Important disclosures appear on the last page of this report. The Henry Fund Henry B. Tippie School of Management Michael Kelleher [[email protected]] UGI Corporation (UGI) April 22nd, 2015 Utilities – Natural Gas Utilities Stock Rating HOLD Investment Thesis Target Price $38.00-41.00 UGI is positioned with 65% of revenue accountable from non-regulated business segments. Classified in the utility sector, UGI’s bus iness diversification has high organic growth potential, and is naturally defensive against potential interest rate hikes. With current market conditions and 8- 14% upside potential, we confidently recommend a hold on UGI. Drivers of Thesis x UGI is labeled as a utility company, yet the regulated UGI utility segment only accounted for 35.2% of 2014 revenue. We project stagnant earnings across the utility sector, yet UGI has a competitive advantage over peers with 65% derived not regulated utilities. x UGI engaging in a stock buy back program aiming to repurchase 10 million shares, or 5.8% of current shares outstanding. x UGI’s Marketing and Mainstream segment has seen significant distribution expansion; net income rose 124% in 2014 to $96 million. Net Income is forecasted to improve an additional 18% by 2018 to $232 million, contributing 25% to UGI’s total. Risks to Thesis x UGI is extremely sensitive to winter temperatures. UGI’s 2015 Q1 year over year revenue dropped 5.2%, mainly attributable above average temperatures. As a result we forecast 2015 revenue to decline 1%. x UGI’s cost of goods sold will remain constant due to regulation, though natural gas and propane prices have fallen. COGS are forecasted to 62% of sales, only seeing slight decline commodity hedging reflects lower prices. x Utility companies are subject to inverse movement in relation to interest rates. The Henry fund projects the Federal Funds rate to rise above 0.60% within two years, potentially hampering UGI’s long-term growth. Henry Fund DCF $42.00 Henry Fund DDM $37.50 Relative Multiple $35.50 Price Data Current Price $35.11 52wk Range $29.93 – 39.74 Consensus 1yr Target $36.90 Key Statistics Market Cap (B) $6.01 Shares Outstanding (M) 172.79 Institutional Ownership 79.20% Five Year Beta .59 Dividend Yield 2.50% Est. 5yr Growth 10.6% Price/Earnings (TTM) 24.64 Price/Earnings (FY1) 16.56 Price/Sales (TTM) .74 Price/Book (mrq) 2.24 Profitability Operating Margin 8.99% Profit Margin 3.13% Return on Assets (TTM) 4.24% Return on Equity (TTM) 8.67% Chart and 12 Month Performance Source: Yahoo Finance Earnings Estimates Year 2012 2013 2014 2015E 2016E 2017E EPS $1.18 $1.62 $1.96 $1.60 $2.23 $2.17 growth 7.0% 37.3% 21.0% -22.5% 39.4% 2.75% 12 Month Performance Company Description UGI is a natural gas utility, propane distributer, and electricity producer based in PA. UGI’s mission is to “In a rapidly evolving marketplace, we will deliver competitively priced, high quality energy products and services to costumers in our communities in a manner that expands opportunities, meets shareholders’ expectations and fosters economic growth. 1 ” 24.6 8.7 8.9 18.6 9.7 9.8 25.2 8.5 8.9 0 5 10 15 20 25 30 P/E ROE EV/EBITDA UGI Industry Sector -10% 0% 10% 20% 30% A M J J A S O N D J F M UGI S&P 500
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Important disclosures appear on the last page of this report.
The Henry Fund
Henry B. Tippie School of Management Michael Kelleher [[email protected]] UGI Corporation (UGI) April 22nd, 2015 Utilities – Natural Gas Utilities Stock Rating HOLD
Investment Thesis Target Price $38.00-41.00
UGI is positioned with 65% of revenue accountable from non-regulated business segments. Classified in the utility sector, UGI’s business diversification has high organic growth potential, and is naturally defensive against potential interest rate hikes. With current market conditions and 8-14% upside potential, we confidently recommend a hold on UGI. Drivers of Thesis x UGI is labeled as a utility company, yet the regulated UGI utility segment
only accounted for 35.2% of 2014 revenue. We project stagnant earnings across the utility sector, yet UGI has a competitive advantage over peers with 65% derived not regulated utilities.
x UGI engaging in a stock buy back program aiming to repurchase 10 million
shares, or 5.8% of current shares outstanding.
x UGI’s Marketing and Mainstream segment has seen significant distribution expansion; net income rose 124% in 2014 to $96 million. Net Income is forecasted to improve an additional 18% by 2018 to $232 million, contributing 25% to UGI’s total.
