An Earnings Miss For Southwest Gas Is An Opportunity For Investors

Summary

• Southwest Gas saw its share price dented in recent months following a sizable Q1 earnings miss and a disappointing Arizona rate case decision.
• The company's long-term outlook has brightened considerably since early 2016 on a strengthening service area, however, which will allow it to maintain its track records of earnings and dividend growth.
• Investors seeking capital preservation and dividend income should consider the opportunity presented by the recent downturn of the company's share price.

Southwest Gas (NYSE:SWX) is a natural gas transportation and distribution company that operates in Arizona, Nevada, and Eastern California. The company operates two segments: natural gas and construction. The natural gas segment provides regulated services to nearly 2 million customers, 99% of which are residential and small commercial entities, across its service area. The second segment, named Centuri, is a construction entity that operates within the utilities and pipeline areas in the U.S. and Canada. The company's natural gas operations provide the large majority of its consolidated earnings (81% last year), while its regulated operations in Arizona are in turn responsible for the majority of that segment's gross margin (54% last year). (For more details on its operations, see my previous article from 2015.)

Southwest's share price rallied strongly beginning in October of last year, rising by 35% over the subsequent six months (see figure). A Q1 earnings miss and disappointing rate case decision have caused the share price to retrace much of its earlier gain, and it has shed 16% of its value from its March peak. This reversal has dinged the share price's record of outperformance: whereas it has solidly beat the S&P 500 Utilities Index over the last 10-, 5-, and 3-year periods (boosted by a 10.9% dividend CAGR over the last five years), it has slightly underperformed the index for the 12-month period ending May 31. This article takes a deeper look at Southwest Gas's operating position to evaluate it as a potential long investment opportunity.

SWX data by YCharts

Outlook

Two years ago, I was relatively bearish on Southwest Gas, concluding that "continued signs of [economic] weakness in its service area threaten to dampen future earnings growth for the company." In 2015 I was worried by the fact that Arizona and especially Nevada had much higher unemployment rates than the U.S. average, which threatened customer growth in the company's service area. Likewise, both states were experiencing below-average rates of personal income growth at the time. Nevada was hit particularly hard by the housing bust and the collapse of new construction in that state was especially worrisome for a natural gas utility that relies almost entirely on small entities for its revenue and growth.

What a difference 24 months can make. While Arizona and Nevada continue to have higher unemployment rates than the U.S. average (see figure), both states' rates have fallen sharply since 2015 and are below where the U.S. average was in that year (despite a recent uptick for Arizona). Personal income in those states has fared even better. Arizona experienced an increase of 4.3% between 2015 and 2016, well above both the U.S. average for the same period of 3.6% and its own 10-year CAGR of 2.9%. If Arizona has rebounded nicely in this context, Nevada has staged a complete turnaround (and the latter contributes more than 1/3 of the natural gas segment's total customers and gross margin). Personal income in that state jumped by 5.9% between 2015 and 2016, more than twice its 10-year CAGR of 2.4%. Furthermore, this growth was heavily focused on personal net earnings (which experienced a 7.2% annual increase versus 4.1% for the U.S. and a 10-year CAGR of 1.5%) rather than interest and dividends (which experienced a 1.7% annual increase in Nevada). This is important in that it suggests the wealth increases are concentrated among younger generations that are less likely to own their own properties at present.

Arizona Unemployment Rate data by YCharts

Sure enough, housing permits are expected to experience steady growth of up to 9-10% annually through 2019 in the company's service areas in Arizona and Nevada. This projection is in turn driven by strong population growth via relocation from other states to those locations. Maricopa County in Arizona achieved the country's highest population growth last year, while Nevada as a whole achieved the country's second-fastest growth rate at the state level (trailing only behind Utah) for similar reasons. Arizona and Nevada are expected by S&P Global Market Intelligence (as reported by Southwest Gas in a recent presentation) to achieve overall growth rates of 5.9% and 6.4%, respectively, between 2017 and 2022, well above the average U.S. population growth rate of 3.8% over the same period. The company's recent annual customer growth rate of 1.5% could be low compared to future years if population growth in Arizona and Nevada meets those expectations.

