SWX - ONE Gas: Solid Fundamentals But The Price Is High

2023-06-20 19:55:18 ET

Summary

• ONE Gas, Inc. is one of the largest regulated natural gas utilities in the United States.
• The company enjoys stability over time, which could be an advantage if the economy falls into a recession during the second half of the year.
• The company has some growth prospects and is positioned to deliver a 7% to 9% average annual total return over the next five years.
• The company has one of the strongest balance sheets in the industry, with relatively low levels of debt.
• The stock price appears high right now relative to some peers, so the company could underperform.

ONE Gas, Inc. ( OGS ) is one of the largest regulated natural gas utilities in the United States, serving parts of Texas, Oklahoma, and Kansas. It is one of the few pure-play natural gas utilities in the nation. The utility sector in general has long been loved by retirees and other conservative investors due to its very stable cash flows and high yields. Indeed, ONE Gas has a 3.32% yield at the current price, which is well above most other things in the market.

Unfortunately, natural gas utilities have something of an image problem due to some corners of the market believing that electrification will render these companies obsolete. This has caused some of these companies to have more attractive valuations than many electric utilities. ONE Gas is unfortunately an exception to this, as it currently looks more expensive than other pure-play natural gas utilities. Its yield, while decent, is not outsized relative to its peers. As such, it may be worth watching but not buying today.

About ONE Gas

As stated in the introduction, ONE Gas is a regulated natural gas utility that serves parts of Kansas and Texas along with most of the state of Oklahoma:

This is an incredibly large service area geographically, but most of it is rural so the company's customer count is only 2.3 million. That is not much larger than a utility that serves a single large city might possess. However, it is still one of the largest pure-play natural gas utilities in the country. As I have pointed out in numerous previous articles, though, the customer count of a utility does not change the fact that it will possess certain characteristics. Perhaps the most important of these characteristics is that the company will enjoy remarkably stable cash flows over time. We can generally see this by looking at the company's operating cash flows. Here are the company's figures during each of the past eleven twelve-month periods:

Admittedly, a reader might point out that there is significant volatility here. After all, the company had negative operating cash flows during four of the periods. However, this was all caused by Winter Storm Uri back in February 2021. That was one of the most severe cold weather events occurring in the company's service territory in the last century. It had a major impact on all utilities in the area because it froze natural gas pipelines and infrastructure and briefly spiked natural gas prices in the area. As we can see here, the company had a negative $1.6593 billion operating cash flow in that quarter:

This naturally would have adversely impacted each of the following quarters up until the January 2022 to March 2022 period. That naturally makes the company's cash flow look much more volatile than it normally is. As we can see above, the year-over-year numbers for a given quarter usually show somewhat less volatility.

The reason for the general stability should be fairly obvious. After all, ONE Gas provides a product that is generally considered to be a necessity by its customers. After all, if a person has a home heated by natural gas then they will need to maintain their natural gas service in order to avoid all of the problems associated with losing their heating. In most cases, this means that people will sacrifice other spending and basically do whatever is needed in order to avoid that outcome. This means that utility bills are paid ahead of other bills when times get tough, such as during a recession. This is also a desirable characteristic today because the high inflation that has been dominating the economy has strained the budgets of many consumers. A company like ONE Gas can probably weather such an environment much better than a company that is highly dependent on consumer spending.

ONE Gas's stability is also reinforced by the fact that 93% of its customers are residential users. This is nice because residential users tend to be more reliable than businesses. After all, business use of utilities is highly correlated with the economy. During a poor economy, vacancies tend to increase and a landlord with a vacant property will not heat it to nearly the same level as a tenant in an occupied property might. As such, utility bills from businesses are normally higher during a strong economy than in a weak one. However, residential consumers will generally heat their homes to a comfortable level regardless of the conditions in the broader economy. It is also much rarer for a residential property to be vacant than a commercial one. Thus, the fact that the majority of the company's customers are residential users is a real boon.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied with mere stability. We like to see those companies in which we are invested grow and prosper with the passage of time. Fortunately, ONE Gas is well-positioned to accomplish that going forward.

The primary way that it will achieve this growth is by increasing 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. As this rate of return is a percentage, any increase to the rate base allows the company to adjust the prices that it charges its customers in order to earn that allowed rate of return. The usual way that a utility will grow its rate base is by spending money to upgrade, modernize, or potentially even expand its regulatory-allowed rate of return. ONE Gas is planning to do exactly this as the company has budgeted $3.6 billion of investment capital towards improving its infrastructure network for the 2023 to 2027 period. This is expected to grow its rate base at a 7% to 9% compound annual growth rate over the period, along with a corresponding growth in net income. Unfortunately, the company's earnings per share will almost certainly not grow as quickly due to its need to finance capital expenditures. ONE Gas raises the capital that it needs for infrastructure spending through the issuance of debt and equity, the latter of which dilutes the earnings per share growth that would otherwise result.

