SWX - Northwest Natural Holding: A Solid High-Yield Utility For An Economic Downturn

2023-06-08 17:50:44 ET

Summary

• Northwest Natural Holding Company is primarily a regulated gas utility serving the Pacific Northwest.
• The company is largely immune to macroeconomic strength or weakness, which could make it an attractive holding as the economy weakens in H2, 2023.
• The company has growth prospects due to the population growth of its service territory and its capital investment program.
• The company has a strong balance sheet relative to its peers and a sizable 4.38% dividend yield.
• Northwest Natural Holding Company is a bit expensive relative to its peers.

Northwest Natural Holding Company ( NWN ) is a regulated natural gas utility that primarily operates in the Pacific Northwest region of the United States, although it does have some operations in Arizona and Texas. The utility sector has long been a favorite of conservative investors, such as most retirees, due to its generally stable cash flows and high dividend yields. Northwest Natural Holding is certainly no exception to this, as the stock yields 4.38% at the current price.

As we will see over the course of this article, the company also has very stable cash flows regardless of macroeconomic conditions. This is something that should prove quite appealing as the American economy is widely expected to enter a recession during the second half of this year. As I have pointed out in a few previous articles, natural gas utilities like Northwest Natural Holdings typically have lower valuations than electric utilities due to the widespread perception that natural gas will soon become obsolete in the face of the electrification trend.

In a previous article on the company, I discussed how that is highly unlikely to be the case. Unfortunately, though, Northwest Natural Holding does appear to be somewhat expensive relative to its peers.

About Northwest Natural Holding

As mentioned in the introduction, Northwest Natural Holding is a regulated natural gas utility that primarily operates in the Pacific Northwest states of Washington, Oregon, and Idaho. However, it has some operations in Arizona and Texas:

As we can clearly see, the gas utility is by far the largest, as the company serves approximately 2.5 million people throughout its service territory. Its water utility operations are much smaller as the company only has a customer base of 155,000 people through this operation. The natural gas utility alone accounts for 92% of Northwest Natural Holding's net income:

As such, we can generally consider the company to be a natural gas utility with a few ancillary operations attached. This is good for our thesis as utility companies tend to enjoy remarkably stable cash flows regardless of macroeconomic conditions. Northwest Natural Holding is no exception to this, as we can clearly see by looking at the company's operating cash flow over time. Here are the company's operating cash flows during each of the past eleven twelve-month periods:

This is a period of time that includes both strong and weak economies. Back in 2020, the governments of most states imposed fairly draconian lockdowns that caused a substantial number of people to be out of work, many of whom fell behind on their utility bills. Indeed, the pandemic is generally believed to have caused $40 billion worth of utility bills to fall into arrears. Fortunately, the economy has recovered since then, but inflation promptly reared its ugly head. The rising cost of living pushed those Americans that were in bad financial shape into distress and today it is estimated that one in five American households are behind on their utility bills. Yet, Northwest Natural Holding appears to be completely unaffected by this. This is one of the characteristics that we want a company in our portfolio to have during challenging economic times, such as the recession that is widely expected to hit sometime during the second half of this year.

The reason for this overall stability is that Northwest Natural Holding provides a product that is generally considered to be a necessity for modern life. After all, most people that have natural gas heating systems in their homes will utilize them during the winter months. In fact, heating is generally covered by habitability laws and the government provides support to people struggling to pay their heating bills in the winter. Thus, our society appears to recognize that heating is indeed a necessity. As such, most people will prioritize paying their utility bills ahead of discretionary expenses during times when money gets tight. This provides a great deal of recession resistance to natural gas utilities like Northwest Natural Holding.

With that said some readers may note that the stability shown above is over a given twelve-month period. Northwest Natural Holding's cash flow does to exhibit considerable variation when measured on a quarter-over-quarter basis, as shown here:

This is common for a natural gas utility. The reason comes from the fact that the primary use of utility-supplied natural gas is as a fuel for space heating and cooking. It is not really necessary to heat a building during the warm summer months, so natural gas is not heavily used during those time periods. The heaviest use of natural gas is during the winter, and since the company bills its customers based on their usage, utility bills will be highest in the winter. This results in the company receiving much higher revenue during the winter months. Indeed, Northwest Natural notes that 70% of its gas utility annual margin is earned during the winter months:

The warmer months see the company collecting much less revenue from its customers and spending money to refill the natural gas that is consumed during the winter. As such, the second and third quarters of the year will almost always be the weakest. This is different from electric utilities that have much less seasonal fluctuation (although they do experience some from air conditioner use during the summer).

