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SHORT OPPORTUNITY: OGS (NYSE)

OGS: OIL INDUSTRY EXPOSURE & VALUATION RISKS


Disclaimer The opinions expressed in this presentation by Lateral Capital Management, Inc. (“LMCI�) are not an investment recommendation and are not meant to be relied upon in reaching an investment decision. LCMI and its employees, consultants and contractors are not acting in an investment, tax, legal or any other advisory capacity. The opinions expressed herein address a limited number of aspects regarding a potential investment in securities of the companies mentioned and are not a substitute for a comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations as to its accuracy. LCMI recommends that potential and existing investors conduct a thorough investment analysis of their own, including a detailed review of the companies' SEC filings, and consulting a qualified investment advisor. This material is based on information obtained from sources believed to be reliable, but the reliability of that source information. Any opinions or estimates constitute a best judgment as of the date of this presentation and are subject to change without notice. LCMI explicitly disclaims any liability that may arise from the use of this material. 1


Executive Summary [ ]

[ ]

[ ] 

[ ]

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Table of Contents 1. Introduction & Background 2. Shale Oil Industry Downturn 3. Valuation Risks 4. Conclusion Appendix: Trading Multiples


Section One

Introduction & Background


Types of Utilities [ ] [Side bar commentary]

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Section Two

Shale Oil Industry Downturn


There is Material Geographic Overlap With Major Shale Oil Basins OGS’ gas LDC service territory would appear to have significant exposure to lower economic activity in the tight oil basins

Figure 1

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Atmos Energy Service Territory In addition to OGS, ATO and CNP also have material gas LDC overlap with the major tight oil basins. However, ATO’s service territory extends beyond tight oil basins and CNP owns a vast number of additional businesses

Our best “pure play” example of potential gas LDC exposure to declining tight oil production in the lower 48 would appear to be OGS

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[ ] [ ] Figure 2

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The Declining Horizontal Well Rig Count Is Obvious from late 2014 [ ] Figure 3

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US oil production in 2015-16 Only Declined Marginally from 2014-15 However, the dramatic decline in the US rig count suggests further production declines are in store Figure 4

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Onshore Crude Oil Stock Are Reaching Record Levels Another reason to expect US crude oil production to decline in the near future. In fact, there is data suggesting that onshore crude oil storage is nearing its physical capacity limits

Figure 5

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At First Glance, OGS Volumes Are Being Impacted By the Oil Downturn Both volumes sold and volumes delivered by the gas LDC subs are showing materially declines yearover-year

Figure 6

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However, Most of the Reduction is Due to Unseasonably Warm Weather All 3 of the OGS gas LDC regions experienced significant HDD reductions in 2015 (except for Q1 2015 in Texas)

Figure 7

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[ ] [ ] Figure 8

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OGS Customer Numbers Have Increased in Recent Quarters As Have Gross Margins. Suggesting that any impact from lower crude oil production has been mitigated by other factors. Including weather normalization provisions.

Figure 9

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Crude Oil Production in OGS States [ ] Figure 10

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In Terms of Employment, Oil Production is Not Material in OGS States This data suggests that even if oil producers were to conduct major staff layoffs in response to the lower crude oil price, that OGS residential and commercial gas LDC volumes may not be materially affected

Figure 11

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Section Three

Valuation Risks


US Gas LDCs Are Currently Valued in Relation to Their Leverage Ratios Because of its lower relative leverage since the ONEOK spin-off, OGS trades at a higher P/E multiple than comparable US gas LDCs

Figure 12

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[ ] [ ] Figure 13

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OGS Trades At Higher EBITDA Multiples & Lower Dividend Yields Despite paying out less of its earnings as dividends Figure 14

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Gas LDCs & T&D Utilities Trade At the Highest PEGY Multiple Within the Gas LDC space, OGS has the highest PEGY multiple Figure 15

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The OGS Stock Price Tends To Be Highly Correlated To Interest Rates The rolling correlation between OGS and the 10-year Treasury bond tend to fluctuate between 0.5 and 0.9 for extended periods of time

Figure 16

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Since Its Spin-Off from ONEOK, OGS Has Materially Outperformed Part, but not all, of this relative performance can be explained by the S&P500 bull run (until early or mid-2015) and the material decline in Treasury yields. The outperformance since early 2015 appears less attributable to macroeconomic factors

Figure 17

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We Value OGS Using Two Scenarios of Uninterrupted Growth 5% to 8% EPS growth is arguably excessive relative to the nominal growth rate of the US economy Figure 18

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We Re-Levered the OGS Equity Beta Using Comparable Gas LDCs As its peers are more high levered, a re-levered equity beta will lower the re-levered OGS equity beta and inflate its equity value (i.e. we are being conservative)

Figure 19

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Investors Who Anticipate 20% Dividend Growth Will Encounter Payout Issues It is difficult to find a scenario where OGS can increase its dividend per share without encountering a > 100% dividend payout ratio in a few short years

Figure 20

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Similarly, Cash Flow To Pay These Dividends Is Not Readily Apparent [ ] Figure 21

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To Justify The Current OGS Multiple, Dividends Need to Grow 16% p.a. If the dividend growth rate declines to a rate that is consistent with its earnings growth (a payout ratio < 100%) and its projected free cash flow, then OGS is overvalued by 20+%

Figure 22

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Under A Range of Scenarios, OGS Will Need to Reduce Its DPS Growth [ ] Figure 23

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Section Four

Conclusion


Recap 

The recent declines in OGS gas LDC volumes is due to warmer weather rather than reduced employment and/or retail spending in crude oil producing regions of OGS’ service territory 

Warmer weather does reduce volumes transported but the regulatory mechanisms compensate OGS for any weather related declines

While future oil industry layoffs appear inevitable given rig count, storage levels, etc, the local economies are very diversified with only <5% of local employment in the oil & gas sector (data actually includes mining and logging)

The bigger risk we see for OGS is that it is trading at relatively high multiples and expectations of double-digit dividend per share growth rates appear unsustainable

If interest rates increase, or the utility sector falls out of favor, OGS is one of the most highly valued utilities (based on its PEGY ratio) exposing it to potentially more downside than its competitors. Its relatively low dividend yield will only provide a small measure of insulation from any stock price declines

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Appendix

Trading Multiples


Appendix: Utility PEGY Multiples [ ] [Side bar commentary]

A1


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