PNM - PNM Resources: High Valuation Uncertain Backup Plan

2023-06-14 16:05:59 ET

Summary

• PNM Resources, Inc. is a regulated utility that operates in the U.S. states of New Mexico and Texas.
• The company enjoys remarkably stable cash flow through all economic environments, which should serve it fairly well as the economy weakens.
• The company's growth plan only extends out to 2025, and it appears to have no backup plan in the event its merger fails to obtain regulatory approval.
• The company has a fairly high debt load relative to its risk.
• The company is very expensive relative to its forward growth prospects.

PNM Resources, Inc. (PNM) is a regulated electric utility operating in New Mexico and Texas. The utility sector has been among the most popular places for risk-averse investors to park capital for decades. There are many reasons for this, including the fact that they tend to be resistant to economic shocks and pay out respectable dividend yields. PNM Resources is no exception to this, as its 3.16% current yield is certainly more attractive than most other things in the market right now. Unfortunately, as I discussed in my last article on the company, PNM Resources does not seem to have a plan in place to help it manage the growing demand for green energy apart from selling itself to another company. The company did manage to deliver pretty decent earnings growth year-over-year for the first quarter , though, and there are some signs that it can continue this going forward. Unfortunately, the stock appears to be somewhat expensive today, which means that the company's investment appeal could still be somewhat limited.

About PNM Resources

As stated in the introduction, PNM Resources is a regulated electric utility that operates in the U.S. states of New Mexico and Texas. The majority of the company's business is in New Mexico though, as 550,000 of its approximately 800,000 homes are in that state. Admittedly, this customer count may not sound particularly high compared to some of the major utilities like Dominion Energy ( D ) or Exelon Corporation ( EXC ), but it is still bigger than many of the companies that provide services throughout America's sparsely populated middle region. As I have pointed out in numerous previous articles though, a utility's size has little impact on its characteristics. The most important of these is that a utility firm typically has remarkably stable cash flows regardless of the conditions in the broader economy. PNM Resources certainly possesses this quality, which we can see by looking at the company's operating cash flow. This chart shows PNM Resources' operating cash flow during each of the past eleven twelve-month periods:

As can be clearly seen, there is not very much change from period to period. This is despite the fact that there were several events that had an impact on the broader economy during the above period, including the pandemic-driven lockdowns in 2020 and the high inflation of the 2021 to present period. This thus indicates that the company should be able to remain relatively stable financially in the event that the economy weakens in the near future. As the consensus among economists and the Federal Reserve is that the economy will enter a "mild recession" during the second half of the year, that is something that could be attractive to investors today.

The biggest reason for this stability is that PNM Resources provides a product that is generally considered to be a necessity for our modern way of life. After all, how many homes and businesses do not have electric service today? As such, most people will prioritize paying their electric bills ahead of discretionary expenses during times when money gets tight. This makes sense as few people want to have their electric utility service turned off. It is also something that gives the company an advantage over firms in other sectors right now since many consumers are under severe financial stress. I discussed this in a recent blog post .

In addition to the adverse impacts that the rising cost of living is having on household budgets, the prospect of a near-term recession could also prove detrimental. This is because recessions frequently cause businesses to lay people off or cut back on their hours. That means that the consumer sector will have less money to spend, and they will be more apt to pay their electric bill than waste it on some frivolous gadget. This should thus position PNM Resources to weather the next several months better than many other companies.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied with mere stability. We want to see companies in our portfolio grow and prosper. Fortunately, PNM Resources is well-positioned to accomplish this.

There are two ways in which a utility can grow. The first is through population growth in its service territory. This is admittedly something that is mostly out of the company's control since utilities are confined to a specific area and they cannot really compete for customers. Unfortunately, this poses something of a problem for PNM Resources as the population of New Mexico has not been growing. In fact, as we can see here, it has been falling off over the past few years:

The same is true for the city of Albuquerque, New Mexico, which is the major city in PNM Resources' New Mexico service territory. While the city was one of the fastest-growing regions of the nation for most of the past two decades, its growth has leveled off significantly and has been falling since the COVID-19 pandemic:

As already mentioned, New Mexico is home to more than 50% of the company's business so this is something that can be expected to have an adverse impact.