Southwest Gas's outlook is not completely positive, although its less attractive aspects appear to be short-term in nature. The company's recent share price decline was driven in part by a substantial miss on its Q1 earnings report, with its diluted EPS for the quarter of $1.45 missing the consensus estimate by $0.20 while also declining by 8.2% YoY. While the company attributed some of this poor performance to a $4.1 million reduction to the construction segment's TTM net income (through Q1) that in turn resulted from a regulatory work stoppage for training and inclement weather, other recent developments have also been of concern.

The company received a relatively disappointing decision on its latest Arizona rate case when regulators granted it a 9.5% return on equity instead of the 10.25% requested rate; the amount of granted rate relief was also only 50% of what the company had requested. A consequence of this decision is that the company's annual operating income growth attributable to its Arizona operations is now projected by management to fall from $45 million in FY 2017 to only $16 million in FY 2018. The rate base did come in close to the request, however, missing by a mere 1.5%.

Compounding this issue is an anticipated peak for annual capex attributable to the natural gas segment. The company's own outlook is for the segment's capex to hit a high of $620 million in FY 2018, then decline to $607 million in FY 2019. The decline is due to the construction timeline for a new $80 million, 233,000 dekatherm LNG facility that is due to be completed by the end of FY 2019, meaning that the bulk of associated capex is not due until next year. While investors would prefer to see steady capex growth so as to offset the lower-than-requested allowed return on equity, Southwest Gas still finds itself in a solid position. The customer growth is already showing up on the company's earnings, contributing to an $8.5 million increase to the natural gas segment's net income for the TTM period ending March 31, 2017. Furthermore, while the construction segment's performance has disappointed of late, the temporary nature of the factors that resulted in its recent poor performance is outweighed by its long-term record: between 2012 and 2016 the segment doubled its net income, and there were no indications in the Q1 earnings call that this long-term trend had been permanently altered.

Finally, even the Q1 earnings miss, substantial as it was, failed to affect the company's dividend growth record. Management declared a 10% YoY increase to the dividend for FY 2017, marking its 11th straight annual increase and resulting in a TTM yield of 2.53% (see figure). While this record is not as strong as that boasted by many utilities, it is still notable given how drastically its service area economy and outlook have improved over that time period. Future dividend growth and capex is supported by the company's continued ability to access the capital markets, with management announcing last month that it had successfully increased the natural gas segment's credit facility by $100 million to $400 million.

SWX Dividend Yield (TTM) data by YCharts

Valuation

Analysts expect Southwest Gas to maintain its earnings growth, with customer growth offsetting the lower-than-requested rate case decision to maintain the company's long-term annual average earnings growth rate of 6.3%. The consensus EPS estimate for FY 2017 of $3.38 has declined from a consensus of $3.43 90 days ago but still represents an annual increase of 6.2%. Likewise, the FY 2018 consensus of $3.59 is down from $3.67 90 days ago but also represents an annual growth rate of 6.2%.

These earnings estimates result in forward P/E ratios of 21.6x and 20.4x for FY 2017 and FY 2018, respectively, based on a share price at the time of writing of $70.06. At first glance, these appear to be high, especially within the context of where they were at the beginning of 2016 (see figure). Both numbers are well below their peaks from 2016 and 2017, however, and it must be remembered that the company's outlook before 2016 was not nearly as attractive as it is today, so a higher P/E ratio is justified in this situation.

SWX PE Ratio (TTM) data by YCharts

Similarly, while the company's forward EV/EBITDA ratio of 8.5x is above its 3-year median of 7.9x, it is still below its 2016 and 2017 peaks and, as with the forward P/E ratios, should be considered within the context of a greatly improved service area economy.

SWX EV to EBITDA (TTM) data by YCharts

Conclusion

Southwest Gas has experienced a strong turnaround in its service area, especially within Arizona and Nevada. Both states contribute the large majority of its consolidated earnings, so the population growth, personal income growth, and declining unemployment rates that have been reported for those states since 2015 are notable positives for the company's outlook. While a sizable Q1 earnings miss and disappointing Arizona rate case decision have dented its share price of late, the former was attributable to temporary factors while the latter will mitigate but not offset the impact of the rebounding service area economy and short-term capex growth. Investors looking for capital preservation and dividend income should take a close look at the opportunity provided by Southwest Gas's shares in the wake of their recent downturn, as a company with its track record should have little difficulty maintaining its earnings and dividend growth performance under the improved conditions that it now finds itself operating in.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SWX 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.