UPW - Northwest Natural: Buy A Dividend King Utility With A New Growth Plan

2023-08-22 07:39:36 ET

Summary

• Come for the 4.8% dividend and stay for the new businesses and share price growth.
• Northwest Natural Water division started in 2018 and has grown connections 10-fold.
• Northwest Natural Renewables, for biogas, just started operations in 2023 with two new plants.
• NWN is diversifying in product and geography, with a superb 67-year streak of rising dividends under its belt.
• I estimate that the current share price of $40.69 is 10-15% undervalued.

Northwest Natural ( NWN ) is a holding company headquartered in Portland, Oregon, and the company has been in existence in various forms for 160 years. I believe the shares are undervalued at the current price of $40.69, down 25.1% from the recent May 2022 peak of $54.29. If you are an income investor with a long-term horizon, I believe a share price under $40 is a particularly strong entry point, and the stock has briefly reached that point during the last week. The upside with Northwest Natural will be the company's new businesses and a recent streak of acquisitions.

NWN, the holding company, has three divisions: 1) Northwest Natural, a gas utility, 2) Northwest Natural Water, a water and wastewater utility, and 3) NW Natural Renewables, a biogas business creating purified gas from decomposed organic matter. The gas utility is by far the largest revenue generator with over 90.0% of the company's income, see the 2022 Annual Report . I think that in the future, healthy new business growth will come from the water and biogas businesses which have only recently been launched.

Growth Areas For The Future

Northwest Natural Water (and wastewater) began in 2018 through an acquisition, starting with less than 10,000 connections. Today, there are about 77,500 connections after the 2023 acquisition of Hiland Water Corporation and King Water Company in Washington and Oregon State. There are also customers in Idaho, Arizona (Truxton Canyon Water and Cerbat Water), and Texas (Everett Square) from prior purchases in 2022. The cumulative investment to date is $260 million, and customers have grown at a compound annual growth rate of 50.6%. NWN Water has also acquired an increased ownership stake in Avion Water Company, an investor-owned utility in central Oregon, to 40.3%. I would not be surprised if this stake increased and I think the water management business, in particular, has long-term potential to improve growth at NWN.

Northwest Natural Renewables was started in 2021 with a $50 million investment in two renewable natural gas production facilities. This was partnered with EDL Energy and the plants came online in May of this year. They are expected to generate enough gas to serve 5,400 connections. These investments were made possible through Oregon Senate Bill 98, which supports renewable energy procurement and investment by natural gas utilities. It will take time to know how profitable this division will be.

The Core Gas Business, NW Natural, is a local distribution company that currently provides natural gas service to approximately 2.5 million people through more than 795,000 meters. About 88.0% of its gas customers are located in Oregon and 12.0% in Washington, and about 60% of end users are residential, the balance industrial. This business is growing the number of its connections organically at about 1.1% to 1.5% per year. In 2015, it was one of the first gas utilities in the U.S. to replace all cast iron and bare steel pipelines with modern polyethylene and "cathodically protected" pipes. These are reported to be highly resistant to corrosion, perform better in seismic events and keep more gas in the pipes. They also have a life expectancy, in theory, of 100 years. So this costly infrastructure expense is an item in the past. The demand drivers in this segment moving forward will be population growth in Oregon and Washington.

NWN's Fundamentals

2022 and 2023 have been strong years for NWN. Operating revenues increased from $860 million in 2021 to $1.04 billion in 2022. Earnings per share were generally steady at $2.56 in 2021 and $2.54 in 2022, the latter lowered by share dilution. See the 2022 Annual Report. 2022 also saw tighter margins due to the increased price of natural gas, which peaked at $8.81 per Btu in August 2022.

Northwest Natural handily beat earnings estimates for the first two quarters of 2023. During Q1, earnings were $1.36 while during they were $2.01, 53.4% above the consensus estimate of $1.31. Much of this was due to new regulatory rates. For the first half of 2023, the company reported net income of $72.9 million, compared to earnings of $58.0 million for the same period in 2022. It also added nearly 6,400 natural gas meters for a growth rate of 0.8% in that sector so far. 2023 EPS guidance was affirmed in the range of $2.55 to $2.75 per share, an increase of 8.3% over last year's numbers. The Natural Gas Distribution segment net income increased some $16.1 million this year reflecting new increased rates in Oregon and Washington that went into effect on Nov. 1, 2022, partially offset by higher operating expenses. Also, the March weather was colder than average.