Risks to Thesis x UGI is extremely sensitive to winter temperatures. UGI’s 2015 Q1 year
over year revenue dropped 5.2%, mainly attributable above average temperatures. As a result we forecast 2015 revenue to decline 1%.
x UGI’s cost of goods sold will remain constant due to regulation, though
natural gas and propane prices have fallen. COGS are forecasted to 62% of sales, only seeing slight decline commodity hedging reflects lower prices.
x Utility companies are subject to inverse movement in relation to interest
rates. The Henry fund projects the Federal Funds rate to rise above 0.60% within two years, potentially hampering UGI’s long-term growth.
Henry Fund DCF $42.00 Henry Fund DDM $37.50 Relative Multiple $35.50 Price Data
Current Price $35.11 52wk Range $29.93 – 39.74 Consensus 1yr Target $36.90 Key Statistics
Market Cap (B) $6.01 Shares Outstanding (M) 172.79 Institutional Ownership 79.20% Five Year Beta .59 Dividend Yield 2.50% Est. 5yr Growth 10.6% Price/Earnings (TTM) 24.64 Price/Earnings (FY1) 16.56 Price/Sales (TTM) .74 Price/Book (mrq) 2.24 Profitability
Operating Margin 8.99% Profit Margin 3.13% Return on Assets (TTM) 4.24% Return on Equity (TTM) 8.67%
Chart and 12 Month Performance Source: Yahoo Finance
UGI is a natural gas utility, propane distributer, and electricity producer based in PA. UGI’s mission is to “In a rapidly evolving marketplace, we will deliver competitively priced, high quality energy products and services to costumers in our communities in a manner that expands opportunities, meets shareholders’ expectations and fosters economic growth.1”
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EXECUTIVE SUMMARY
UGI is a uniquely positioned utility company offering services both in government regulated, and non-regulated segments. Additionally, UGI has an international segment offering propane and natural gas distribution to Europe and Western China.
The utility sector in the near future could be affected by Federal Reserve fiscal policy. In times of low interest rates, as experienced since 2009 in the US, utility companies have experienced solid growth. Though the Federal Reserve has not formally proposed interest rate hikes in 2015, indications have been building. UGI could be seen as a defensive utility play as 65% is deregulated, and it does not offer industry standard dividend yields.
UGI, having 35% of net income regulated, has room to expand beyond traditional utility natural monopolies. The Marketing and Midstream segment nearly doubled in net income last year alone, still being a major segment of growth.
As UGI is not a traditionally pure utility company, it opens its business strategy to opportunity and risks. We currently recommend a hold on the company given current economic factors. Monitoring global macro economic changes, as well as local yearly weather patterns, will determine the future strength of UGI stock.
COMPANY DESCRIPTION
UGI is a utility and gas distribution company with operations based mainly in the eastern US and Europe. UGI Corporation is a parent holding company of four main subsidiaries; AmeriGas Propane, UGI Utilities, UGI International, and Midstream and Marketing. UGI is heavily diversified in services and location, though subject to heavy government regulation.
AmeriGas Propane
AmeriGas Propane is the nations largest retail propane distributer. AmeriGas contributed 18% of overall revenue to UGI in 2014. It serves 2 million customers across all 50 states from 2,000 distribution centers. AmeriGas additionally installs propane based heating systems and appliances. Service is mainly based in rural or suburban areas where natural gas infrastructure is not in place. 2014 sales represented 41% to residential, 36% commercial/residential, 13% motor fuel, and 6%
agriculture. Sales are highly diversified as no customer represents more than 5% of total revenue.
Source: UGI 2014 10k
The propane industry is predictably cyclical due to fluctuating propane costs and winter weather. AmeriGas has attempted to reduce volatility by purchasing over 90% of their supply under 1-3 year agreements. Additionally, they have increased summer storage volume to maintain inventory during the non-heating season (67% of revenue is recognized between October-March)2. The winter of 2013-2014 experienced a propane shortage. UGI prepared in summer 2014 by purchasing additional propane to avoid a similar crisis. As natural gas and propane have since dropped in price and December temperatures were above average, UGI is still distributing the now overpriced summer storage.
Source: UGI
AmeriGas is UGI’s only non-fully owned subsidiary. UGI owns a 26% minority interest with the remaining 74% being publicly owned, traded on the NYSE under AmeriGas Partners (APU). APU is currently trading at
41%
36%
13%6%
AmeriGas Revenue
Residential
Commercial
Motor Fuel
Agriculture
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$48.86 per share with a market cap of $4.54 billion. Based on UGI’s $6.01 billion market cap, APU accounts for 18% of UGI’s valuation, or approximately $6.30 of the current stock price. Proceeds from the ownership will be represented as non-controlling interest on financial statements.