Fortunately, the state of Texas is one of the most rapidly growing in the nation, which has helped offset this. Overall, the company's customer base increased by 1.5% year-over-year in Texas and surprisingly by 0.8% year-over-year in New Mexico during the most recent quarter. It seems unlikely that it will be able to continue to deliver that sort of growth in New Mexico over the long term though considering the declining population in that state.

Now, the company does have another method through which it can generate growth independently of the population of its service territory. This is to increase the size of its rate base, which is the only method that is somewhat within the company's control. The rate base is the value of the company's utility assets upon which regulators allow it to earn a specified rate of return. As this rate of return is a percentage, any increase to the rate base allows the company to increase the price that it can charge its customers in order to earn that specified rate of return. The usual way through which a company grows its rate base is by investing money into upgrading, modernizing, and even expanding its utility-grade infrastructure. PNM Resources is planning to do exactly this as the company has budgeted $2.8 billion over the 2023 to 2025 period for this purpose:

It is very disappointing that the company has only provided details of its planned expenditures through 2025. This is because most of its peers have now provided their capital spending guidance through 2027, which gives investors an additional two years of visibility to use to make their own determinations of the company's future value. We can also see that the company's capital spending is expected to decrease with the passage of time. This is unusual, to say the least, as it is a very real sign that PNM Resources expects its growth to slow going forward. That is certainly possible considering the poor demographics of New Mexico right now, but it is hardly encouraging from an investment perspective.

The company's capital spending plan is intended to grow the firm's rate base at an 8% compound annual growth rate over the 2020 to 2025 period. Once again, as we know little of the firm's plans beyond 2025, it is difficult to make a better or more helpful projection than that. As I have noted in various previous articles on PNM Resources, it appears that the company has bet the farm on its merger with AVANGRID ( AGR ) and either does not have or has not publicly revealed any contingency plans in the event that the merger does not go through.

This is unfortunate, as the merger remains troubled due to concerns from the New Mexico Public Regulation Commission. As of April 12, 2023 , the situation remains with the Courts and the companies have until July to complete the transaction. Despite this deadline, there is no certainty when the Court will issue a ruling nor when the transaction will be. It is therefore very disappointing that PNM Resources has not provided any contingency plan to assuage the concerns of investors in the event that this deal does not go through.

Financial Considerations

It is important to analyze the way that a company finances its operations before investing in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is normally accomplished by issuing new debt and then using the proceeds to repay the existing debt. This can cause a company's interest expenses to go up following the debt rollover, depending on the conditions in the market.

As everybody reading this is likely aware, interest rates are currently at the highest level that we have seen since 2007, so most rollovers today will result in rising interest expenses. In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. Thus, an event that causes a company's cash flows to decline could push it into financial distress if it has too much debt. While PNM Resources does enjoy remarkably stable cash flows over time, this is still a risk that we should not ignore as there have been bankruptcies in the utility sector before.

One metric that we can use to evaluate a company's debt load is the net debt-to-equity ratio. This ratio tells us the degree to which a company is financing its operations with debt as opposed to wholly-owned funds. It also tells us how well a company's equity will cover its debt obligations in the event of a bankruptcy or liquidation event, which is arguably more important.

As of March 31, 2023, PNM Resources had a net debt of $4.5594 billion compared to $2.2763 billion of shareholders' equity. This gives the company a net debt-to-equity ratio of 2.00 today. This is, unfortunately, a bit of an increase over the 1.94 ratio that the company had at the end of the fourth quarter of 2022. Here is how that compares to some of the company's peers:

As we can clearly see, PNM Resources has higher leverage than its peers. This was also the case the last time that we reviewed the company and as already noted, it appears that the company's leverage is going up. This is concerning as it could be a sign that PNM Resources is relying too heavily on debt to finance its operations, which exposes its investors to more risk than its peers. As the company does enjoy stable cash flows, it can carry a fairly high debt load, but heavy reliance on debt is far more concerning today than it was back when the Federal Reserve was running its quantitative easing policies. This is, therefore, something that we will want to watch in order to ensure that the company's debt does not rise further.

