A Small and Hardy Utility
For investors concerned with achieving a growing stream of income - utilities have always been quite popular, particularly in low interest rate environments where conventional fixed income investing is often unrewarding and potentially fraught with risk. Utilities offer investors an attractive proxy for achieving stable and growing returns over time due to their essential nature.
As many investors have invested in common shares in utilities as a proxy for a "super safe" investment, the increased demand for those shares both drives up the price and drives down yields. This makes conventional wisdom increasingly suspect and thus increases the risk of unjustifiably high prices and unacceptable volatility - two things which are the bane of risk-averse investors.
Despite the fact that many utilities have experienced an unjustified level of appreciation in price, some companies remain appealing. Of particular interest are those companies that are smaller and have diverse operating segments in both regulated and unregulated areas. I believe that WGL Holdings (NYSE:WGL) is one such company, as it is currently trading around five year lows, pays a dividend over 4% and has a few interesting potential catalysts.
What the Company Does: Regulated Utilities Complemented by Unregulated Subsidiaries
WGL is organized as a holding company that "owns subsidiaries, which sell and deliver natural gas and/or provide a range of energy-related products and services to customers in the District of Columbia and the surrounding metropolitan areas in Maryland and Virginia. The Company operates in three subsidiaries: regulated utility segment, retail energy-marketing segment and design-build energy systems segment."
WGL operates regulated utilities in a very attractive area in my mind, as the area around the nation's capital is an essential market that is experiencing robust economic development. The area is also growing as real estate in Washington D.C grows more expensive, encouraging the development of outlying areas.
The company also has a long history and has paid a dividend continuously for over one hundred and fifty years, a record that is extremely impressive. I am attracted to businesses that have long operating histories for a variety of reasons. A long operating history is evidence that a company is able to weather depression, war and natural disasters and will likely continue to do so in the future.
The company's design-build segment, Commercial Energy Systems, is engaged in the production and installation of solar power facilities, with management mentioning this segment as providing a robust pipeline of future products under contract.
The Numbers on WGL Holdings
With a market capitalization of $2 billion, the company is small. Currently priced at $39.31 against a book value of $26.75, the company trades at a significant premium to its underlying assets. I believe that this premium is justified given the nature of the business, its stability of revenue and its long operating history. The company also currently pays a stable and growing dividend of 4.29% and has a payout ratio of .60, a number that is fairly average for most businesses however is somewhat low for a utility.
Insider ownership of the company stands at under 1%. Though I often look at insider ownership as a proxy for management involvement and effectiveness - for utilities that have been operating as long as WGL, I believe that this number cannot alone be used as a negative when it comes to evaluation.
This Company Has a Chance of Being Acquired
Smaller regulated utilities that throw off healthy and growing dividends represent attractive assets for established companies given their predictable cash flow and essential nature. Given the small size of WGL Holdings, I believe that it is likely that the company could be acquired in the future, particularly if interest rates remain low. Deal activity in the utility sector over the past year validates my hypothesis.
The acquisition of DPL Inc. (NYSE:DPL) and the recent purchase of NV Energy (NYSE:NVE) by the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) subsidiary MidAmerican Energy indicates persistent interest in utility assets. I believe that the acquisition of DPL is particularly interesting given the parallels between DPL and WGL. Though DPL operates solely in electricity generation and not gas, the company has a similar structure to WGL Holdings consisting of both core regulated utilities and profitable unregulated subsidiaries.
Though I would not advocate purchasing this company with the expectation that it will be acquired at a significant premium, I believe that there is potential for this type of transaction to occur given previous activity this year and the increasingly attractive nature of utilities to large entities as a method of generating stable returns in the absence of considerable risk (evidenced by the recent activity of Berkshire Hathaway in the space).
I will also caution those who want to purchase this company hoping that it will be acquired to cultivate realistic expectations about the acquiring price. Regulated utilities do not command a large premium relative to companies operating in other industries, as their assets and future cash flows are largely predictable.
What About a Spin-off?
Instead of being acquired, I believe that there is also the potential for WGL to separate its regulated and nonregulated business segments to create a value-realizing event for shareholders. Separating the regulated and nonregulated portions of the business has the potential to reduce volatility and provide shareholders with better options for investment going forward.
