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Energy: Powerful Production

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Tim Winter, CFA
Gabelli & Company
[email protected]

On August 5, Southwest Gas Corp. (SWX) reported second quarter earnings of $0.21 per share (includes $0.05 of corporate owned life insurance proceeds, or COLI) vs. $0.22 per share (includes $0.04 of COLI proceeds) last year. Excluding COLI, earnings were $0.16 per share versus $0.18 per share.

The gas utility earned $1.8 million in the second quarter compared to $2.0 million last year, as higher customer growth (+28,000 customers) was offset by the need for California rate relief, higher operations & maintenance, depreciation and interest expense.

NPL Construction Co.’s contribution was $7.8 million, or $0.17 per share, compared with $8.1 million, or $0.17 per share, last year driven by the ongoing effect of the harsh winter weather in April and higher expenses to necessary to meet contract obligations.

Over the trailing 12 months, SWX earned $2.88 per share compared to $3.19 per share for the previous 12-month period, including a decline in the utility contribution to $2.50 per share from $2.61 per share. NPL’s contribution declined to $0.37 per share from $0.58 per share as a result of weather-related delays. Lower utility earnings were due to higher O&M, depreciation and interest expense, as well as the ongoing delay in the California rate case.

In June, SWX was authorized to raise California rates by $7.1 million annually based on a 10.1% return on equity and 55% common equity ratio. SWX had filed the rate request in December 2012.

We lowered our 2014 earnings estimate to $3.05 per share, from $3.15 per share, to reflect a -$0.10 per share lower NPL contribution. SWX remains cautiously optimistic that NPL will meet or exceed its 2013 results of $0.45 per share and grow at 5-8% annually. NPL is one of the premier pipeline replacement contractors in the nation, and we believe the pipeline replacement cycle remains in its “early innings” of a long ballgame.

Our 2015 and 2016 earnings estimates remain $3.25 and $3.40 per share, respectively. We expect healthy gas utility growth to continue driven by rate increases, decoupling mechanisms, expanded infrastructure tracking mechanisms, customer growth and cost controls. In addition, SWX expects to implement a $9 million annual rate increase in September 2014 for its Paiute Pipeline and expand the Federal Energy Regulatory Commission-regulated pipeline.

Over 2014-2016, SWX plans gas-utility investment of $1.1 billion, including $375 million in 2014. Management also outlined further growth projects, including the potential $35 million expansion of the Paiute Pipeline with a targeted in-service date is November 2015.

SWX is also seeking approval for a $55 million, 230,000-dekatherm LNG storage facility from the American Chemistry Council. A decision is expected in 2014 and construction would be completed in 24-30 months.

SWX shares trade at 15.6 times and 14.6 times our 2014 and 2015 earnings estimates, compared to the gas utility distribution group multiples of 18.4 times and 18.2 times, respectively.

On an enterprise value/EBITDA basis, SWX appears inexpensive at 6.7 times and 6.7 times our 2014 and 2015 estimates. SWX’s common equity ratio is a strong 55%, which compares to 41% five years ago, and S&P rates SWX’s credit A-. Shares offer a current return of 3.1% on the $1.46 annual dividend, which we consider secure and growing.

Given a 48% payout ratio of our 2014 earnings estimate and reasonable capital budget, we expect well-above average annual dividend growth to continue. Our 2014 and 2015 private market values (PMVs) are $65 and $68 per share, respectively, using a 9.0 times multiple for the utility and a 5.5 times multiple for the construction company. Risks to our investment thesis include poor regulatory decisions, continued economic weakness and/or a material rise in interest rates

Christopher Sighinolfi, CFA
Jefferies Group
[email protected]

Following extreme Q1 winter conditions across a majority of [Southwest Gas unit] NPL Construction Co.’s operating areas, management had remained cautiously optimistic of flat to positive year-over-year 2014 results; however, NPL Q2 net income declined approximately 4% year over year, weighing on SWX’s consolidated results. While full NPL details are not available until the 10-Q, we suspect higher labor costs (overtime, etc.) may explain some of NPL’s ongoing headwinds.

Total system throughput of 39.4 million dekatherms declined approximately 6% year over year due to warmer year-over-year conditions. Specifically, heating degree days (HDDs) across SWX’s service territories were about 1% lower year over year and about 27% below their 10-year period average. However, due to its decoupled rate designs & customer additions, the utility still posted a roughly 2% year-over-year rise in gross profit.

We note that SWX added some 28,000 net new customers in the trailing 12 months.

Stephen Simko, CFA
[email protected]

Royal Dutch Shell (RDS-A, RDS-B) is an integrated energy company with operations along almost every part of the oil/gas supply chain. With production of more than 3 million of barrels of oil equivalent (boe) a day—roughly half is oil, Shell is one of the largest energy producers in the world. Refineries are predominantly located in the United States, Europe and Asia. Year-end 2013 proven reserves stood at 13.9 billion barrels of oil equivalent a day, equal to 11.6 years of annual production volumes.

Shell’s narrow economic moat relies on the oil and gas resources it possesses, which included 13.9 billion boe of proven oil and gas reserves at year-end 2013.

The company also benefits from skills and expertise developed through decades of exploration and production. Shell’s huge financial resources provide it with opportunities most oil and gas producers are unable to pursue (for example liquefied natural gas, oil sands and Arctic drilling).

With its large operating cash flows, the company can maintain capital spending levels through the troughs of commodity price cycles. All of the oil majors remain highly leveraged to oil prices and therefore benefit from OPEC’s ability to maintain a floor in oil prices.

We are raising our Shell Class B fair value estimate to $74 per American Depository Receipt (ADR) from $72 as we update our near-term oil price projections. Our forecasts assume Shell increases production roughly 1% annually during the next five years, although it should be noted that actual figures will be lower due to asset sales (which we do not model unless explicitly announced).

For its downstream segment, we model annual profits to range between $4 billion and $5 billion, which implies that single-digit returns on capital employed are likely to continue. The cash flow outlook remains robust, and we believe the company is well positioned to continue increasing its dividend by mid-single-digit rates each year (assuming $5 billion in asset sales occur annually as guided by management).

For oil and gas prices, our forecasts use prices based on NYMEX futures contracts for 2014-16 and our own mid-cycle price assumptions for 2017-2018. Brent oil pricing: $108 per barrel in 2014, $106 in 2015, $102 in 2016, and $100 in 2017-2018. West Texas Intermediate oil pricing: $100 per barrel in 2014, $95 in 2015, $91 in 2016, and $90 in 2017-18. Henry Hub natural gas (U.S.): $4.23 per thousand cubic feet in 2014, $3.88 in 2015, $4.03 in 2016, and $5.40 in 2017-2018.

Shell has two share classes that possess the same rights, except Class A shares are domiciled in the Netherlands, whereas Class B Shares are traded in London.

What this ultimately means is Class A shareholders must pay a dividend withholding tax, and this can only be claimed on U.S. taxable income reported to the Internal Revenue Service. In other words, tax leakage is possible (in tax-sheltered accounts). U.S. investors don’t have to pay withholding taxes on U.K. dividend income, which make Shell’s Class B shares a simpler proposition from a tax perspective.

Additionally, Shell’s $5 billion-$6 billion in annual share repurchases can only be from Class B stock. Together, these dynamics lead to Class B shares trading at a premium (recently 3%-7%) to Class A shares.