PNM Resources: Debate Hinges On Merger, Economic Value Absent Either Way

Investment Briefing

Broad-based utility companies are currently in a favourable position to capture risk premia stemming from various macro-crosscurrents. In light of this, it is prudent to consider screening the larger providers.

Under this convention, PNM Resources, Inc. (NYSE:PNM) came onto our radar as a potentially selective opportunity. PNMR is a holding company with two regulated utilities serving ~820,000 residential, commercial, and industrial customers and end-users of electricity in New Mexico and Texas. It was established in 1818 and serves the New Mexico and Texas markets, in residential, commercial and transmission settings.

Within the broad utilities sector—electric utilities included—a major obstacle is the lack of differentiation in terms of cost and product, resulting in no significant consumer or branding advantages. This is because most, if not all, suppliers are bound by the same pricing mechanisms and offer an undifferentiated product—it's all the same electricity at the end of the day.

Therefore, the key to distinguishing oneself lies in the idiosyncratic features of individual companies. In particular, this includes production and efficiency advantages, where capital productivity and earnings power are the key competencies.

Upon closer inspection, it appears that PNM does not possess any significant advantages in either of these domains. This forms the basis of the hold thesis presented here today, along with other uncertainties. What isn't discussed at length here today is the company's dividend, which is seen in Figure 1(a). It has grown YoY over the past 10 years, and income investors can buy a 3% forward yield as I write.

Net-net, I rate PNM a hold for the reasons discussed in this report.

Figure 1.

Figure 1(a).

Critical investment facts to hold thesis

1. Avangrid Merger

As a reminder, Avangrid (NYSE:AGR) and PNM proposed a merger in October 2020, aiming to complete the $4.3Bn deal in Q4 of 2021. The merger would have given Avangrid access to over 500,000 New Mexico customers and important infrastructure, such as transmission lines, access points and so forth.

This was a significant proposal in the electric utility industry, which has seen limited merger and acquisition activity in recent years. The last comparable transaction was the $3.8Bn merger between Narragansett Electric and PPL Corp. in May 2022, according to FactSet's M&A database.

However, the proposed merger faced opposition from regulatory bodies, regarding concerns on a number of issues. In particular, the New Mexico Public Regulation Commission ("NMPRC") had specific concerns about reliability, alleged mismanagement at Avangrid-owned utilities in New England, uncertainty about customer benefits, and ongoing investigations involving Iberdrola executives in Spain. The advocacy group New Energy Economy also opposed the merger from the outset.

The NMPRC ultimately rejected a proposal for a merger and slapped a fine of $10,000 on the applicants for violating discovery directives. The joint applicants have filed an appeal against this decision, citing improper evaluation of the merger's benefits and the consideration of inappropriate evidence. They have now moved to dismiss their appeal with the State Supreme Court and are requesting a rehearing and reconsideration by the NMPRC. The New Mexico Supreme Court heard the case in earlier this month after it was denied a request for remand to the NMPRC that occurred back in May.

The major risks here are that (i) the merger doesn't get approved, or (ii) the deal will be terminated by surpassing the effective time. It was extended in June until the end of this year.

2. Q3 FY'23 Insights

PNM put up Q2 operating revenues of $477.1mm, down 4.5% YoY on operating income of $92.3mm, up from $86mm the year prior. It pulled this to earnings of $0.55/share, down $0.02 YoY decrease. Adverse weather conditions in both its markets reduced EPS by $0.04 YoY. PNM also returned dividends of $0.3675/share. The breakdown of its H1 FY'23 contributions is observed in Figure 2.

PNM aims to increase its carbon-free capacity to 60% by adding 410 MW of solar and storage in Q3 '23. Additionally, the company plans to integrate 1,300 MW of solar and storage resources by the end of '24, which would take the carbon-free portfolio to >70%. To support growth and improve reliability, PNM is investing heavily in its teams and CapEx in Texas. Over the past 5 years, the annual capital investment plans have doubled, from $200mm, to over $400mm in the current year. The investments are evenly distributed across all 3 regions of the service territory (North Central Texas, the Gulf Coast, and West Texas).

Regarding base rates, PNM has applied to the NMPRC for an increase in retail electric rates. The request includes a forecasted test year of 2024 and a $2.7Bn recovery, an increase of $63.8mm in non-fuel revenues, and an ROE target of 10.25%.

Critically, growth in the North Texas housing market and increased demand in the Gulf Coast region has drawn heavy investment from PNM into new substations and supporting T&D infrastructure. These investments resulted in a $14.5mm increase in rate to be implemented from September 1. On analysis, this will recover an incremental investment of ~$157mm of rate base. For transmission, updated rates were implemented under the first Transmission Cost of Service filing for 2023 back in May, with a subsequent filing in July. The request is for an annual increase of $4.2mm to recover an incremental $21.4mm in capital investments.

