Delta Natural Gas: Approaching 52-Week Lows, This Small Natural Gas Utility Deserves A Look

| About: Delta Natural (DGAS)

Summary

With no analyst coverage, a dividend yield over 4% and trading near 52 week lows, Delta Natural Gas deserves a look from income oriented investors.

Operating in a stable and predictable business, shares of Delta Natural Gas offer attractive relative prospects as shares of other utilities become increasingly expensive.

The company's small size and recent deal activity in the utility sector indicates investors enjoy an embedded catalyst of a potential acquisition by a larger multi-state utility at a premium.

Small but Steady

When purchased at sensible prices, common shares of utility companies provide investors with both a margin of safety and the chance to build income over time through the predictable dividend increases. Unfortunately due to a prolonged period of low interest rates, many shares of utility companies have become (in my opinion) unjustifiably expensive due to global demand for yield. As the share prices of these companies increase (and dividend yields correspondingly decrease), a substantial risk of overpaying begins to emerge in a sector that has been popularly thought of as a safe haven investment.

One way for investors to "dodge the bullet" of expensive utilities is to purchase shares of smaller and more obscure utility companies. Despite being smaller and less well known than their often gigantic counterparts, these utilities retain the cardinal virtues of their sector including healthy and increasing yields in addition to a stable, predictable operating history while furnishing investors with attractive entry points during a period of lofty market valuations.

Another particularly significant advantage inherent to smaller utilities is the fact that they provide investors with an attractive embedded catalyst: the possibility of being acquired by a larger utility at a premium, with recent M&A activity in the space over the past few years furnishing several examples for study.

Today I will be discussing a small regional gas utility located in Kentucky known as the Delta Natural Gas Company (NASDAQ:DGAS) that I believe offers investors both a growing dividend yield in addition to being a particularly attractive acquisition candidate due to the company's small size relative to peers.

What Delta Natural Gas Does

(Quoted Text Courtesy of Google Finance)

Founded in 1949, the Delta Natural Gas Company is a relatively young company that operates as a regional gas utility located in the state of Kentucky. The company's business is focused on the distribution, transportation and storage of natural gas to approximately 36,000 customers, with

the Company's distribution and transmission systems...located in central and southeastern Kentucky, and it owns and operates an underground storage field in southeastern Kentucky. The Company transports natural gas to its industrial customers who purchase their natural gas in the open market and the Company also transports natural gas on behalf of local producers and customers not on its distribution system. The Company has three wholly owned subsidiaries: Delta Resources, Inc., which buys natural gas and resells it to industrial or other customers on its system; Delgasco, Inc., which buys natural gas and resells it to Delta Resources and to customers not on its system, and Enpro, Inc., which owns and operates production properties and undeveloped acreage.

Of all the utilities in the United States (Water, Electric, Gas and Telecom), I believe that natural gas represents one of the most interesting opportunities for investors for several reasons. The first is the fact that the use, affordability and applications of natural gas have significantly increased over the past decade as advances have been made in the American petrochemical industry. The second is the increasing desirability of natural gas assets, particularly infrastructure assets, among larger utility companies due to the current low interest rate environment, predictable cash flow streams and potential tax advantages regarding the MLP corporate structure. The attractiveness of midstream assets makes smaller companies operating in the field increasingly attractive targets for acquisition as natural consolidation occurs which can produce significant wins for investors.

The Numbers on Delta

With a market capitalization of $137 million, Delta Natural Gas is one of the smallest publicly traded utilities operating in the United States. Currently priced at $19.41 a share against a book value of $10.75, the company is offered at a significant premium to its assets, something which is understandable given the essential nature of the service the company provides. Insider ownership in the company currently stands at 11.43%, a number that is relatively high for many utilities but is understandable given the fact that Delta Natural Gas is a relatively young company having been founded in 1949.

The company currently pays a dividend yielding 4.1% which has been paid every year for over fifty years. This dividend has also been regularly increased with a payout ratio standing at .74. From an historical perspective, Delta Natural Gas currently trades at the higher end of the company's historical five year average dividend yield, which stands at 3.8%, indicating an attractive purchase opportunity.