The company's management projects that it will only be able to achieve a 4% to 6% earnings per share growth rate over the 2023 to 2027 period. When we combine this with the current 3.32% dividend yield, we get a projected average annual total return of 7.3% to 9.3%. That is considerably less than some of the company's peers are projecting over the same period. This is admittedly somewhat off-putting, although ONE Gas is planning to increase its dividend in line with earnings per share growth.

Financial Considerations

It is important that we investigate the way that a company is financing its operations before making an investment in it. This is because debt is a riskier way to finance a company because debt must be repaid at maturity. As very few companies can afford to do this with cash as the debt matures, it is normally accomplished by issuing new debt and using the proceeds to repay the existing debt. This can cause a company's interest expenses to go up following the rollover in certain market conditions. As of the time of writing, interest rates are at the highest level that we have seen since 2007, so this is a very real concern right now. In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. Thus, an event that causes a company's cash flow to decline could push it into financial distress if it has too much debt. Although utilities like ONE Gas tend to have remarkably stable cash flows, this is still a risk that we should not ignore as bankruptcies have occurred in the sector.

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 equity 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 a bankruptcy or liquidation, which is arguably more important.

As of March 31, 2023, ONE Gas had a net debt of $2.955 billion compared to a shareholders' equity of $2.6515 billion. This gives the company a net debt-to-equity ratio of 1.11 today. Here is how that compares to some of the company's peers:

As we can see, the company has a relatively conservative financial structure relative to its peers. This is a very clear sign that ONE Gas is not using too much debt to finance its operations. As such, the company's leverage should not represent a particularly outsized level of risk for its investors.

Dividend Analysis

As mentioned in the introduction, one of the reasons in which investors purchase utility stocks like ONE Gas is the very high dividend yields that these companies usually possess. At the current stock price, ONE Gas yields 3.32%, which is well above the 1.66% yield of the S&P 500 Index ( SP500 ). ONE Gas also has a long history of raising its dividend on an annual basis, which we can see here:

This is something that is very nice to see during inflationary environments, such as the one that we are in today. This is because inflation is constantly reducing the number of goods and services that we can purchase with the dividend that the company pays out. This can make it feel as though we are getting poorer and poorer with the passage of time, and is especially problematic for those that are dependent on their portfolios for the income that they need to pay their bills (such as retirees). The fact that ONE Gas increases its dividend annually helps to offset this effect and ensures that the dividend maintains its purchasing power over the long term.

As is always the case though, we want to ensure that the company can actually afford the dividend that it pays out. After all, we do not want to be the victims of a dividend cut since that would reduce our incomes and almost certainly cause the stock price to decline.

The usual way that we judge a company's ability to pay its dividend is by looking at its free cash flow. The free cash flow is the amount of money that was produced by the company's basic operations and is left over after it pays all of its bills and makes all necessary capital expenditures. This is therefore the amount that can be used to benefit the shareholders through debt reduction, share buybacks, or dividends.

During the twelve-month period that ended on March 31, 2023, ONE Gas had a levered free cash flow of $1.2489 billion. This is somewhat surprising, because utilities do not usually have positive free cash flow, but it is not a problem. This was more than sufficient to cover the $136.7 million that the company paid out in dividends during the period. Thus, it appears that ONE Gas is having no problems covering its dividends.

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 ONE Gas, we can value it by using 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 the stock may be undervalued relative to its forward earnings per share growth and vice versa. However, there are very few companies that appear undervalued in today's market. Thus, the best way to use this ratio is to compare ONE Gas to its peers to determine which stock has the most attractive relative valuation.

According to Zacks Investment Research , ONE Gas will grow its earnings per share at a 5.00% rate over the next three to five years. This is the midpoint of the company's own guidance based on its projected rate base growth, so it is probably a pretty solid estimate. This growth rate gives the company a price-to-earnings growth ratio of 3.79 at the current stock price. Here is how that compares to its peers:

As we can see, ONE Gas does appear expensive relative to some of its peers, but it is admittedly not the most expensive company in the sector. However, both of the companies that are more expensive have higher yields, which may be favorable to those looking for income. Overall, the best play here is probably to wait for ONE Gas to correct, reducing its price and raising its yield, before buying into the stock.

Conclusion

In conclusion, ONE Gas, Inc. is one of the largest pureplay natural gas utilities in the country. The company looks pretty decent overall, as it does have some growth prospects and a very strong balance sheet . It should be well positioned to handle any economic turbulence that may happen in the near term. Unfortunately, the price for ONE Gas, Inc. stock is rather high right now, so it appears likely to underperform some of the other companies in the sector.

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