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied by mere stability. After all, we like to see a company that we are invested in grow and prosper. Fortunately, Northwest Natural Holding is positioned to accomplish this in two ways.

First, the Pacific Northwest is one of the most rapidly-growing areas of the nation. There are a few reasons for this, including the fact that many people are leaving neighboring California for a variety of reasons. According to U.S. Census data , the three states served by Northwest Natural Holding grew at the following rates over the 2020 to 2022 period:

This has benefited Northwest Natural Holding. This is because population growth is one of the only ways through which a utility can grow its business. After all, if the company has more people in its service territory, then it has more people paying their utility bills every month. All else being equal, that results in higher revenue, which means that more money is available to cover the company's expenses and make its way down to the bottom line. As shown here, Northwest Natural Holding has managed to increase its customer count every year since 2009:

This makes the company one of the few utilities with this strong of a track record. This is because companies like this are typically monopolies in their service territories and have very limited ability to add new customers through advertising or other competitive methods. Thus, they are highly dependent on the population growth in their respective service areas, and not all regions of the country have been growing as rapidly as the Pacific Northwest (especially Idaho).

As we can see though, Northwest Natural Holding's customer base only grew at a 1.0% year-over-year rate during the first quarter of 2023. That is nowhere close to the growth rate that we would really like to see a company in our portfolio deliver. Fortunately, the company has other methods through which it can generate higher levels of growth. The most important of these is by increasing the size of its rate base. The rate base is the value of the company's assets upon which regulators allow it to earn a specified rate of return. This rate of return is usually about 10%, but the exact number varies by jurisdiction. In the company's most recently filed rate cases, it requested a rate of return of 6.9% in Washington and 9.5% in Oregon, with regulators approving a rate of return that was slightly lower in both cases. As the allowed rate of return is a percentage, any increase in the size of the company's rate base allows the company to increase the price that it charges its customers in order to earn that allowed rate of return.

The usual way that a utility like Northwest Natural Holding increases the size of its rate base is by investing money into upgrading, modernizing, and expanding its utility-grade infrastructure. The company is planning on doing exactly that as it recently unveiled a plan to devote $1.4 billion over the 2023 to 2027 period to this process. That works out to approximately $290 million per year:

This is a slight spending decline from the $300 million per year average that the company was planning to spend over the 2022 to 2024 period. We discussed this previous plan in my last article on this company. We can also see above that the company's spending on technology in 2021 and 2022 was much higher than what it is planning to spend going forward, which accounts for the majority of the spending decline. That is acceptable as we do not want to see customer growth or safety and reliability spending drop too much. That is the most critical area for the company to be spending when it comes to rate base growth. The plan as presented should grow the company's natural gas infrastructure rate base at a 6% compound annual growth rate over the period, which is comparable to many other utilities.

Unfortunately, the company's earnings per share will not grow quite as rapidly because Northwest Natural Holding will need to issue some new stock to finance the growth plan and could encounter issues with regulators not allowing it to increase rates as much as it would like. As such, the company is expected to grow its earnings per share at a 4% to 6% rate over the projection period. When we combine that with the current 4.38% dividend yield, the company should be able to deliver a 9% to 11% total average annual return over the next five years. That is reasonable and generally in line with other utilities.

Financial Considerations

It is always important that we investigate the way that a company finances its operations. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. This is normally accomplished by issuing new debt and using the proceeds to repay that maturing debt. Naturally, that can cause a company's interest expenses to increase following the rollover in certain market conditions. As interest rates are currently at the highest levels that we have seen since 2007, that is a concern today.

In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. As such, an event that causes a company's cash flows to decline could push it into financial distress if it has too much debt. While utility companies like Northwest Natural Holding typically have remarkably stable cash flows over time, bankruptcies have occurred in the sector so this is a risk that we should not ignore.

One metric that we can use to evaluate a company's financial structure 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 bankruptcy or liquidation, which is arguably more important.

As of March 31, 2023, Northwest Natural Holding had a net debt of $1.547 billion compared to $1.2483 billion of shareholders' equity. This gives the company a net debt-to-equity ratio of 1.24 today. This is quite a bit better than the 1.30 ratio that the company had the last time that we discussed it, which is probably due to the fact that it built up its cash balance significantly in the first three months of 2023:

Here is how the company's net debt-to-equity ratio compares to some of its natural gas utility peers:

As we can clearly see, Northwest Natural Holding seems to be somewhat less reliant on debt to fund its operations than most of its peers. This is a good sign as it should indicate that the company's current debt load will not pose an outsized risk for its shareholders.