While Delta's dividend payout ratio does appear high, it is important to understand that Delta Natural Gas has limited expansion potential due to operating in a constricted geographic area and in a regulated industry. Despite the fact that the company pays out almost three quarters of its cash flow to shareholders, Delta's current ratio currently stands at over 2.4, indicating that the company is more than able to satisfy its current obligations.

Catalysts for Acquisition?: Recent M&A Activity Shows Sector Interest

As with any heavily regulated and essential industry, there are limited options for significant organic growth to be realized and as a result, many utilities grow through acquisitions. Given the small size of Delta Natural Gas relative to other utilities I believe that there is a significant opportunity for the company to be acquired by a larger utility as a "bolt on" style acquisition, where savings has the potential to be realized both through cost saving synergies and the reduction of the costs associated with remaining a public company.

Recent activity that has occurred in the sector supports this opinion, with the acquisition of UIL Holdings (NYSE:UIL) by the Spanish company Iberdrola and the acquisition of Alagasco last year by the Laclede Group (LG), indicating that there is significant interest in purchasing regulated assets due to their attractive and predictable cash flow profiles which are made increasingly attractive by the current low rate environment. Outside of the Laclede Group, which has grown into one of the largest natural gas utilities in Southeastern United States, another potential acquirer could be the Atmos Corporation which operates a large system of both regulated and unregulated natural gas transmission assets and already does a significant amount of business with Delta Natural Gas.

From an inverted perspective, I believe that there is significant potential for Delta Natural Gas to continue growing through "rolling up" fragmented municipal natural gas infrastructure within the company's service area, which will both increase the scale of the company's business and boost the company's "franchise value" which makes the company more valuable to an acquirer.

Risks

Despite the fact that I believe the essential and uncomplicated industry within which Delta Natural Gas operates in addition to the company's operating history of over fifty years provides investors with a significant margin of safety it is important to understand that there are some investment risks inherent to the company.

In spite of providing an essential service, a major part of the company's business is subject to regulation and as a result there is a significant risk that Delta Natural Gas could be prevented from increasing the rates it charges customers by the Kentucky PUC which could both jeopardize the profitability of the business as well as the ability of the company to increase dividend payments.

Due to the potentially volatile nature of natural gas and Delta's operations involved with both moving and storing the commodity, there is also a risk of a disaster which could cause a significant loss of life or property which in turn could expose the company to protracted litigation and regulatory fines.

Weather is another significant issue that investors must be aware of, given the fact that a large amount of the company's natural gas sales are related to heating and thus during prolonged periods of colder weather the company will record a higher volume of natural gas sales and thus realize higher profits.

Another significant risk that investors must be aware of is the fact that shares of Delta Natural Gas are illiquid and thus could be prone to bouts of significant volatility which could cause significant though fleeting increases or decreases in the price of the company's shares that are not related to the operating fundamentals of the business.

Conclusions: Opportunity in Obscurity, Lack of Risk and Takeout Potential

Currently trading near 52 week lows, I believe that shares of Delta Natural Gas offer investors a safe opportunity for "base hit" investing. While the company may not experience wildly profitable growth in the future due to the inherent limitations of the industry in which it operates, Delta Natural Gas operates in an essential business that provides the opportunity for moderate organic growth in conjunction with healthy dividend payments that will increase gradually over time.

For investors that are seeking uncomplicated sources of predictable income, Delta Natural Gas deserves a spot on your list as the company's size and relative illiquidity helps to provide a natural barrier against large institutional funds from purchasing shares at higher prices and thus depressing the company's dividend yield.

One significant embedded catalyst in the company due to the smaller size of Delta Natural Gas and the recent consolidation that has occurred in the utility sector, I also believe that the assets of the company represent an attractive opportunity to the right acquiring party for an uncomplicated "bolt on" style acquisition. Should this occur, I believe that investors will receive a moderate premium to the assets of the company and (or) shares of another utility company as a result of the transaction.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Gas Utilities
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here