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Financial Analysis of NACCO Industries

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Financial Analysis of NACCO Industries - February 18th, 2011

NiSource Inc. (NYSE:NI) provides natural gas and electric utilities to approximately 3.8 million customers, from the Gulf Coast up to New England. NI competes against other companies that produce natural gas, including MDU RES GROUP (MDU), Atmos Energy (ATO), and Puget Sound Energy (PSD).

One of the primary factors affecting NI's performance is the demand for natural gas in the United States. In 2007, 72% of NI's net income came from business segments centered around the natural gas industry, either transporting natural gas at wholesale or selling it at retail to consumers. As demand for natural gas increases, revenues at NI's pipeline and distribution segment increases as volumes transported rise. The price of natural gas affects demand for natural gas. For example, the price of natural gas hit a record high in 2005, [1] which caused electrical power companies, who consumed 32% of all natural gas produced in 2007, to switch to coal power.[2] Virtually all of NI's revenues come from regulated sources.[3] Its natural gas and electric utilities are regulated by the state governments in which they operate. The specific laws which govern NI's utility operations vary from state to state, but all contain clauses regulating rates NI can charge on its utilities and requiring regulatory approval for expansion. Some states also have provisions which insulate NI from changes in net income due to changes in customer usage patterns or adverse weather patterns. NI's interstate pipeline business is federally regulated by the FERC and requires regulatory approval for rate increases or expansion projects. The benefit of government regulation is relatively steady earnings while the cost is low growth potential.

Contents
1 Business Financials
1.1 Gas Distribution (56.0% of revenue, 34% of income)
1.2 Gas Transportation and Storage (14% of revenue, 38% of income)
1.3 Electric (17% of revenue, 27% of income)
1.4 Other (13% of revenue, 1% of income)
2 Trends and Forces
2.1 Fluctuating Natural Gas Prices Affect Demand
2.2 The United States is Switching Towards Eco-Friendly Energy Sources, Which Hurts NI's Electric Operations and Has A Mixed Effect On Demand For Natural Gas
2.3 A 2007 Court Ruling Will Likely Increase Rates NI Can Charge The Customers Of Its Pipeline Segment
2.4 Demand for All Three of NI's Business Segments Are Dependent on the Weather, Creating Seasonality and Fluctuations in NI's Revenues
3 Competition
3.1 Diversified Utilities
4 References
Business Financials

NI operates in three main segments:

Gas Distribution (56.0% of revenue, 34% of income)
NI's gas distribution segment purchases natural gas at wholesale than resells it at retail to residential, retail and industrial users. As of December 31st, 2007 NI operated over 58,000 miles of pipeline and distributed natural gas to about 3 million end users.[4] NI's gas distribution segment is subject to regulation by the state governments where it operates. NI requires regulatory approval for expansion projects or to change rates it charges its customers.[3] Because rates are set, revenues in this business segment are determined by volumes demanded by consumers, and net income is a fairly constant percentage of revenues. From 2006 to 2007, sales to the Gas Distribution segment increased 6.1% -- an increase reflecting NI's $500 million investment in its Gas Distribution segment and Gas Transportation and Storage segment.[5]

Gas Transportation and Storage (14% of revenue, 38% of income)
NI operates 16,000 miles of interstate pipelines and underground storage systems.[4] NI's transportation segment earns revenue by charging customers a volume based fee to transport gas on its natural pipeline. It does not actually purchase natural gas, but just transports it. This segment is subject to federal regulation by the FERC. NI requires regulatory approval for expansion projects and to establish rates it charges its customers.[3] From 2006 to 2007, sales to the Gas Transportation and Storage segment increased 5.5% -- an increase reflecting NI's $500 million investment in its Gas Distribution segment and Gas Transportation and Storage segment.[5]

Electric (17% of revenue, 27% of income)
NI's electric segment provides electric power to 457,000 customers in Northern Indiana on a 2,800 mile transmission system.[4] 90% of NI's electric power is generated from coal generators, while the remaining ten percent comes from natural gas.[4] NI's electric segment is subject to regulation by the government of Indiana, which sets rates it can charge customers and approves expansion projects.[3] From 2006 to 2007, sales to the Electric segment increased 4.5%.[6]