NW Natural Renewables' first project began operations in the first half of 2023 and Northwest Natural Water expanded in Oregon and Washington. It previously closed seven water and wastewater utility transactions in 2022. The full impact of these operations on the bottom line won't be known for another year, but I suspect it should generate a meaningful increase. Water revenues grew from $17.3 million in 2021 to $23.0 million in 2022, an increase of 32.9%. So far, the latter is only a fraction of 2022 revenues, but I expect this to change for 2023 and 2024. In 2020, revenues were only $14.9 million from this segment. The company's overall profit margin is 8.5%.

As for the natural gas segment, the main driver in the future will be population growth. Overall, the industry is expecting earnings per share to increase by 6% in each of the next two years. This is affirmed by Institutional Investor which forecast 6.0% EPS growth on average across utilities.

Notes on Rate Structures

The Northwest Natural Gas is the most regulated of the three business segments. All its customers are located in Oregon and southwest Washington. NW Natural has an exclusive service territory granted by the Oregon Public Utility Commission (OPUC) and Washington Utilities and Transportation Commission (WUTC), which includes the Portland metropolitan area, and portions of western Washington along the Columbia River. Since 2002, NW Natural in Oregon has operated under a rate structure called "partial decoupling." In this structure, the company is allowed to keep a fixed amount of money for each residential and commercial customer. If it receives more or less than that fixed amount each year, customer rates are adjusted for the difference. In October 2022, NW Natural received approval for an Oregon rate change, with a $59.4 million increase in the revenue requirement and rate base of $1.76 billion. This was a positive change of 14.4%. In Washington, the second year of a multiyear rate plan went into effect, increasing that revenue by $3.0 million. These increases were evident in the Second Quarter EPS results.

As for water rates, water distribution operations are seasonal in nature with peak demand during warmer summer months. Wastewater is less seasonal and more consistent. NWN's recent acquisitions operate in exclusive service territories with no direct competitors, but they are regulated by state utility commissions. Wastewater services are partly state-regulated and partly unregulated depending on location, whether Idaho, Texas, Oregon, or Arizona. The RNG sector is non-regulated.

Dividend History

NWN hasn't missed a regular dividend since its first dividend payment in 1956. It has increased its dividend every year since then. NWN is not a member of the S&P 500 Dividend Aristocrats , where members have increased their dividend for a minimum of 25 years, because that list requires a minimum float-adjusted market cap of $3.0 billion. The current market cap of Northwest Natural is $1.4 billion. This is not a restriction for the Dividend Kings list, however, which has the chief requirement that companies have raised their dividend every year for the last 50 years. You can find the 2023 list here . Dividend Kings don't have to be members of the S&P 500.

NW Natural moved from the Nasdaq - Wikipedia stock market to a listing on the New York Stock Exchange under the symbol NWN in 2000. Since that time, it has raised its annual dividend from $0.31 to $0.485, an increase of 56.5 percent, or about 2.0% per year. For many years, this was above the rate of inflation; now it is not and recent increases have been along the lines of $0.0025 per share. So, slow growing. NWN just paid its fourth dividend of $0.485 on August 15 of this year, so when the next dividend is paid in November, I would expect an increase. Based on the recent pattern of increases, I would expect the next dividend amount to be $0.4875 per quarter. At the current share price of $40.69, this would make the dividend yield 4.79%.

The current payout ratio for NWN is 76.0%. If 2023 income reaches the consensus of $2.70 per share, and the dividend is $1.95, the payout will be 72.2%. S&P cites recent average utility payout ratios as 63% ( see article ), but they vary widely from companies like ConEd (ED) at 45.9%, to Dominion Energy (D) at 98.9%.

You can compare the current 4.79% yield to other utility stocks such as Southern Company ( SO ) at 4.07%, Consolidated Edison at 3.67%, American Electric Power ( AEP ) at 4.19%, and Spire Incorporated ( SR ) at 4.8%. It is also worth comparing with an index like ProShares Ultra Utilities ( UPW ) with a current dividend yield of 2.05%. The average dividend yield for gas utilities is reported as 3.35%, as illustrated below.

