SWX - Spire Inc: A 4.46%-Yielding Natural Gas Utility

2023-06-06 18:25:41 ET

Summary

• Spire Inc. is a natural gas utility that operates in three states in the southern part of the United States.
• The company generally enjoys financial stability, although natural gas utilities are not quite as stable as electric utilities.
• Spire is well-positioned for growth and is likely to deliver a 10% to 12% total return on average over the next decade.
• The company is more leveraged than some of its peers, which could be a risk considering that high interest rates are likely with us for quite some time.
• Spire Inc. stock appears to be fairly valued relative to its peers today.

Spire Inc. ( SR ) is a regulated natural gas utility that operates in Mississippi, Alabama, and Missouri. The utility sector in general has long included many of the most popular stocks among retirees and other conservative investors. Indeed, utilities are frequently called "widows and orphans'" stocks. There are some good reasons for the popularity, though, as these companies typically offer remarkably stable cash flows in any economic climate combined with a high dividend yield.

Spire is no exception to the characteristic high yield, as its stock yields a very attractive 4.46% at the current price. Unfortunately, it suffers from the same problem as other natural gas utilities in that the market perceives it to be in an obsolete industry. This is far from the truth though and this general market aversion has resulted in the stock trading at a very attractive valuation. I mentioned some of this in the thesis that I presented six months ago in my previous article on Spire, but as six months have passed, it is time to revisit the company and re-evaluate our thesis.

About Spire Inc.

As stated in the introduction, Spire is a regulated natural gas utility that serves the states of Mississippi, Alabama, and Missouri.

These are generally among the more rural areas in the United States, although Spire typically only serves the largest cities in each state. This is not unusual as natural gas utilities do not provide universal service as electric utilities do. In many of the most rural areas of the nation, people heat their homes with propane, oil, or occasionally coal. Thus, natural gas utilities tend to be rather concentrated around population centers. This is evidenced by the fact that Spire serves approximately 1.7 million homes and businesses despite operating in states that are generally perceived to be rural.

As I have pointed out numerous times in the past, though, the size of a utility's customer base matters very little when it comes to the characteristics of the business. The most important characteristic for our purposes is that Spire tends to have remarkably stable cash flows over time, regardless of the conditions in the broader economic environment. We can see this somewhat by looking at the company's operating cash flows. Here they are during each of the past eleven twelve-month periods:

Admittedly, some readers might point out that these cash flows are nowhere near as stable as we might see from an electric utility. This is due to the fact that natural gas utilities are impacted by changes in natural gas prices and weather much more than electric or water utilities. We saw that this year as the winter was exceptionally warm in much of the northern hemisphere. That caused people to use less natural gas than normal heating their homes. Despite that, Spire still reported an operating cash flow of $350.7 million, which was its highest in a single quarter for a very long time:

Spire did not provide a specific reason for the strong performance in the first three months of 2023, although it did acknowledge that the warm winter had an adverse impact. From the earnings press release :

"We delivered improved results for the second quarter, with a continued strong performance from our gas marketing and midstream businesses, despite warm weather."

Midstream companies typically enjoy stable cash flows over time due to their contract-based business model. Spire owns a small midstream business that operates in the Western United States but that business only accounts for a relatively small portion of its revenue or earnings. Ultimately though, midstream operations are regulated by states and the Federal Government, much as utilities are so roughly 90% of Spire's revenue and net income come from highly regulated activities. This is something that could actually help the company's financial stability as regulators usually like to ensure that the company does earn a sufficient profit to avoid having to get financial support from the government.

Another reason for Spire's inherent financial stability is that the company provides a product that is generally considered to be a necessity for its customers. After all, someone that owns a gas-heated building will want to make sure that the gas is available to run the HVAC system as needed. As such, the company's customers will normally prioritize paying their utility bills ahead of making discretionary expenses with the money. That is something that could be especially important as the economy is widely expected to enter into a recession during the second half of this year. The persistently high inflation has already strained the finances of many people in the United States and a recession would impart further strains on their budgets. Thus, those companies that are highly dependent on discretionary spending could find their businesses weakening over the next several months while a company like Spire will remain in solid shape. This is exactly the kind of company that we want to own in such a scenario.

Growth Prospects

Naturally, as investors, we are unlikely to be satisfied by mere stability. We like to see any company that we are invested in grow and prosper over time. Fortunately, Spire is well-positioned to deliver on this objective.

The primary way that the company will accomplish this is by expanding 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 around 10%, but it varies by jurisdiction. As this rate of return is a percentage, any increase in the size of the rate base allows the company to increase the price that it charges its customers in order to earn this regulatory-allowed rate of return. This was one of the things that helped the company offset the impacts of the warm winter, as a recent rate approval allowed it to charge higher prices in Alabama and Missouri than it did in the equivalent quarter of the previous year.

The usual way that a company will expand its rate base is by investing money into upgrading, modernizing, and possibly even expanding its utility-grade infrastructure. Spire is planning to do exactly this, as the company recently unveiled a $7.0 billion capital investment plan for the 2023 to 2033 period. This is a much longer period of time than the five years that most utility companies' capital programs cover, which is quite nice since it gives investors an added amount of visibility into the company's future investment activities and capital needs.

Unfortunately, Spire has not stated where exactly it is going to deploy this capital, although some of it will be used to support the company's renewable natural gas ambitions and replace pipelines to reduce methane emissions. Ultimately, the most important thing is that this capital plan should allow the company to grow its rate base at a 7% to 8% compound annual growth rate over the projection period.

