Description

NiSource presents a solid alpha-generating short opportunity. We believe fair value is ~30% lower than present levels.

NiSource is a fully regulated natural gas and electric utility company. Its natural gas utilities supply about 3.5 mm customers in 7 states, making it one of the nation’s largest gas utilities, and its electric operations generate electricity and supply it to half a million customers in Indiana. Two-thirds of operating income comes from gas distribution operations, and one-third from electric operations.

In 2015 it spun out of Columbia Pipeline Group to become a fully-regulated utility company. For more background on the spin, see sugar's writeup from March of 2015:

https://www.valueinvestorsclub.com/idea/NISOURCE_INC/136669. Note, sugar pitched going long NI pre-spin, and this turned out to be an excellent bet, with over 45% total returns to NI alone vs. 16% for the S&P 500. Now, I am pitching going short NI.

As a utility, customer and volume growth is low. In 2016 the company had its best year for customer growth since 2006 -- and only added 0.8% to its customer count. Total volume of gas delivered actually declined in 2016 vs. 2015 due to a warmer year than normal (9% warmer). In general, volume growth is in the very low single digits. In addition to growth from customer or volume growth, the company can boost its topline through regulatory approval of rate base changes. In 2014, NiSource outlined $30 bn in planned infrastructure projects to increase that rate base over the long term. The company is tracking on that plan, with about $1.5 bn in capex per year.

Like other utilities, NiSource has a maximum allowed rate of return (~10%) on its approved rate base. NiSource is currently earning an 8.1% ROE.

All-in, the company seeks to deliver 4-6% of annual earnings/dividend growth.

Yet, it trades at 21x forward earnings. As a utility with both natural and regulatory limits on growth constraining upside potential, this is an absurd valuation. It also differs significantly from the company's, and the sector’s historical valuations. Since 1980, NiSource has averaged a 5.5x forward earnings multiple, while the SP500 Utility Index has averaged a more reasonable 13.6x. Note the following chart and the anomaly in the last couple years:

NiSource, NTM P/E, 1980-present (clearly at historical highs):

Also, note the SP500 Utility Sector Total Return Index NTM PE 1990-present (just short of historical highs):

The recent run-up in utility valuations has been well covered in the financial press, as investors have bid up yield plays and safety stocks to historically high multiples. Here are just a couple articles:

http://seekingalpha.com/article/3985076-income-yielding-equity-sector-valuations-near-historical-highs

https://www.benzinga.com/analyst-ratings/analyst-color/16/03/7733094/gas-utility-valuations-too-high-morgan-stanley-warns

Yet, we find no fundamental reason why these stocks deserve supra-normal valuations. The value of a company remains the discounted present value of its future cash flows. As we ran our screens last year, many of these utility names came up and we did deeper dives on them, and shorted NiSource as well as OGS and ATO.

One of the issues with any DCF valuation model is certainty around future projections. But utilities are some of the easiest kinds of companies to model future cash flows. The greater the certainty in future estimates, the greater the certainty one can have in one’s assessment of valuation.

In valuing NiSource, we give the company credit for higher earnings growth than their stated target of 4-6%, as well as a higher terminal multiple than utilities have historically traded for. To be conservative, we project combined earnings and dividend growth of ~10% over the next 5 years, and apply a discounted market multiple to that value, and still find the company to have nearly 30% downside to fair value.

Good arguments can be made as to why we shouldn’t give the company credit for any more than its stated 4-6% growth target, and why a utility should earn a lower multiple than the market, but we prefer to be conservative in our valuation and let those arguments provide additional bonus downside. We’re happy with ~30% downside while assuming the best for the company.

In addition to the stretch for yield, some of the uptick in valuations came from a wave of consolidation in the industry. While acquisition risk is present, we believe most of that wave is now past. NiSource itself has been the subject of acquisition rumors, but at current valuations, and as one of the largest utilities in the US, and with the complexity of integrating operations from across so many states, we don’t find the risk strong enough to dissuade us from shorting the company. We could always be wrong.

While NiSource is not the most exciting short because the downside isn’t as great as that of a fraud or a fad, and there's no exploding catalyst on the horizon, it’s also unlikely to go dramatically against us, and the potential for alpha generation is compelling. We like these "sleep at night" shorts.

Catalyst

Primary catalyst: multiples normalize. Much of the recent run-up in valuation can be attributed to a dearth of good yield opportunities. Interest rates rising or simply changing investor preferences would likely reduce the demand for yield plays and bring about a correction in multiples for these companies.

Even if valuations stay at present highs, if the company continues to grow earnings at only 4-6%, the return on the stock should track that earnings growth, which should result in returns below that of the market, and alpha, if the market grows at historical rates. 

There are also some potential catalysts from changing energy prices and potential tax reform, but we do not base our case on these.