UGI Utilities
UGI Utilities is the regulated utility portion of UGI Corporation, adhering to the Pennsylvania Public Utility Commission (PUC). Utility was UGI’s main source of revenue in 2014, contributing 35.2%. The main segment of UGI Utilities supplies natural gas to over 600,000 customers (adding 6,500 customers in 2015 Q1) in eastern and central Pennsylvania, in additional to a single western Maryland county. UGI operates 12,000 miles of gas main throughout their service area. In 2014, 69% of the 208.8 billion cubic feet throughput was supplied to commercial and industrial customers with the remaining 31% going to system sales. By March 2017, pipelines constructed of cast iron (approximately 3% of total infrastructure) must be replaced with contemporary materials. By 2043, bare steel pipelines (approximately 10%) must additional be replaced. UGI expects to spend a total of $1.2 billion over the 30-year remaining project life. Our model calls for $500 million yearly cap ex with the pipeline replacement included.
Source: UGI.com
UGI Utility is subject to heavy government regulation. Utility can charge for service in two ways: rates designed to recover purchased gas costs (PGC’s), and rates designed to recover costs other than PGCs. PGC’s are reviewed annually by the PUC and adjusted appropriately based on actual cost of gas and economic factors. If extenuating circumstances exist between meeting dates, utilities can request a quarterly review, or even a monthly review under extreme conditions.
UGI additionally operates an Electrical Utilities segment. Electric Utilities serves 62,000 customers in northeastern Pennsylvania via 1,900 miles of line and 13 substations. PUC regulates the Electric Utilities segment, and requires additional requirements in regards to alternative energy3.
UGI International
UGI International is comprised of two entities; Antargaz, and Flaga & Others. These subsidiaries expand UGI’s global exposure into Europe and Asia. In 2014, UGI International accounted for 14.3% of total company revenue.
Antargaz is a wholly owned French subsidiary Liquid Petroleum Gas (LPG) distributer. They are the largest LPG distributer in Belgium and Luxembourg, and holds large market share in France and the Netherlands. Antargaz distributes heavily to small purchasers distributing from 15,000 retail outlets and supermarkets. In 2014, 60% of sales were small bulk, 17% medium bulk, 20% large bulk and 3% automobile service stations. Antargaz additionally operates a natural gas marketing segment in France and Belgium.
Flaga & Others is a wholly owned subsidiary providing LPG distribution throughout Europe and China. Flaga is the largest distributer in Austria and Denmark, and holds competing market share in Poland, the Czech Republic, Hungary, Slovakia, Norway, Sweden, and Finland. Additional partners are AvantiGas who distributes LPG through England, and ChinaGas Partners, L.P. who distributes in portions of Western China4.
Europe experience above average winter temperatures, severely hurting the international segment’s profitability. Additionally, Europe’s economy is expected to make a slower recovery in comparison to the US, placing additional growth risk on the sector. Though UGI hedges successfully against the weakening Euro, growth will be difficult as the dollar strengthens. We forecast a 3% decline in the segment in 2015, and an additional 2% in 2016. We believe the international segment will be the weakest performer moving forward.
Midstream and Marketing
Midstream and Marketing is the fastest growing subsidiary of UGI. Midstream and Marketing accounted for 34.9% of 2014 overall revenue, up 124.4% from 2013’s 18.9% contribution. The Auburn pipeline became operational in Q1 2014 increasing throughput for the
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remainder of the year. Additionally, extremely cold weather in early 2014 spiked demand above normal. Midstream and Marketing operates two segments: Energy Services and Electricity generation.
Energy Services sells natural gas, liquid fuels, and electricity to 19,000 customers in Pennsylvania, New Jersey, Delaware, New York, Ohio, Maryland Massachusetts, Virginia, North Carolina, and the District of Columbia. Energy services utilize a natural gas distribution system of 36 locally connected gas utility companies, and an electric distribution system of 20 local utility companies. Opposed to a fixed period cost “take-or-pay” contract, Energy Services has switched to a fixed price pay as you go contract model due to pricing competition. Supply cost volatility is mitigated via diverse suppliers, owning distribution networks, futures and derivative instruments, and utilizing hedging against transmission costs.
Electric Generation (UGID) owns a 130-megawatt natural gas-fuel generator in Wilkes-Barre, Pennsylvania. An additional 102 megawatts are produced via a 5.97% interest in Conemaugh generation station in Johnstown, PA. UGID owns and operates an 11-megawatt, gas-fueled landfill earning renewable energy credits. Finally, UGID has 11.67 megawatts of solar-power capacity across Pennsylvania, Maryland, and New Jersey. UGI competes with other electric utilities tied into the PJM Interconnection, LLC., the largest competitive power grid in the nation, further tightening price competition. UGID adheres to the regulations of the Federal Energy Regulatory Commission (FERC)5.