Dividend Analysis

One of the biggest reasons why investors purchase shares of utility companies is that they typically have a higher yield than many other things in the market. This is because utilities have fairly low growth rates, so they pay out a significant portion of their cash flows to the investors in order to provide an acceptable return. The market also normally does not give them high multiples so the dividend ends up being a large percentage of the total share price.

Northwest Natural Holding is no exception to this, as the stock yields 4.38% at the current price, which is substantially higher than the 1.51% yield of the S&P 500 Index (SP500). In fact, Northwest Natural has a substantially higher dividend yield than the 2.56% of the U.S. Utilities Index ( IDU ), which will likely appeal to some investors. The company also has a long history of growing its dividend on an annual basis:

The fact that the company increases its dividend on an annual basis is something that is quite nice to see during inflationary periods, 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 relying on their portfolio for income could 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 its shareholders every year helps to offset this effect and maintains the purchasing power of the dividend. With that said, the company's dividend increases over the past decade have been nowhere close to enough to keep up with inflation, but it is still better than nothing.

As is always the case though, it is critical to ensure that the company can afford the dividend that it pays out. After all, we do not want the company to be forced to reverse course and cut the dividend since that 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 maintain its dividend is by looking at its free cash flow. The free cash flow is the amount of money that was generated by a company's ordinary operations and is left over after it pays all of its bills and makes all necessary capital expenditures. This is therefore the amount that is available for such tasks as repaying debt, buying back stock, or paying a dividend. During the twelve-month period that ended on March 31, 2023, Northwest Natural Holding had a negative levered free cash flow of $183.1 million. That is obviously not enough to pay any dividends, yet the company still paid out $64.9 million during the period. At first glance, this is concerning as the company's free cash flow is insufficient to cover the dividend.

However, it is common for utilities to finance their capital expenditures through the issuance of debt and equity. This was hinted at earlier in this article. The company will then pay its dividends out of operating cash flow. The reason that this is done is that it is extraordinarily expensive to construct and maintain utility-grade infrastructure over a wide geographic area. If a utility were to attempt to finance this solely through its cash flow, it would either never be able to upgrade its systems or never pay a dividend to the shareholders. During the most recent trailing twelve-month period, Northwest Natural Holding had an operating cash flow of $183.5 million. This was more than sufficient to cover the $64.9 million in dividends that it paid out and leave it with quite a bit of money left over for other purposes. Overall, the company's dividend is probably reasonably safe and investors should not have to worry too much about a cut.

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 Northwest Natural Holding, one metric that we can use to value it is the price-to-earnings growth ratio. This is a modified version of the familiar price-to-earnings ratio that takes a company's forward earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 is a sign that a stock may be undervalued relative to its forward earnings per share growth and vice versa. Unfortunately, there are relatively few stocks that are undervalued in today's overheated market. Thus, the best way to use this ratio is to compare Northwest Natural Holding's ratio to that of its peers and determine which company offers the most attractive relative valuation.

According to Zacks Investment Research , Northwest Natural Holding will grow its earnings per share at a 3.70% rate over the next three to five years. This is a bit lower than the 4% to 6% range that we projected earlier based on the company's five-year rate base growth, but it is not ludicrously lower so we can use it for now. This growth rate gives Northwest Natural Holding a price-to-earnings growth ratio of 4.44 at the current stock price. Here is how that compares to some of the company's peers:

As mentioned in the introduction, Northwest Natural Holding looks a bit expensive relative to its peers. It is not the most expensive company in the comparison, however. This may be a bit of a turn-off to some and as such it might be worthwhile to wait and see if the price comes down before buying shares. As the U.S. Treasury will be vacuuming up about $1 trillion over the next few months, this is a very real possibility.

Conclusion

In conclusion, Northwest Natural Holding Company could be an attractive position as the economy is projected to weaken over the next several months. This comes from the fact that the company is almost immune to macroeconomic shifts due to the fact that it provides a necessary product to its customers. The company boasts a stronger balance sheet than many of its peers and has a relatively high dividend yield, which adds to its appeal. The biggest problem here is that Northwest Natural Holding Company stock appears to be a bit expensive at the current price, so it might be advantageous to wait for the price to come down before buying in.

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