As the company will need to issue equity to partially finance its growth, its earnings per share are not projected to grow as quickly as the rate base over the projection period. This is normal for a utility company, which we will discuss later. Spire should still be able to grow its earnings per share at a 5% to 7% compound annual rate over the next ten years. When we combine that with the company's current 4.46% dividend yield, Spire should be able to deliver a total average annual return of 10% to 12% over the ten-year period, which is higher than most companies in the utility sector are likely to deliver over the same period. This should be reasonably attractive for just about any investor.

Financial Considerations

It is always important to examine the way that a company finances its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity. This is because debt must be repaid at maturity. This is usually accomplished by issuing new debt and using the proceeds to repay the existing debt, which can cause a company's interest expenses to increase following the rollover in certain market conditions. As interest rates in the United States are currently at the highest levels that we have seen since 2007, that is a very real 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 revenue or cash flow to decline could push it into financial distress if it has too much debt. Although utilities like Spire tend to have remarkably stable cash flows, this is still a risk that we should not ignore as bankruptcies have occurred in the sector in the past.

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. The ratio 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, Spire had a net debt of $4.5132 billion compared to a shareholders' equity of $2.9865 billion. This gives the company a net debt-to-equity ratio of 1.51 today. This is almost identical to the ratio that the company had six months ago when we last discussed it, which is nice as this is a sign that the company is not leveraging itself up in order to finance its growth. Here is how Spire's net debt-to-equity ratio compares to its peers:

Unfortunately, we can see that Spire uses somewhat more debt to finance its operations than its peers. This could be a sign that the company is relying too much on leverage, which could pose a risk to its investors. This is particularly true as the company is forced to roll over its debt as the Federal Reserve has hinted that rates will not be coming down for quite a while. With that said, Spire does not have as much reliance on debt as some electric utilities, but electric companies are also enjoying more support from the capital markets right now so it is not a fair comparison.

Dividend Analysis

As mentioned in the introduction, one of the biggest reasons why investors purchase shares in utility companies is that utility stocks tend to have higher dividend yields than many other things in the market. This comes from the fact that these companies have relatively low growth, so they pay out a substantial portion of their cash flows to their investors in order to deliver a competitive return. Spire is certainly no exception to this as the company's 4.46% yield is quite a bit higher than the 1.51% yield of the S&P 500 Index (SP500). It is also much higher than the 2.57% yield of the iShares U.S. Utilities ETF ( IDU ). As is the case with most utilities, Spire also has a long history of increasing its dividend annually:

The fact that the company increases its dividend on an annual basis is something that we very much like 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 we can buy with the dividend that the company pays out. This can make it seem as though we are getting poorer and poorer with the passage of time. The fact that the company distributes a greater amount of money each year helps to offset this effect and ensures that the dividend maintains its purchasing power over time.

As is always the case, though, it is critical that we 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 afford 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 to perform tasks such as reducing debt, buying back stock, or paying a dividend. In the twelve-month period that ended on March 31, 2023, Spire had a negative levered free cash flow of $332.9 million. That is obviously not enough to pay any dividends, but Spire still paid out $161.1 million to the shareholders over the period. At first glance, this is quite concerning, as the company clearly failed to generate enough free cash flow to pay its dividends.

With that said, it is common for utilities to finance their capital expenditures through the issuance of debt and equity. These companies will then pay their dividends out of operating cash flow. The reason for this is that otherwise, the high expenses involved in constructing and maintaining utility-grade infrastructure over a wide geographic region would preclude any dividend payments. In the trailing twelve-month period, Spire had an operating cash flow of $79.8 million, which was likewise insufficient to cover the $161.1 million in dividends that the company paid out.

This is very concerning, as the most recent twelve-month period in which the company did manage to earn enough operating cash flow to cover its dividends was the twelve-month period that ended on June 30, 2022. Thus, Spire was generally struggling to cover its dividends over most of the last year. In the most recent quarter though, the company's operating cash flow was $350.7 million, which was easily enough to cover its quarterly dividends of $41.9 million. It was also enough to cover the dividends paid over the past year, the problem is that the company had negative operating cash flows in two of the past four quarters:

As long as this pattern does not repeat going forward, the dividend is probably reasonably safe. Fortunately, natural gas prices have stabilized during the first six months of 2023, which should help here.

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 Spire, we can value it by looking at 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 are undervalued relative to their earnings growth in today's overheated market. As such, the best way to use this ratio today is to compare Spire's valuation to that of its peers in order to see which company offers the most attractive price-to-earnings growth ratio.

According to Zacks Investment Research , Spire will grow its earnings per share at a 4.22% rate over the next three to five years. This seems a bit low based on the growth rate that the company should be able to achieve given its projected rate base growth. However, the Zacks estimate gives Spire a price-to-earnings growth ratio of 3.60 at the current stock price. Here is how that compares to some of the company's peers:

As we can see here, Spire looks a bit more expensive than some of its peers, although it is not the most expensive company on this list. However, this is using the Zacks projected growth rate, which may be too low based on the projected rate base growth. If we use the 5% low end of the projected earnings per share growth as discussed earlier, the company's price-to-earnings growth ratio drops to 3.04, which is more competitive with its peers. A 7% growth rate (our high-end estimate) gives a price-to-earnings growth ratio of 2.17, which is well below that of any other major natural gas utility. That growth rate seems optimistic though, but it seems likely that Spire is fairly priced relative to its peers.

Conclusion

In conclusion, Spire Inc. is a multi-state natural gas utility that should not be overlooked by investors. Natural gas as a fuel source is not going anywhere in the near future, but the market's perception that it is has resulted in Spire having a fairly high dividend yield relative to many other utilities. The company is positioned to deliver an attractive total return as its growth story plays out. Unfortunately, the company does not appear to be undervalued relative to its peers but it is not overpriced either. Overall, Spire Inc. could be a reasonable way to earn a high dividend yield and ride out the imminent recession.

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