Company Analysis
Segment as Percentage of UGI Overall Revenue
Source: UGI 10K
UGI Corporation is uniquely position as a utility classified company. Operating as a US based natural gas utility provider, a natural gas distributer, propane deliverer, and international energy business places UGI separate from its US based competitors. UGI exposes itself to strengths and weaknesses pending future global market macro effects.
x UGI’s Marketing and Mainstream segment is quickly growing and has competitive proximity to the Marcellus shale. Continuing to expand their pipeline network will increase throughput and profit for the company.
x UGI Utilities market is mature; unless small market mergers and acquisitions occur in directly surrounding areas, utilities will be dependent on cold winters to drive winter revenues.
x As UGI utilities will grow quickest through M&A, so must the international segment. The rising strength of the dollar will only hamper current gains overseas if the segment does not grow in the near future.
x AmeriGas is the strength of UGI’s overall profitability. Propane is mostly distributed to rural areas that do not have infrastructure reaching the service area. Local natural gas distributers and electricity companies pose as threat of substitution.
x As UGI derives its income mainly from heating, the company is extremely sensitive to winter temperatures. Outside of natural seasonal cyclicality, UGI is exposed to potential yearly cyclicality pending weather patterns.
RECENT DEVELOPMENTS
Sunbury Pipeline Announcement
UGI recently announced planes to construct a 35 mile, 20 inch pipeline connecting the Marcellus Shale to a soon to be constructed natural gas fueled power plant. The $150 million project (included in our model capex projections) would extend from Lycoming County, PA to a 1,000-megawatt power facility currently being planned by Panda Power Funds and Sunbury Generation LP. Once complete, the pipeline is expected to transport 200,000 dekatherms per day. The project is aiming to capitalize on the recently boosted production in the Marcellus natural gas basin. UGI is aiming to increase their natural gas throughput in the northeast. The Sunbury pipeline would further increase the quickly growing Marketing
0.00%10.00%20.00%30.00%40.00%
2013
2014
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and Mainstream segment, which currently accounts for roughly 35% of revenue. Additionally, It could potentially take away market share of current transportation companies serving the Marcellus shale6.
UGI is expecting to make their initial filings for the project in mid 2015. Little resistance is expected in the legal proceedings. The Marcellus shale has experienced a drilling influx since 2008, with many major companies investing heavily in infrastructure since output has increased. UGI is strategically located in the vicinity of the Marcellus Shale, but are generally considered latecomers. We believe the expansion has strategic benefits for several reasons. First, the Sunbury will serve a direct power plant creating steady cash flows. Second, this move benefits the Marketing and Midstream segment, which is the fastest growing in the company. Finally, UGI’s broad portfolio will not rely on the Sunbury pipeline to be a cash cow. It will simply add revenues to an already established and profitable company.
Source: State Impact
1Q 2015 Results
UGI’s fiscal year begins on October 1st. UGI reported below expected results in the companies first fiscal reporting quarter (October – December). Year over year Q1 performance fell from 122 million in 2014 Q1 to 116 million in 2015 Q1. Analyst expected earnings was set at $0.78 per share, however UGI missed estimates by $0.12, recording actual earnings of $0.66. Taking out AmeriGas profits, the non-fully owned partnership, profits attributable to UGI were $36 million.
Weather, which will be covered in detail shortly, was a major contribution to lower revenues. Below average Q1 2015 temperatures, during the winter heating season was a major contributing factor to the earnings
disappointment. An additional factor in missed earnings was losses on derivative instruments; UGI utilizes both futures and swaps. Both natural gas and propane have dramatically fallen in price since the end of 2014, causing UGI to recognize a $6.6 million dollar loss after taxes compared to a $4.3 million gain recognized in 2013. UGI uses short term revolving hedging strategies, meaning derivative losses should quickly diminish in Q2-Q3.
On the quarterly conference call, management reaffirmed the company performed strongly amongst the challenging conditions. Weather is generally unpredictable, and hedging contracts will quickly reflect the current low price of natural gas. Through the poor winter season, UGI managed to gain 6,500 utility customers and make headwinds on acquiring a Hungarian natural gas distribution company. Management sounded optimistic on Q2 while describing cold weather in the Northeast since January. Management did downgrade their 2015 EPS forecast to $1.89 in response to missed earnings in Q1. Our model projects 2015 EPS at $1.75. Missing earnings during a major revenue producing quarter leaves us bearish on 2015. However, the company’s diversification should be able to produce solid capital gains through 2015.
Strong Dollar
Source: Capital Management Services
Since mid-2014, the US dollar has strengthened significantly against the Euro. As the Eurozone financial risk increases, the Euro faces further devaluation against the dollar. UGI is uniquely position as a utility company as it has overseas exposure, unlike many of its US based competitors. In 2014, approximately 15% of revenue came from overseas business, dramatically dropping from
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its nearly 30% contribution in 2013. UGI hedges against foreign currency risk via derivative financial interments. This hedge was well position and mitigated nearly all loses attributable to foreign currency devaluation. The derivatives are revolving short term, offering flexibility in strategy. The biggest threat to UGI would be a sudden rise in Euro value, though losses would be short lived. UGI is still well hedged against the Euro, though global markets will still play a role in international business for UGI.
