Dividend Kings #9: Northwest Natural Gas - Don't Fall For This Dividend Trap

| About: Northwest Natural (NWN)

Summary

Dividend Kings are companies showing over 50 consecutive years of dividend payment increases.

NWN shows 157 years of business history doubled with a streak of 60 consecutive years of dividend increases.

Unfortunately, I have a feeling management is hiding behind its stellar history.

NWN appears to be the perfect example of a dividend trap.

By definition, dividend kings are the most elite group of dividend growth companies. Many investors are familiar with the dividend aristocrats, which are companies with at least 25 consecutive years of dividend increases. To date, the list shows a little bit more than 50 businesses. Over the past decades, many years this list has gone through the cap of 50 consecutive years. Therefore, we had to find a name for those super-powered dividend payers. It was already a feat to stay in business for more than 50 years, it is quite extraordinary to have been able to distribute and increase their payouts for a half century. The list now counts 18 companies and are named the Dividend Kings. In these weeks, I am reviewing the 18 Kings.

Today, I will analyze Northwest Natural Gas (NYSE:NWN).

What Makes Northwest Natural Gas a Good Business?

NWN is a small utility with a market cap of 1.75B operating in Oregon and a part of Washington state. The company serves slightly more than 700,000 customers in the area. The stable demand for natural gas in this region make it a "no-worry" stock where continuous cash flow comes in repetitively. The main downside of such a business model is that it is quite hard for management to present a growth vector for the future. I guess the strong base of NWN lies in its 157 years of business history doubled with the 60-consecutive-year dividend increase streak. This is usually enough to gain investors' attention.

Revenue

Click to enlarge

Revenue Graph from Ycharts

Unfortunately, we can't determine that NWN shows any kind of growth over the past 10 years. In fact, lower natural gas prices pushed the revenue down and the company failed to grow its customer base. Between 2011 and 2015, the company grew its number of clients by less than 5%. In annualized growing rate, we are talking about numbers lower than inflation!

How NWN fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I've been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let's take a closer look at them.

Click to enlarge

Source: Ycharts

Principle #1: High Dividend Yield Doesn't Equal High Returns

My first investment principle goes against many income-seeking investors' rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it's because the market thinks it's a risky investment - or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comes with dividend growth, and this is what I am seeking most.

Click to enlarge

Source: data from Ycharts.

The company has shown a stable dividend yield around 4% like many other utilities over the past 10 years. With the recent stock price surge, the dividend yield dropped to 3%. In no time, this company has shown a high dividend yield as its business model is fairly stable. NWN meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metric of all. It proves management's trust in the company's future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can't be derived from anything else but increasing revenue. Who doesn't want to own a company that shows rising revenues and earnings?

Click to enlarge

Source: Ycharts

This utility has been increasing its dividend payouts for the past 60 consecutive years. As you can see, the dividend hikes are not impressive, but rather conservative. This is the kind of management shareholders have been used to: steadily increasing each year without much hype. NWN meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth.

Click to enlarge

Source: data from Ycharts.

While the dividend payment has increased consistently, management makes sure to keep a payout ratio of 80% and a cash payout ratio around 50%. When you look at a utility, the cash payout ratio is more important than the payout ratio. A utility's business model is based on strong cash flow generation. As an investor, you want to make sure the company continues to generate such revenue to keep their distribution going. As I previously mentioned, management shows a very conservative approach to ensure dividend increase sustainability in the future. NWN meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

This utility is the largest player in Oregon and benefits from a very strong customer base. The company focused on providing a top notch service which they have been awarded the J.D. Power & Associates award for being #1 in customer satisfaction. The stability of demand and relatively interesting size of NWN could seduce any income seeking investor.

As is the case with many utilities, NWN owns its market. This ensure it will continue to exist and make money year after year. Unfortunately, besides a very small growth in line with the GDP growth of its territory, there is very little to be expected. NWN doesn't meet my 4th investing principle.

Principle #5: Buy When You Have Money in Hand - At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn't mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Click to enlarge

Source: data from Ycharts.

At first glance, NWN seems overvalued. Over the past 10 years, the company has never traded for such high multiples. I guess income-seeking investors have become a little bit more desperate as interest rates fail to rise, and NWN offers a better safe investing option.

Digging further and using the DDM, I arrive at the same conclusion. I've used a discount rate of 9% since it's a utility. You can't expect much growth from this kind of company and I respect that. Since the past 5 years of dividend growth stands at 2.08% with a decreasing EPS of -6.41%, I can't expect more than 3% as a dividend growth rate. Even then, I consider myself generous.

Here are the details of my calculations:

Click to enlarge

Source:Dividend Monk Toolkit Excel Calculation Spreadsheet

As you can see, NWN trades at around $58, and its fair value as a dividend paying stock is $32.27. We are far from getting a deal here. There are many other options better than overpaying for this dividend king. NWN doesn't meet my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I've found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by whether the company confirms my investment thesis or not. Once the reasons (my investment thesis) why I purchase shares of a company are no longer valid, I sell and never look back.

Investment thesis

I see an investment in NWN as a good bond. The stock delivers a yield around 3% and the company has still managed to perform as well as the S&P 500 over the past 10 years. That makes it an investment better than any bond on the market with about the same overall risk. You can understand I'm not a fan of this company, but still, I can appreciate the investment of a safe and increasing dividend payment.

Risks

I'm a bit concerned about NWN's growth perspectives. For example, the company has grown its client base from 680,000 clients in 2011 to 714,000 in 2015. This means a 5% client base growth over the past four years. Please note that I'm not talking about annual growth but total growth (leaving the annual growth way below 2% per year). I think management is somewhat hiding behind their stellar history and impressive dividend increase streak without having something solid to offer for the future. The business model is strong and not at stake, but I just don't see how the word "growth" will be part of a discussion involving Northwest Natural Gas. Finally, the company has issued more shares than it has bought back since 2007. This is a bit worrisome as financing through new shares will have to stop at one point or another.

The company shows more risk than a strong investment thesis. Therefore, NWN doesn't meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments. The first is the core portfolio built with strong and stable stocks meeting all our requirements. The second part is called the "dividend growth stock addition," where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segments helps me to categorize my investments into a "conservative" or "core" section or into a "growth" section. I then know exactly what to expect from it; a steady dividend payment or higher fluctuations with a greater growth potential.

At this point of the analysis, you can expect me to tell you that I would not hold NWN in any of my portfolios. There is definitely no growth vector, and management doesn't seem to be able to shed some light on how the company will grow in the future. On the other hand, while the payout ratios are in line and do not worry me at the moment, I'm still concerned about the future dividend growth. As I have completed 15 of the 18 dividend king analyses so far, I can tell you that there are 13 better options. NWN doesn't meet my 7th investing principle.

Final Thoughts on NWN - Buy, Hold or Sell?

It is quite surprising to see that a Dividend King could not meet most of my dividend investing principles. I guess this serves a lesson to investors looking only at the past. NWN is definitely a dividend trap: a company seducing income seeking investors with very little to offer in the future. I'm afraid the stock price will eventually drop in the event of better interest rates and the dividend payment will not show a strong growth trajectory in the future. I would definitely stay away from NWN.

Disclaimer: I do not hold NWN in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.