Other (13% of revenue, 1% of income)

NI also operates an "Other" business segment which is primarily involved in supporting the first three business segments through gas marketing, derivative contracts, real estate operations, etc.All NI's revenues are subject to government regulation.[3] Regulation provides a tradeoff; it gives NI relative income stability and insulation from competition in exchange for limited ability to earn above average profits. NI uses derivative contracts to hedge its Distribution and Electric segments against fluctuations in the price of coal and natural gas, and is permitted by the FERC to change rates at those segments to make up for any losses on those derivative contracts.[7] The primary factor affecting revenues at NI's three business segments is customer demand. A decrease in the demand for natural gas or electricity decreases the amount of natural gas and electricity sold at NI's Distribution and Electric segments and decreases the amount of natural gas transported at NI's Transportation segment. Due to government regulated rates NI's income earned on revenues is fairly constant, so a decrease in revenues would result in a proportional drop in net income. From 2006 to 2007, sales to the Other segment increased 7.9%.[8]




[9][10]
From 2006 to 2007, NI revenue increased 6.0%, gross profit increased 4.5%, and cost increased 7.1%.[11]



[12]
Trends and Forces

Fluctuating Natural Gas Prices Affect Demand
The price of natural gas has undergone wide fluctuations in the past five years. The price has declined slightly in the past two years, down 5% since a record high in 2005.[1] However, the price is still up 43% since 2002.[1] These price fluctuations affect demand for natural gas as other fuels become cheaper substitutes, especially among facilities with the capacity to switch to other types of fuels. For example many electrical power companies, who consumed 32% of all natural gas produced in 2007, switch to coal power during periods of high natural gas prices.[2] Many industrial users, who used 31% of natural gas produced in 2007, also have built in fuel switching capacities. [2] While residential and commercial users usually have no built in switching capacity many still conserve energy during periods of high gas prices. When demand for natural gas falls, NI feels the affects in its transportation and distribution segments, accounting for a combined 73% of revenue in 2007.[13] In pipeline transportation, revenue falls as declining demand results in smaller volumes being transported to end users. In distribution revenue declines as consumers, electric companies and industrial users either switch fuels or conserve gas usage, lowering volumes sold.

The United States is Switching Towards Eco-Friendly Energy Sources, Which Hurts NI's Electric Operations and Has A Mixed Effect On Demand For Natural Gas
Increasing environmental concern has a direct affect on the demand for natural gas. In the long run, increasing consumer concern over Global Climate Change will decrease the demand for natural gas. Already increasing environmental consciousness has led both consumers and electric companies to seek out and invest in renewable energy sources such as nuclear, solar, and wind power to heat homes and generate electricity.[2] As residential customers and electric power plants switch to other forms of energy, the demand for natural gas will fall. However, these renewable sources of energy are not yet developed enough to provide for the majority of energy uses in the United States. In the short run natural gas is one of the cleanest burning fuels in widespread use today.[14] Many electric companies are switching to natural gas as a cleaner alternative to coal and oil power plants.[15] The movement in the United States to combat Global Climate Change and will likely increase the demand for natural gas in the short run as other, more environmentally energy sources are not yet fully developed. This shift in consumer consciousness also affects NI's electric utilities. Ninety percent of NI's electric power is generated from coal generators.[4] Coal combustion produces more Carbon Dioxide, Carbon Monoxide, Nitrogen Oxides, Sulfur Dioxide, Ash and Mercury, all major pollutants and many contributors to global warming, per billion BTU's of energy produced than either oil or natural gas.[16] Though consumers do not have the choice to purchase electricity from another operator, increasing consumer consciousness about the effects of coal will likely lead many consumers to conserve electricity and lobby for more environmental regulations. This has already started to be a problem for NI. In 2007 the EPA issued NI a Notice of Violation (NOV) stating their electric plants were not up to code with the new Clean Air Act.[17] Though the results of this NOV are not yet known, the company estimates it will involve penalties and require additional investment to bring its generators into compliance.[18]

