OGS - ONE Gas: Balance Sheet Concerns Hold

2023-12-25 21:19:26 ET

Summary

• ONE Gas is currently a hold due to uncertainty of cash flows based on balance sheet concerns.
• The company pays a large dividend, which is the most beneficial use of cash flow for the firm.
• ONE Gas has underperformed the broader market in the past 5 years and needs to resolve its debt burdens to hold a competitive return.

ONE Gas, Inc. ( OGS ) has seen declining price action due to debt concerns with the firm. Although fundamentals seem cheap and the firm pays a large dividend, I believe that ONE Gas is currently a hold due to the uncertainty of cash flows based on balance sheet concerns.

Business Overview

ONE Gas, Inc. is a fully regulated natural gas utility serving over 2.3 million customers in Oklahoma, Kansas, and Texas. Important divisions under its operations include Oklahoma Natural Gas, the largest distributor of natural gas in Oklahoma; Texas Gas Service, the third-largest distributor of natural gas in Texas based on customer count; and Kansas Gas Service, the largest distributor of natural gas in Kansas. Together, these divisions serve a wide range of clients from the transportation, business, and residential sectors, highlighting the company's broad market penetration and size of operations in the natural gas distribution industry.

ONE Gas has a market value of approximately $3.56 billion and has achieved a 4% Return on Invested Capital. The company's stock has fluctuated within a 52-week range, reaching a high of $84.26 and a low of $55.50. Currently, the stock is priced at around $65.06, closely aligning with its 50-day moving average of $62.37. With a P/E GAAP ratio of 15.69, ONE Gas' stock appears to be relatively undervalued compared to its industry peers, suggesting potential for growth or a reassessment of its market value.

ONE Gas also pays out a dividend of 4.05% representing a payout ratio of 62.63%. I believe that this payout is the most beneficial use of cash flow for the firm as they can pay out consistent income to shareholders and do not have a large ROIC making cash distributions more beneficial. This payout also allows the firm to continue paying down debt without the worry of FCF declines in order to maintain stability in its core business model.

Performance Compared to the Broader Market

Over the past 5 years, ONE Gas has underperformed the broader market when adjusting for dividends. With the S&P returning over 80% while ONE Gas isn't even positive, it must resolve its debt burdens to hold a competitive return. This will allow the firm to enhance infrastructure with a lower cost of debt in the long term making deleveraging a top priority.

Balance Sheet

As mentioned before, ONE Gas holds a rather leveraged balance sheet. But, with debt declining 23% in the last year and operating income continuing to increase, the firm seems to be stable regarding long-term liabilities especially due to macroeconomic headwinds subsiding such as rate declines as early as next year. But, although interest coverage is sufficient, a Current Ratio of 0.36 and Altman-Z-Score of 1.01 show potential issues in paying off short-term debt.

Earnings

ONE Gas, Inc. reported its Q3 2023 earnings with a net income of $25.2 million, an increase from $23.7 million in the same period last year. After $154.7 million in the prior year, the net income for the first half of 2023 was $160.5 million. While profits indicate a reasonable increase in profitability, ONE Gas has reduced its earnings outlook for 2023. It now projects net income to be between $214 and $231 million ($3.7 and $4.00 per share), down from the previous estimate of $4.16. This decline in expectations is due to utilizing cash flow to pay off liabilities and due to higher expenses. Although I believe that the debt is a sufficient reason, higher operating costs are more long-term and can hurt cash flows years ahead. But, with a solid recovery in profitability in 2025, I believe that the firm will reestablish operational improvements once debt headwinds cool off.

Analyst Consensus

Analysts view ONE Gas as a "Hold" with an average 1Y price of $61 presenting a 6.24% downside. This bearish view of the firm is due to the leveraged balance sheet ONE Gas holds and the solvency concern for the firm. I believe that once this issue is resolved, analysts will raise projections to meet future cash flows without many risks weighing down operations.

Valuation

Before finding the ONE Gas' fair value, I decided to find the firm's Cost of Equity using the Capital Asset Pricing Model to provide an accurate discount rate. By using a risk-free rate of 3.9% based on the current 10-year treasury yield , I calculated a Cost of Equity of 6.96%. This represents the expected return for holding ONE Gas' equity.

After finding an appropriate Cost of Equity, I used an Equity Model DCF based on net income to find ONE Gas' fair value. For this, I used a discount rate of 8% which represents a 1.04% risk premium to account for balance sheet concerns that could further hurt future cash flows. I also estimated revenues and margins to continue growing with historical rates which align with their future guidance as well. This resulted in a fair value of ~$60.05 which means the firm is overvalued by ~8%.

Infrastructure Upgrades Improving Cash Flows

To meet the increasing demands of its service territories, ONE Gas, Inc.'s present 2024 strategy is concentrated on improving system infrastructure and extending its key capabilities. For instance, the business intends to make large capital investments, with a focus on system integrity and replacement projects, as well as customer extensions, particularly in Texas and Oklahoma. In 2023, these expenditures are expected to total roughly $675 million.

These investments, in my opinion, will promote organic growth and guarantee system dependability, which in turn generates shareholder value by reducing operating expenses—a present challenge for the company. The company anticipates a net income in the range of $224 million to $238 million for 2023, which reflects the financial upside of this strategy. Earnings per share are also expected to improve. The long-term objective of ONE Gas is to achieve an average annual dividend growth rate of 4% to 6% by 2027, and this rise in cash flows is in line with that ambition. As a result, this strategy not only improves the company's standing in a cutthroat market but also guarantees a lucrative and sustainable growth trajectory, which eventually raises shareholder value.

Risks

Indebtedness: Excessive debt could make it more difficult for the business to get new loans and remain competitive.

Geographical Concentration: Due to the company's concentration of operations in Oklahoma, Kansas, and Texas, there may be risks related to changes in regulations or local economic situations.

Conclusion

To summarize, I believe that ONE Gas is currently a hold because although the firm is undervalued when compared to its peers, its balance sheet poses a risk in the short term and will decrease future cash flows. I believe that once this debt issue is resolved, the required return to hedge against risk will decrease and result in an undervalued high-dividend stock. But, with much uncertainty, waiting would be the best option.

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