Warmer Winter Season
UGI Utility, AmeriGas Propane, and Marketing and Midstream were all affected by the warmer 2014-2015 winter heating season. UGI Utility operates in PA. 2014-2015’s average winter temperature was 30.1 degrees, compared to 28.1 degrees the year before. February 2015 in PA was 8 degrees below normal giving the appearance of a below average winter. However, October - December 2014 (UGI’s first fiscal quarter) was high above average resulting in less heating natural gas being used, and thus a major contributing factor to the year over year quarter loss7. Winter weather patterns and temperature trends are difficult to predict into the future, though better guidance for the 2015-2016 heating season should be available towards Q4. Q2 reporting (January – March 2015) will mark the end of the heating season and the below average February should help recoup losses endured in Q1.
Pennsylvania 2014 Temperatures Versus Average
Source: Weather Spark
INDUSTRY TRENDS
Government Regulation
As early as the mid-1800’s, it was discovered that the vast distribution network needed to service natural gas made one company more profitable than having two competing in the same area8. With a natural monopoly over the local market, government saw the need to regulate the natural gas utility companies. Regulations limited how much above cost utility companies could charge those they serviced. The early 1900’s saw the pipeline redefine the industry allowing shipment of product well beyond the well it was produced from. The Natural Gas Act of 1938 was the first federal government regulation over natural gas shipment stating that “no new interstate pipeline could be built to deliver natural gas into a market already served by another pipeline.” This set the stage for natural monopolies upon the utility companies: heating, water, and electric.
Currently, each state operates their utilities regulations in different manors. Most effective on UGI is the PA Public Utility Commission. UGI is not only regulated on the price paid for gas, but natural gas utilities have an additional set of rules to follow over when they can or cannot cease service to customers. A complete copy of PA laws can be found at the PUC’s government website9
Negative Correlation to Interest Rates
Utility companies, traditionally offering high dividend yields, have been known to move in contrary to interest rate changes. Below depicts 2014 performance of the S&P 500 Utilities index (XLU) versus the 10-year T-bill floating interest rate. As can be seen, there is clearly a direct negative correlation in the movement between the two. Q1 2015 saw a 12% decline in the ETF price, as the 10-year T-bill raised 53 basis points to 2.2%. This period, shown below, shows general trends between the two indexes.
Source: ETF Guide
Since 2008, as interest rates have been near zero, fixed-income investors seek greater returns from the highly stable, high dividend yielding utility sector. If the Fed
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does raise the target Fed Funds rate, causing short and long-term treasuries to increase yield, utility companies across the board could see correction as fixed-income investors revert to holding bonds. UGI is more favorably positioned among its peers as it offers lower dividend yields compared to its competitors. Current companies among local competition offer an average of 4.45% dividend yield, while UGI distributes 2.7%. UGI has experienced recent growth based on it nonregulated segments offering capital gains. If interest rates do increase, the low dividend offering could make UGI less sensitive to higher treasury yields, though it will still carry risk associated with the utility sector.
Natural Gas Prices
Source: Market Realist
Natural gas prices have fallen 40% since December 2014. Falling prices should have little effect on Government regulated utilities, since utility companies are under obligation to recover cost of gas purchased. However, several utility companies operate non-regulated segments. Non-regulated distributers, companies involved in transportation or sales, will experience lower margins in times of falling natural gas prices. The largest loses will be realized from large summer storage facilities buying natural gas or propane prior to price declines. UGI is still distributing natural gas that was purchased under hedging rates, unable to quickly distribute the supply due to warmer October – December temperatures. Forward hedging strategies will determine the profitability of heating utilities as prices are predicted to remain low.
Cyclicality
The heating utility industry experiences high levels of seasonal cyclicality. UGI generates 65% of their yearly revenue during the heating months of October – March. The chart below shows the winter spikes in US natural gas usage during typical winter months. A warm winter season can have high effects on natural gas usage, and thus profitability. This places more risk on utility companies that provide heating services opposed to a less versatile water utility company. Additional risk is carried in the form of summer storage. UGI increased storage in summer of 2015 to avoid a shortage. Consequently, natural gas prices fell leaving UGI with high inventory purchased at a premium. Further, the above average winter temperatures lowered consumption, making it difficult for UGI to turnover the high priced inventory.
Natural Gas Yearly Storage and Usage
Source: Energy Trends Insider
MARKETS AND COMPETITION
The utility industry is mainly shaped on three factors: the natural monopolies, government regulations, and mergers and acquisitions. Through the years, the market competition has come from major holding companies expanding their serviceable reach via mergers and acquisitions. UGI is one of the few utilities to expand to international operations in addition to nonregulated segments. Though they have been hurt recently from derivative hedging, it could prove a profitable model in the future.
Neither buyers nor sellers have strong power over price. Rather, it is market rates and government regulation controlling pricing. In regulated segments, government regulations are in place for utility companies to capture a percentage above price paid for the product. Regulations
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are in place to protect users against overpricing of necessities. For natural gas and propane, pricing is dependent on supply and market conditions. Price fluctuation does occur within regional spot markets, but it is still based on broader commodity pricing. The main way for companies to increase profitability is to maximize throughput.