3. Economic value analysis

Given the sector hurdles outlined earlier, the following analysis of PNM's economic value is a fruitful exercise. It is pertinent to benchmark PNM and gauge whether it is a sensible steward of capital.

Like most providers of electricity and energy, PNM enjoys NWC efficiencies. Figure 3 depicts the firm's cash conversion cycle ("CCC") since late 2020. It has tracked lower over the last 3 years and came in at 17 days last period. This means each $1 committed to NWC is recycled back to cash in just 17 days, on DSO of ~29 days. Cash collections are therefore timely and can be put back to work faster. Say it continues holding a CCC of 17–20 days, it would turn over its NWC 18–21.5x each year, presuming 365 days a year.

More critically, PNM had deployed $7.5Bn of capital at risk into the business as of Q2, equating to $87.86/share, and nearly double its current market value per share. The c.$88/share produced just $4.28/share in trailing post-tax earnings last period, a paltry 4.9% return on investment, in line with historical range. The capital tied up in PNM's business is simply not valuable, in that it produces sub-standard rates of return.

Deeper analysis explains clearly why this is so:

1. Post-tax margins are tight and average ~16% each rolling period. This suggests PNM enjoys neither consumer advantages nor benefits of cost differentiation, as outlined in the opening remarks of this report.
2. At the same time, capital turnover is just ~0.3x, illustrating where PNM lacks production advantages. This squares off with the economics of the business. It simply can't lower its pricing or produce supply at cheaper rates.

You'd expect capital intensity to be low and capital turnover to be high to imply PNM possessed some competitive position, where it could produce supply at more profitable rates. Not the case here. Each $1 of investment rakes in just $0.3 in revenues, $0.15 in profit after tax.

We employ a 12% required rate on capital across all equity holdings as a core competency (in line with long-term market averages). To advocate a buy we need a company to be throwing off profits at rates above this threshold to create economic value. Figure 5 depicts what PNM needed to have produced in order to beat this 12% capital charge. For instance, in Q2, it's $7.5Bn of investments needed to have thrown off $904mm in NOPAT, but it did $367mm instead (TTM values). This produced an economic loss of $6.26/share. In 2020, it was a $500mm economic loss corresponding to $5.83/share. In terms of value creation, this isn't it.

4. Expectations and forward estimates at steady-state

The critical value drivers of PNM's operating and FCF performance over the last 3 years are observed in Figure 6. Sales have grown at a rate of 4.3% on stable operating margins of avg. ~17.5%.

Critically, the bulk of PNM's capital allocation has been geared toward fixed assets, squaring off with the economics of the business. For every new $1 in revenue, it required an investment of $1.52 towards fixed capital. Meanwhile, NWC requirements increased by $0.08 on the dollar. No doubt, this is a capital intensive business.

The question is what are the requirements of PNM to maintain its competitive position going forward. A 4.3% forward revenue growth rate is an unreasonable expectation for PNM in my opinion. Consensus has it to do <1% this year, and my numbers have it to push 1–2% over the coming 5 years. The requirements of growing sales at 2% going forward, and holding the same stipulations as its steady-state above are seen in Figure 7. It would likely have to invest ~$77–$84mm each quarter, of 22% of trailing NOPAT. It could throw off $280–$310mm in FCF at this rate.

To keep the 4% growth rate, it would require $167–$198mm investment per quarter, otherwise 47% of NOPAT. FCFs would crimp to $205–$243mm, ultimately crimping shareholder value. This is a clear example of how sub-par returns on capital torture the growth calculus. Given PNM's low returns on investment, growth actually erodes value, in that higher growth leads to lower shareholder value (measured by the present value of future FCFs).

Valuation and conclusion

The stock sells at 16x forward earnings and 19.5x forward EBIT. But it sells at a small premium to invested capital of 1.15x. This isn't an attractive multiple, as I'm looking for 3x at least to imply the market sees value in a firm's core assets. Comparing the EV/IC to the ROIC/12% rate figure gives a good indication as to what earnings power is priced in. Both compare returns on PNM's capital—one compares business returns, the other, market returns. As you can see, it looks as if the forward earnings projected off PNM's core assets is well captured at their current market values.

Extending the numbers in the steady-state analysis out to FY'28, and compounding the firm's intrinsic value at the function of its ROIC and reinvestment rates, arrives at an implied valuation of $52/share, around 18% value gap as I write. This is roughly the level of value that Avangrid proposed as part of the proposed merger. Hence, I am retaining a neutral value in lieu of this, even if it's not approved.

In short, there are multiple inflection points to consider with PNM. Most of the investment debate hinges on whether its merger with Avangrid will be approved. If not, then the economic analysis presented here doesn't support a buy rating. In that vein, I rate PNM a hold.