. We expect the Gas Company’s net income to reach $2.7 million, with consolidated earnings jumping 50% to $0.97 a share, based on the following walk.

To reach the bottom line, we add $0.9 million of expected net earnings from Pike (similar to FY18), subtract a $50,000 loss from the Leatherstocking joint venture (a modest Y/Y improvement due to customer growth), and $317,000 in non-deductible Series A preferred dividends. The result for FY19 is a bit over $3.2 million of net income, a 70% improvement from FY18. Series B dividends are omitted here for the calculation of diluted EPS, so dividing $3.2 million by 3.3 million fully-diluted shares produces earnings of $0.97 a share. Moreover, return on equity jumps to about 9%, crossing into respectable territory.

We see another step higher in Gas Company earnings in FY20 as the last phase of the rate increase flows through the P&L with math similar to the walk described above. At that point we believe earnings per share will reach about $1.20 a share, with a return on equity joining Corning’s peers in the 10%-11% range. We see no good reason why the stock should continue to trade at such a massive discount to other regulated gas utilities once its financial performance matches theirs.

The Long Run

Thus far we have focused closely on the near-term earnings outlook as the most likely motivator of a higher stock price, but the Corning story won’t end with the final phase of already-scheduled rate increases in FY20.

• By then the Gas Company should still have left about five more years of $5-$6 million of annual capital spending atop a rate base in the low $60 million area; thereafter, this segment should start generating a lot of free cash flow that can be used to fund other projects.
  
  
• Pike’s capital spending will likely ramp up with its own gas pipeline replacement program and hardening for the electric grid. Pike may also pursue new connections for electricity and gas supply, both of which are still sourced from Con Ed but could be obtained cheaper from other directions, with the benefit of increased resilience. These projects could top $15 million, a major mover given Pike’s current rate base in the low $20 million range.
  
  
• The investment potential within the Leatherstocking joint venture is largely untapped. Thus far Corning has committed $2.7 million for its 50% share, and it’s currently focused on backfilling customers to reach profitability and, as planned within a couple years, a roughly 10% return on equity. That said, pipe has only been laid in the first three of the 31 franchises it has been awarded thus far, and the abundance of cheap Marcellus gas could open up many more franchise opportunities over time.
  
  
• The Gas Company already does a bit of natural gas gathering from old-but-still-flowing conventional wells within its footprint. Should the state of New York relax its hardline stance against fracking, abundant new investment opportunities could emerge. (As it is, the Gas Company owns a compressor station just across the Pennsylvania border that isn’t used at present due to unfavorable pipeline differentials, but that could change and add to earnings in the future.)

All considered, we see a long runway--at least five and maybe ten years--for high-single-digit annual growth in rate base and earnings. While as good as just about any of its larger peers, this growth rate would still be lower than Corning’s over the past 12 years, making regulatory lag less of a pressure on earnings than it’s been since 2006. If the company stays independent, the stock should become a nice, low-risk compounder.

But Corning may also be nearing the end of its long run as a standalone company. To put it bluntly, Mike German is now 68 years old, and the most practical way for him to monetize his stake (or that of any of the top three holders) would probably involve some kind of sale. Putting the company’s true earning power on display this year could be the final step toward attracting and/or seeking interested buyers. A buyer--strategic or financial--could accelerate capital spending at Pike and Leatherstocking compared to the rationed outlays Corning makes today. That in turn is what would justify an ultimate takeout in line with other industry transactions: Obtaining control of a utility may require a premium, but subsequent investments in rate base are priced at par. The bigger the rate base growth potential, the larger the potential premium in a takeout.

Risks

• Interest rates/inflation. As with all regulated utilities, higher rates and/or inflation stands to raise Corning’s costs immediately, while rate increases to offset those costs would take time and involve potential pushback from regulators. A meaningful upswing in interest rates could also dent valuations for public utilities and private transactions, reducing the upside potential we identify for Corning on an absolute basis.
  
  
• Weather fluctuations. The Gas Company is partially shielded from adverse (warm) weather through normalization mechanisms for residential and small commercial customers, but on the whole a warm winter or a cool summer would dampen profits. The first quarter of fiscal 2019 included somewhat unfavorable (warm) weather in December, but thus far it looks like the key heating months of January and February should lead to at least an average season overall.
  
  
• Adverse regulatory decisions. New York is not known for a particularly friendly stance toward investor-owned utilities, which in turn could limit the multiple Corning could fetch in a sale. (However, we believe this effect is mitigated by the company’s top-tier potential for rate base growth in both New York and the more accommodative state of Pennsylvania.)
  
  
• Key man risk. Corning is run by a small number of executives led by Mike German; the loss of their services could pose operating challenges.
  
  
• Accidents. In sharp contrast to 2006, Corning now posts very strong safety metrics, but gas utilities can be held financially responsible if they are found at fault for explosions or fires.

Catalyst

• Likely ~50% improvement in earnings per share during fiscal 2019, another 20%-25% into fiscal 2020, that investors appear to have overlooked.
  
  
• Probable sale of the company, particularly in the context of higher earnings and an aging CEO who is also the largest shareholder.