Barriers to entry are extremely high, offering long-term security to UGI. Regulated utilities often operate in a regional monopoly in exchange for regulated pricing. The biggest threat to utilities is M&A, usually conducted by larger companies to expand their footprint into new markets. Shipping and distribution companies are dependent on extensive pipeline infrastructure and distribution networks, requiring extremely high initial capital expenditures. Again, large players expanding operational area will be the biggest risk to entering UGI’s market.
Given the high rate of M&A and fixed customer base (population), competition in the industry is very high, especially in the distribution industry. With pricing controlled mainly by the market, companies’ sole aim is to increase throughput to grow revenue. Recent activity around the Marcellus and Backken Shales show the willingness of distributers to invest capital to capture future throughput.
Threat of substitution has a moderate affect on UGI. Pending geographical location, a house can be heated via natural gas, propane, or electricity. Propane is mainly used in rural areas where natural gas distribution lines have not yet been constructed. However, as natural gas becomes cheaper and more widely distributed, AmeriGas could see a diminishing customer base. A future dependence on renewable energy could see electric heating rise as well. Changing heating mediums does require a capital investment. Appliances are designed to run off a single energy source. Though there is a threat of substitution, the process takes time. Management would be able to see a trend emerge and take corrective action before revenues could unexpectedly drop.
Dominion is the largest market cap natural gas distribution in the eastern US. They have the largest market cap that will compete with UGI’s marketing and midstream segment. The Marcellus shale is the largest natural gas basin in the US and has been extensively drilled since 2008. Dominion has had extensive infrastructure set up for years, giving a competitive advantage over UGI’s newly created pipelines; and the soon to be created Sunbury Pipeline.
UGI ranks in the low middle averages of major company ratios in comparison to its competitors. Unlike competition, UGI operates in a several separate segments. UGI’s peers operate in utilities, distribution, and electricity generation. When the Euro was strong over the dollar, the international business segment of UGI was a proven performer in the utility sector. Having the international business segment opens up UGI to risk factors that most of its competitors are not exposed to.
A major utility investing factor is dividend yield. UGI is currently offering a 2.7% yield, as the sector average is 3.15%. If integrates do rise, it is reasonable to believe that utility companies that will be hurt the least will be those that are non-cyclical with the highest dividend yields; as they can be substituted most for fixed-income. UGI’s 2.7% yield ranks towards the bottom with its peers, suggesting that improving treasury bonds could be a quick substitute. UGI lowered Q1 2015 dividend payments by a fraction of a cent. However we project dividends to reach $0.95 per share by 2019.
ECONOMIC OUTLOOK
US GDP Projections
The US has experienced a reduction in GDP percentage growth since 2014, with the Federal Reserve predicting real GDP growth rates to be 2.1-2.3% through 2020. The forecast is in line with the Q1 2015 GDP growth rate. Cold climate residents need heat in the winter months. Three factors will dictate energy volume consumed; temperature, cost of product, and purchasing power.
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Utility companies have no control on winter temperatures the demand it will place on heat. Natural gas prices have dropped, with the savings being past on to consumers. People will be more likely consume more heat when the cost is reduced. This will be favorable for UGI’s throughput totals. Finally, most affected by GDP, is purchasing power as a result of personal capital. As people will tend to increase heat when prices are low, a person with excess capital is more likely to comfortably heat their home during cold temperatures. A strengthening GDP will aid this last factor. Though GDP growth is not near the historical average of 3.0-3.5%, steady projected growth will still be beneficial to utility companies.
Interest Rates
US interest rates have been near zero since the 2009 financial crises. The US Federal Reserve has recently removed the word “patient” from statements released regarding a potential rise in Fed Funds rate target. Utilities are generally strong performers during times of low interest rates. The usually slow growth, steady performing utility companies often offer high dividend yields posing as a fixed income substitute. When rates rise, investors will be more prone to exposure in treasuries that potentially offer higher rates of guaranteed return. If the Fed raises the Fed Funds target, utility companies have the potential to see declines in stock value. Future 2015 Feral Reserve meetings (April 28-29, June 16-17, July 28-29, September 16-17, October 27-28, December 15-16) will indicate the Fed’s intentions of raising rates10. Raised rates could have an inverse correlation to utility companies future earnings potential. The Henry Fund does not project interest rates to rise within the next six months, but we project a Fed Funds rate of 0.68% (43 basis points) within the next two years.