Dividend Analysis

One of the biggest reasons why utilities like PNM Resources are appealing to investors is that they usually have a higher yield than many other things in the market. This comes from the fact that these companies have a very slow growth rate, so they pay out a significant percentage of their cash flows to the investors in order to provide a reasonable investment return. In addition, since the low growth rate means that the market does not assign a particularly high multiple to these firms, the dividend ends up being a significant percentage of the stock price.

PNM Resources is no exception to this high dividend yield rule, as the company's current yield is 3.16%. That is substantially above the 1.66% yield of the S&P 500 Index ( SP500 ). In addition to its high yield, PNM Resources has a long history of raising its dividend over time:

This is something that is very nice to see during periods of inflation, such as the one that we are in today. This is because inflation is constantly reducing the number of goods and services that can be purchased with the dividend that the company pays out. As such, an investor that is depending on their portfolio income to support themselves can feel as if they are getting poorer and poorer with the passage of time. The fact that the company increases the amount that it pays to the shareholders on a regular basis helps to offset this effect and maintains the purchasing power of the dividends.

As is always the case, it is critical that we ensure that the company can actually afford the dividends that it pays out. After all, we do not want to be the victims of a dividend cut, since that event would reduce our incomes and almost certainly cause the company's share price to decline.

The usual way that we judge a company's ability to pay its dividends is by looking at its free cash flow. The free cash flow is the amount of money that is generated by a company's ordinary operations and is left over after the company pays all of its bills and makes all necessary capital expenditures. This is therefore the money that is available for things such as reducing debt, buying back stock, or paying a dividend. In the twelve-month period that ended on March 31, 2023, PNM Resources reported a negative levered free cash flow of $509.5 million. This is obviously not enough to pay any dividends, but the company still paid out $121.0 million during the period. At first glance, this is likely to be concerning as the company cannot pay its dividend out of free cash flow.

However, it is common for utilities to finance their capital expenditures through the issuance of debt and equity. These companies will then pay their dividends out of operating cash flow. This is done because otherwise, the incredibly high upfront costs involved in constructing and maintaining utility-grade infrastructure over a wide geographic area would otherwise preclude any sort of return to investors. During the most recent trailing twelve-month period, PNM Resources had an operating cash flow of $582.2 million. This was easily enough to cover the $121.0 million dividend and still leave a significant amount of money left over for other tasks. Thus, it seems likely that the company can afford to sustain its dividend at the current level over the long term.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a utility like PNM Resources, we can value it by looking at the price-to-earnings growth ratio. This is a modified version of the familiar price-to-earnings ratio that takes a company's earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 is a sign that the company's stock may be undervalued relative to its forward earnings per share growth and vice versa.

However, there are very few companies that exhibit such undervaluation in today's overheated market . As such, the best way to use this ratio is to compare PNM Resources to its peers in order to determine which company has the most attractive relative valuation today.

According to Zacks Investment Research , PNM Resources will grow its earnings per share at a 4.49% rate over the next three to five years. This gives the company a price-to-earnings growth ratio of 3.83 at the current stock price. Here is how that compares to the company's peer group:

As we can clearly see here, PNM Resources appears to be extremely expensive compared to other electric utilities. This has been the case for a while, as we saw the last time that we looked at this company. As mentioned earlier, the outlook for this company is murky considering the uncertainty surrounding the success of its proposed merger with AVANGRID. As such, it may be best to stay away until the stock price comes down to a level that is appropriate for the risk.

Conclusion

In conclusion, PNM Resources, Inc. remains one of the more uncertain plays in the utility sector. While the sector as a whole should be solid right now and PNM Resources itself does have a great deal of stability, the legal issues surrounding its merger destroy much of the potential here. This is because the company has not revealed any backup plan in case the regulators will not approve the merger. When we combine this risk with the high valuation, it may be best to stay on the sidelines for PNM Resources, Inc. stock.

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