Share Valuation

I estimate the current value of NWN shares to be $46.39. I have used discounted cash flow cash to value the company's shares. This involved taking the estimated earnings per share, beginning in 2023, then projecting forward. In this case, I have used a 5-year projection period rather than 10 years, because it is easier to make estimates over a short time period. To do this calculation, I need a discount rate to adjust for time and risk, a growth projection for earnings per share over the next 5 years, and a capitalization rate for converting income in the next year into perpetuity.

Below are NWN's annual earnings since 2018. Between 2018 and 2023 the compound annual growth rate in earnings per share was 1.7%, about 2.0%. However the RNG segment only came online in the second half of 2023, and the number of water customers nearly doubled in 2022. There will also be more organic growth from the natural gas division which expands customers by 1.1 to 1.5% per year. Because of these factors, I am increasing the growth rate in EPS to a still conservative 4.0% per year. This seems easily supported by Institutional Investor , which has projected 6.0% per year growth for utilities over the next three years.

I have valued the shares using NWN's projected net income of $2.80 in 2023, then a 4.0% growth rate in net income each year over the next five years and a 9.25% discount rate. The current P/E ratio for NWN is 14.5. The inverse of the P/E ratio is a cap rate, so 1/14.5 = 0.069 or 6.9%. From this, I have estimated a reversion rate of 6.5%, given the new growth profile of the company. For the discount rate, I looked at the average annual return of the S&P 500. The long-term average is about 9.25%, while over the last 10 years, it has been 10.4% ( source ). I have elected to use a discount rate of 9.25%, at the lower end of the range, discounting beginning in the second year. I chose this lower rate because NWN is a regulated utility, with more stable returns. Yes, all of this is estimated and based on art rather than precision. And for that reason, I have valued the company (in my opinion) very conservatively.

Again, I estimate the value of the shares listed on the NYSE to be worth $46.39. They are being discounted along with other shares in the utility sector. According to Institutional Investor, U.S. utilities have returned an average of 8.6% annually in the last 30 years and posted double-digit returns in 18 of those years. This all changed in 2020 when volatility entered the sector. Compare NWN with the utility sector average, XLU Utilities Select Sector SPDR Fund. This has a P/E ratio of 22.4 and a dividend yield of 3.13%. NWNs stats are 14.5 P/E and 4.79% yield. Another point of comparison is Hennessy Gas Utility Fund (GASFX), which currently has a dividend yield of 1.89%. NWN currently has a Seeking Alpha Quant rating of B+.

Risks to Outlook

In its service areas, the Northwest Natural Gas has no direct competition from other natural gas distributors. However, as management points out, it does compete with other forms of energy. The natural gas segment is seasonal and demand increases during the colder winter months. Of course, a warm winter means less usage, and this may be impacted by climate change. However, I suspect that the rising population in Oregon and Washington will offset this usage risk.

Water distribution operations are also seasonal and have their peak demand during the summer months, while wastewater is not seasonal. The new water service utilities generally operate in exclusive territories with no direct competitors. However, water distribution customer rates are regulated by state utility commissions. The wastewater business has some state-regulated systems and some that are not rate regulated by utility commissions. The renewable natural gas segment is not regulated but should be considered a startup that will take longer to come online than the water business has, which consists of already in-operation acquisitions.

Finally, natural gas itself is subjected to political and supply risks, part of what caused the price spike of 2022. Higher gas prices actually squeeze Northwest Natural's margins rather than improve them. See the gas price volatility chart below:

Finally, Energy Administration's Natural Gas Weekly Update says that it expects "global liquefied natural gas ((LNG)) import capacity (also known as regasification capacity) to expand by 16%, in 2023?24 compared with 2022 once all regasification terminals currently under construction are completed." This would mean a more stable supply and less price pressure.

Conclusion

NWN appears to currently be at a below-market price, and with a very low level of risk due in today's rising interest rate environment. Along with other utilities, the share price has gone down as yields on other investments rise. With sector prices down, yields are starting to look more attractive.

NWN is a Dividend King with a superb 67-year streak of rising dividends. Although the annual increases may be small, I believe there is room here for some significant share price appreciation, especially with two new divisions created in the last five years and increasing geographic diversity with water operations in Texas, Arizona, and Idaho, and likely more acquisitions to come. The market has not fully considered these changes in company strategy. I estimate that the current share price of $40.69 is 10-15% undervalued, and I think shares are particularly attractive when the price dips below $40, which it has occasionally during the last week.

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