Source: ICIS
Strengthening Dollar and the Eurozone
UGI generates nearly 15% of revenue via European unregulated propane distribution. Like every US company with international exposure, recent strong US dollar performance weakens earnings once revenue is exchanged back to US dollars. As seen below, few Eurozone countries are seeing consecutive periods of economic growth with many seeing negative trends. Europea.EU, a government agency, projects slow European rebounds. 2015 GDP growth is project at 1.7 for the Eurozone and 2.1 for 2016; both below US Federal Reserve US projections11. UGI’s international segment’s revenue nearly dropped 50% in 2014, mostly attributable to weather and economic factors as UGI does hedge against the Euro. If the Eurozone is as slow to rebound as analyst predict, UGI could face continual slow growth from their international business.
Source: Money Week
CATALYSTS FOR GROWTH
The natural gas utility and propane distribution markets are fully saturated and mature. UGI’s main source of growth will come from small-scale mergers and acquisitions and increased throughput. Utility companies operate as heavily regulated natural monopolies in concentrated markets. Geographical growth will come mainly from M&A.
Several economic trends will directly have effects on UGI’s revenue. The falling price in natural gas has affected profits. Recent US production from the Backken and Marcellus formations has boosted domestic production to record levels. Since the December fall off in prices, UGI’s derivatives have suffered major losses. If
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natural gas prices rebound, UGI could again experience derivative gains as they did in 2013. Global markets will influence UGI’s international performance. If the dollar stays strong, overseas growth will remain stagnant. A strengthening European economy will grow UGI’s international segment with tremendous potential for upside growth.
Winter weather plays a major roll in heating utilities profits. 2013’s historically cold winter boosted UGI revenue, but a warmer 2014-2015 winter saw throughput diminish. If Eastern US and European winter weather patters remain at or below average temperatures, UGI will see organic growth. However, this is one factor that cannon be easily be hedged against.
INVESTMENT POSITIVES
x Utility companies experience steady revenue streams from a committed customer base. Natural monopolies offer barriers to entry for outside threats.
x UGI has positioned itself to increase natural gas throughput by utilizing the highly productive Marcellus shale via the proposed Sunbury pipeline.
INVESTMENT NEGATIVES
x Natural gas utility companies face heavy government regulation decreasing potential for increased profitability outside of throughput expansion.
x A rise in interest rates will undoubtedly have a negative impact on the utility sector, possible negatively influencing UGI greater due to its cyclical nature.
x The European economy has greatly affected UGI’s Internationals profitability. Slow growth out of the European recession could further hinder UGI’s profitability.
VALUATION
We are expecting negative growth in 2015 of 1%. UGI hedges against foreign risk and falling natural gas prices via commodity derivative instruments. Derivatives were a major factor of Q1 losses. Q2 2015 earnings will be reported on May 4th, which will show the critical second half of the heating season. Natural gas prices have remained low and the dollar has proven stronger over the
period. Further derivative loses and unfavorable economic trends could result in greater loses.
x Management attributed the $0.66 EPS mainly due to the warmer weather in Q1 (Oct – Dec). Management has a yearly EPS set to $1.89. We project a 1% reduction in revenue, and 2015 EPS to reach $1.78. We are discouraged that UGI underperformed during their peak season. January – March temperatures were reported to be colder, meaning UGI could slightly recover losses from Q1.
x UGI announced $571 million in capital expenditures for 2015. UGI is making aggressive infrastructure expansions surrounding the Marcellus shale. The Sunbury Pipeline will begin construction in 2016, thus we have increased CapEx to $600 million, and $700 million in 2017. CapEx should remain near $500 million yearly due to pipeline modernization. It should not spike higher unless new infrastructure is announced.
x Cost of goods sold is forecasted to stay consistent in terms of percentage of sales. UGI is still distributing the higher priced summer storage propane. We have forecasted a slight reduction in COGS moving forward once UGI is able to take advantage of the current low prices. COGS are not expected to make any significant reductions in relation to the lower natural gas and propane costs. COGS increases and decreases are usually passed along to the consumer, given the nature of the market. Additional revenue is mostly derived through higher throughput, in which COGS still remains constant.
x UGI is projected a 2015 yearly dividend pay out of $0.86. The dividend pay out has remained constant since the September 2014 3:2 split. Prior to the split, UGI showed a long trend of boosting quarterly dividends, eventually reaching $0.295 in June 2014. Now entering the third quarter of stagnant dividend payout, we expect UGI to begin boosting quarterly payouts again next year. Yearly payouts beginning in 2015 are forecasted as $0.86, $0.90, 0.92, $0.95, respectively. UGI’s dividend yield is still well below the Utility Sector average (2.52% to 4.37%). A rise in dividend payouts would be no surprise to the industry.
x UGI is engaged in a limited share repurchase program, authorizing 10 million shares to be purchased over the next four years. This represents 5.8% of shares outstanding. UGI is only scheduled to distribute 102,000 shares in the next five years through their employee stock options program, the
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remainder are projected to be distributed five years out or later. Forward guidance regarding stock repurchasing should be monitored, as 3 million ESOP shares could be exercised in 2020.
x Utility companies will often mirror US GDP growth. The Federal Reserve is projecting 2015 GDP growth to be between 2.1-2.3%. We have set UGI’s continuing value growth at 2.2%. Slower growth in Europe could have a negative affect on 15% of revenues. Additionally, the Marcellus Shale will be highly saturated by 2019 limiting future growth possibility in the region.
x UGI’s beta is 0.83. This was derived from Bloomberg, using a two-year, two-week measurement. The sub 1 beta reflects UGI’s tendency to move with the market, but at a slower pace. UGI, though, is higher than industry averages. New York University reporting the utility sector average to be .5912. UGI’s higher beta is attributable to having 65% of the business outside of the traditional government regulated segment.