A 2007 Court Ruling Will Likely Increase Rates NI Can Charge The Customers Of Its Pipeline Segment
The Federal Energy Regulatory Commission (FERC) determines the rates NI can charge its pipeline customers by examining the pipeline’s operating costs then adding what it determines as a reasonable return on invested capital. That reasonable return on capital was traditionally determined by the FERC using a group of proxy companies which included local distribution companies. Pipeline companies argued that local distribution companies do not face the same risk or competition as interstate pipeline companies so their return on equity is lower. In 2007 the D.C. Court of Appeals Ruled that if the FERC continued using local companies as proxies it would have to revise its return on equity upward to reflect those company’s decreased risk.[19] This is likely to increase the rates NI can charge pipeline customers, increasing the segment's revenues.

Demand for All Three of NI's Business Segments Are Dependent on the Weather, Creating Seasonality and Fluctuations in NI's Revenues
Demand for natural gas is highest during the coldest months of winter when it is used to heat homes.[2] Demand for electricity is high during the summer months when people are using it to cool their homes.[2] During the temperate Fall and Spring seasons demand for natural gas and electricity drops sharply.[2] This seasonal shift in demand creates seasonality in NI's revenues; during the spring and fall revenues at NI decline due to lower consumer demand. The weather also impacts NI's annual income. If a winter or summer is longer and more severe than usual customers will demand more natural gas, increasing revenues. The opposite is also true, if the winter and summer seasons are short and temperate customers will demand less gas, decreasing NI's revenues. For example, in 2007 NI estimates that approximately 65% of its revenue increase was due to weather conditions creating a higher demand for its products.[20] Because NI's electric segment is concentrated in Northern Indiana, NI is particularly sensitive to weather changes in this region.

Competition

NI competes with different companies and in different ways in its various business segments. In pipelines, NI competes with such companies as El Paso (EP) and Williams Companies (WMB) for market share and long term gas transportation contracts. Though it has government rate caps for natural gas transmission, it sometimes lowers its rate below these caps to maintain competitive within the market. In its gas distribution and electric utility divisions NI's operations are more regulated and customers often don't have the choice to choose another electric or gas provider. In the case where customers can choose another electric or gas provider, NI is permitted to charge margins for transporting the utilities to these customers equal to the margin it would have earned had it sold to them.

In addition to competing with other natural gas companies, NI competes with suppliers of alternative fuels. Increasing consumer demand for alternative sources of energy is leading to a rise in the amount of nuclear, solar, and wind power available to heat homes and generate electricity. As the market share of these renewable energy sources increases, the demand for NI's natural gas and natural gas transportation services will fall.

Diversified Utilities
NiSource, Inc (NI) -- NI is a natural gas and utility holding company that sells natural gas and electric utilities in the U.S.
MDU RES GROUP (MDU) -- MDU produces electric and natural gas utilities in the Great Plains and Midwest.
Vectren (VVC) -- VVC is an electric holdings company selling primarily in the Midwest.
Atmos Energy (ATO) -- ATO produces gas utilities and has a monopoly in Texas.
Puget Sound Energy (PSD) -- PSD produces utilities, primarily electricity and natural gas, with most of its sales being in the Northwest.

Competition NiSource, Inc (NI)[21] MDU Res Group (MDU)[22] Vectren (VVC)[23] Atmos Energy (ATO)[24] Puget Sound Energy (PSD)[25]
Market Cap $Mil 3,590.00 3,440.00 1,800.00 2,040.00 2,930.00
Revenue $Mil 7,939.80 4,247.90 2,281.90 5,898.43 3,220.15
Gross Profit $Mil 1,020.80 1,012.43 515.30 786.90 1,003.26

Net Profit Margin % 3.93% 7.60% 6.28% 2.86% 5.74%
Operating Margin % 11.11% 13.12% 11.42% 6.76% 13.70%
Natural Gas Customers 3,300,000 256,000 998,000 3,200,000 730,000
Electric Customers 457,000 120,000 122,000 N/A 1,100,000
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Last edited by abhishreshthaa; February 18th, 2011 at 11:17 AM..
   
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