In previous articles about natural gas utilities, I have discussed the potential for pipeline and storage assets to be spun out through an MLP or REIT conversion, a type of scenario which is in my view is a win-win for shareholders. Future shareholders and those seeking to reinvest are able to direct their investment into the less volatile regulated utility segment or the more profitable non regulated elements of the business.
I believe that WGL is also in a similar situation and can benefit from asset division, as its gas storage and distribution pipeline segments could be distributed to shareholders and converted into a more efficient structure - likely an MLP. In addition, the company operates non-regulated segments that have a broader coverage area than the company's core utility segments. I am very attracted to utilities that have non-regulated operating segments, as they can contribute to increased dividend growth (in excess of the regulatory limitations imposed on regulated operating segments and thus providing substantial protection from inflation) in addition to being spun-off to shareholders through a tax free distribution.
Though I do not believe investors should purchase shares in this company with this outcome in mind, retaining an embedded call option on this activity is beneficial, and the small size of the company makes it increasingly likely for activist involvement.
Unregulated Growth Potential Through Capitol Energy Ventures
Achieving growth is a very difficult proposition for many utilities due to the fact that their core businesses are highly regulated. As such, I believe that utilities with "something extra" are highly desirable investments for investors seeking better than average growth prospects.
This type of growth can be achieved through several methods. I have previously discussed two companies - the Otter Tail Corporation and Hawaii Electric - that have operating subsidiaries engaged in non-utility segments as a method of achieving organic growth.
The company's Capitol Energy Ventures, which owns a portfolio of pipeline and storage assets, is engaged in the wholesale distribution of natural gas to customers across the eastern United States. The company uses derivatives to manage its risk profile. While these derivatives can fluctuate in price from quarter to quarter, the company's obligations are closely matched by the company's asset base.
I believe that, given the nature of Capital Energy Venture's underlying assets and the growth in natural gas demand and use in the United States, WGL's CEV segment will contribute essential unregulated growth. In addition, as I have mentioned earlier, I believe that this segment of the company is most likely to be spun out via a MLP or REIT conversion to shareholders.
Though I believe that the long history of this company firmly demonstrates its ability to navigate through challenging economic environments, it is also important to be aware of the fact that there are several possible sources of risk. In spite of providing an essential service, a major part of the company's business is subject to regulation and there is a very real possibility that the company will be prevented from increasing its prices in order to keep pace with inflation. If this affects the dividend of the company, investors looking to increase their dividend income will find their purchasing power gradually eroding due to inflationary pressure.
Given the nature of natural gas storage and distribution, there is also a risk of a disaster - natural or otherwise - that could cause a catastrophic loss of life or property and leave the company vulnerable to litigation and regulatory fines.
Another important factor in utilities is seasonality. Periods of unusually warm or cold weather will produce a significant impact on energy consumption and thus impact the earnings of WGL Holdings. While seasonality is a double edged sword, where the company could reap windfall profits if the weather is in their favor, it could also impair the company's earnings over the season. For short-term investors this might produce some discomfort, however for long-term investors I believe this is of little importance.
Utility Investing in a Low Rate Environment: Be Aware of "Flight-to-Yield"
"Flight-to-yield" is particularly hazardous in the realm of regulated utilities; unlike their unregulated dividend paying alternatives, they lack the ability to adapt quickly to changing market conditions and lack the similar degree of pricing power. I believe that this phenomenon of "flight-to-yield" has recently impacted some areas of the utility sector, and investors in certain companies at current price levels run the risk of being exposed to a degree of volatility which I believe is unacceptable given the nature of the assets.
I would caution investors to utilize dollar cost averaging as making a large singular commitment is especially hazardous in the current environment. As the rates on bonds rise, I believe that there will be a significant drawdown in the price of common shares of utilities as many investors and fund managers seeking risk-reduced yield have created significant demand for this asset class. Despite the fact that WGL Holdings has experienced a heavy sell-off after earnings, I would caution investors to remain cautious and employ dollar cost averaging.
For investors searching for a stable source of dividend income, I believe that WGL Holdings represents an attractive investment because of the long operating history, the inherent stability of regulated utilities and the company's diverse nonregulated operating segments which help to mitigate inflationary pressure. For investors with goals of achieving dividend income growth and moderate capital gains, I believe that WGL Holdings represents an inherently attractive option given the spin-off potential of the company's non-regulated divisions, its diverse regulated assets, healthy dividends and previous merger activity in the regulated utility space.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in WGL over 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.