Below is description of the three Henry Fund models used in deriving our target price of $38-$41 (DDM, DCF, Relative P/E).
Dividend Discount Model – The DDM produces a 5-year target price of $37.64. UGI has leveled their 2015 dividends, making predictions on future dividend growth difficult. However we do project a gradual increase. With the projected negative 2015 growth rate, we do not expect dividends to rise this year. Therefor, a $0.86 yearly dividend has been projected for 2015, with incremental increases leading to $0.95 in 2019. We believe these estimates are in line with pre-stock split practices of increasing yields.
Discounted Cash Flows – The DCF model produces a target of $42.06. The DCF represents a near 20% upside (sensitive to daily price changes), or 5.7% over the 52-week range. The DCF is heavily dependent on a strong Q2 reporting performance. If UGI continued to underperform through the winter months, the model will need to be adjusted accordingly. Through sensitivity analysis, -3% 2015 revenue would result in a $39.93 target price, and a 1% growth in revenue produces a target of $44.84. Through this 4% range in revenue projections, the DCF still shows upside potential.
Relative Valuation Model – The Relative P/E valuation produces a 2015 projection of $35.55, and a 2016 target projection of $34.77. This model is closest to current UGI
stock price. The P/E valuation used peers both in utility and natural gas distribution, since UGI has exposure to both. The cross industry analysis and UGI’s international exposure could result in the relative P/E producing an artificially low projection.
KEYS TO MONITOR
x Rising interest rates will have great affect on utility stock prices. Monitoring the Fed’s policy will be a solid indicator of the movement of utility stock prices
x Weather patters and temperatures play a major role in UGI’s winter heating month’s production. Below average temperatures will negatively affect yearly earnings.
x Q2 2015 10Q will show earnings from the second half of the winter heating months. The US had below average temperatures in early 2015; meaning Q1 underperformance could be supplemented.
x The strength of the dollar versus the Euro impacted overseas organic growth Q1 2015. Though UGI hedges strongly against the Euro, it still affects growth.
13. New York University, Betas by Sector (US). http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
14. Market Realist. “Natural Gas Prices Fall, Affecting the Power Utilities Industry” Matt Philips, Dec 30, 2014. http://marketrealist.com/2014/12/natural-gas-prices-fall-affecting-power-utilities-industry/
15. PPL Electric Utilities, About Us. https://www.pplelectric.com/about-us.aspx
16. Excelon, About Us. http://www.exeloncorp.com/aboutus.aspx
17. National Fuel and Gas, About Us. http://www.nationalfuelgas.com/AboutUs.aspx
22. Federal Reserve, Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
23. Europea, European Economic Forecast, Winter 2015. http://ec.europa.eu/economy_finance/publications/european_economy/2015/pdf/ee1_en.pdf
IMPORTANT DISCLAIMER
Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa’s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.
Net income (loss) 186,600 427,600 532,600 502,404 596,137 623,368 679,194 643,758
Less: net income attributable to noncontrolling interests 12,800 (149,500) (195,400) (200,480) (205,693) (211,041) (216,528) (222,158) Net income attributable to UGI Corporation 199,400 278,100 337,200 301,924 390,444 412,327 462,666 421,601
Investing Activities Capital Expenditures (571,000) (500,000) (600,000) (700,000) (500,000) Other Liabilities 10,794 11,010 11,230 11,455 11,684 Total Cash From Investing (560,206) (488,990) (588,770) (688,545) (488,316)
Finance Activities Long Term Debt 34,336 34,679 35,026 35,376 35,730 Issuance of Common Stock - - - - - Dividends Paid (148,155) (146,093) (143,943) (141,793) (139,643) Cash From Financing (113,819) (111,414) (108,917) (106,417) (103,913)
Change in Cash 247,931 1,090,991 (312,857) 389,555 1,010,242 Cash at Start of Period 419,500 667,431 1,758,422 1,445,566 1,835,121 Cash at end of Period 667,431 1,758,422 1,445,566 1,835,121 2,845,363
Utility taxes other than income taxes 5,373111111111111 5,249111111111111 5,156111111111111 5,627111111111111 5,740111111111111 5,912111111111111 6,090111111111111 6,211111111111111