SWX - Southwest Gas Q3: Improved Financial Performance But No Significant Future Growth Prospects

2023-11-27 16:25:23 ET

Summary

• SWX posted strong Q3 results, beating revenue and EPS estimates, with utility infrastructure services as the top performer.
• The company's gas distribution business saw a rise in revenue due to increased demand, but low profit margins remain a concern.
• SWX's balance sheet is stressed with high debt and limited room for further fundraising, putting the company at risk of being overleveraged.

Investment Thesis

Southwest Gas Holdings, Inc. ( SWX ) is an American natural gas distributor and utility services provider headquartered in Las Vegas, Nevada. In this thesis, I will analyze its third-quarter results and its future growth prospects. I will also be analyzing its valuation at current price levels and the upside potential in the stock price. SWX has presented better than expected quarterly numbers, but the FY23 numbers so far have failed to impress me. The valuation also doesn’t instill much confidence in the company at the current price level, and hence, I assign a hold recommendation for the company.

Company Overview

SWX is a publicly traded company that serves as a holding entity for its subsidiaries, with a primary focus on Southwest Gas Corporation and Centuri Holdings, Inc. It is a natural gas utility company providing natural gas services to residential, commercial, and industrial customers, mostly in the states of California, Nevada, and Arizona. Along with the distribution of natural gas, it also deals with the installation and replacement of underground gas pipes, as well as maintenance services for energy distribution systems. Its revenues can be classified into two business segments: Regulated operations and Utility infrastructure services.

Q3 FY23 Results

SWX posted strong third-quarter results, beating the market revenue and EPS estimates by a significant margin. I believe the utility infrastructure services proved to be the outperformer, contributing maximum profits at $18 million. However, investors should note that the utility infrastructure revenues are contributed by Centuri Holdings, Inc., one of the subsidiaries of SWX. Centuri is planning an IPO and is in the process of becoming a separate entity, in accordance with which Centuri has filed a draft registration statement with the SEC. As per my analysis, this is a correct move by the management as it will help unlock value for the investors and improve the focus on expanding the utility infrastructure services business, which is a comparatively high-margin business with a large market potential.

SWX reported total revenue of $1.17 billion , a 4% increase compared to $1.12 billion in the same quarter last year. Of the total revenue, natural gas distribution contributed $395 million, up 7.5% compared to $367 million in the corresponding quarter last year. The utility infrastructure revenue stood at $775 million, a slight increase of 2.25% compared to $758 million in the same quarter last year. I believe the natural gas distribution saw a rise due to a 5% increase in the rate base of the natural gas and also the increased demand for energy in the Nevada regions. The company is consistently expanding its capacity and infrastructure to cater to the increasing demand, and it is estimated to incur $740 million in capital expenditures by the end of FY23. The utility infrastructure services witnessed an increased demand from offshore wind projects, but other utility segments saw muted revenue growth. When it comes to the profits, the Utility infrastructure led the way with $18 million in profit. However, the natural gas segment reported a loss of $3.2 million, but it is a great improvement from the loss of $22.1 million. I believe higher sales prices led to this improvement, but the increased cost of gas restricted the profit growth. Going ahead, the cost of gas is expected to remain high, and to improve profitability; the company will have to focus on reducing administrative expenses and cutting down on transportation costs. The major problem that I see in this business is low-profit margins. For Q3 FY23, profit margins stood at 0.27%, and for the nine months ending 30th September, the profit margins were 1.9%. With low-profit margins, there is no scope for mistakes, and one major setback can erase its profit margins.

Now, let us have a look at the company’s balance sheet. As of 30 September 2023, it reported cash and cash equivalent of $105 million against long-term debt of $5.2 billion. Here is where the main problem lies. The company is planning on expanding and consistently incurring capital expenditures. This surely will help in long-term growth; however, the amount that the company has leaves no room for further fundraising to expand its operations. The balance sheet is already stressed and puts the company at risk of being overleveraged. Not only this, but the interest expense that the company is incurring is putting a significant dent in its profit margins. To put this in perspective, the company incurred $295 million in interest expenses. The company has assets worth $7 billion in the form of gas plants, but these assets are not liquid in nature, and the company lacks liquid assets. I would recommend investors consider these factors that could adversely affect the company’s performance in unfavorable market conditions.

Valuation

SWX is currently trading at a share price of $60, a YTD decline of 2.8%. It has a market cap of $4.30 billion. SWX is trading at a forward P/E multiple of 21x compared to the sector median of 16.7x. I do not see any significant edge in the company’s business for which it should trade at such a premium. With the low profit margins and single-digit revenue growth rate, I do not see much improvement in the EPS in coming quarters.

Conclusion

SWX posted better-than-expected Q3 results, but future growth doesn't seem evident. The existing investors can hold the stock till the separation of Centuri Holdings, Inc. from SWX, and they can then stay invested in the newly formed Centuri entity dealing in Utility infrastructure services, but I do not see significant growth in the gas distribution business. The company has significant debt obligations and is trading at a very high valuation. Considering all these factors, I assign a hold rating for SWX.

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