Dividend King NW Natural Is Once Again Overpriced

Summary

• NWN was briefly in value territory earlier this year.
• But the stock has rebounded sharply, and despite the company's exemplary dividend history, it's way too expensive.
• NWN is an avoid.

Image source

Very few stocks in the entire world can match the dividend increase streak of a small utility in Oregon. NW Natural (NYSE:NWN) is a gas utility that serves about 2.5 million customers in Oregon and Washington combined, along with a very small water utility business, producing about $800 million in total annual revenue. Despite its small size, NWN has managed to boost its dividend for more than 60 consecutive years, putting it in extremely select company when it comes to dividend increases.

While that's all well and good, with NWN having rallied hard from the bottom set in March, it looks to me like the stock is once again quite expensive. Investors tend to pay premiums for stocks with dividend track records like NWN's, and this time does not appear to be different. So, while the stock is cheaper than it was before the crash, I think the opportunity to buy NWN at a reasonable price has come and gone.

Very limited growth

Utilities in general don't grow that quickly because their pricing is regulated by local authorities, and customer bases usually expand slowly over time. That means that both pricing power and volume increases are limited, so revenue growth is commensurately limited. NWN isn't immune from this, as we can see below, with revenue plotted in millions of dollars for the past three years, as well as forecasts for this year and next year.

Source: TIKR.com

Revenue for 2020 is slated to be just 4% higher than it was three years ago, after 2018 saw negative growth, with some bounce back last year, and more growth this year. NWN shouldn't be expected to grow quickly given it is a regulated utility, but it has tried over the years to boost its top line expansion with a slew of acquisitions.

Source: Investor relations

Just in the past two years or so, NWN has produced the above list of acquisitions, with just one divestiture in June of 2018. NWN has done a lot in the past few years to build out its growing water utility business, but it is still a fraction of the size of the gas utility. As NWN continues to acquire more water utilities, the top line will grow. But investors would do well to remember that acquisitions for any company are generally expensive, and must be funded by either debt, equity, or cash on the balance sheet.

The problem for NWN with this strategy is that it produces little to no free cash flow on a regular basis, as we can see below. We have cash from operations and capex, which are the two components of free cash flow, all in millions of dollars.

Source: TIKR.com

FCF has been negative in each of the past three years, and the deficit is only expected to grow for 2020 and 2021. Running a utility is unbelievably capital-intensive, and NWN certainly isn't immune from this fact. As it tries to build out its water utility business, this problem isn't going to go away. When a company cannot produce enough cash to run its own business, it must raise capital somehow, and NWN has chosen to do so via common shares at times, and with debt at other times.

As a result, its share count has risen gradually and the debt situation has worsened over time, and given it continues to make acquisitions that require further capex, there is no reason to think this will improve any time soon.

Source: TIKR.com

We can see that net debt was $831 million in 2017, but this year, is expected to crest $1.1 billion. Next year, it should be even higher given FCF will almost certainly be negative for 2020. Debt as a percentage of EBITDA continues to rise, meaning relative leverage of the company's debt to its ability to earn against the assets it financed with the debt is increasing as well.

Below, this point can be illustrated with a more direct connection to earnings, with interest expense in blue and earnings before interest and taxes, or EBIT, in black, both in millions of dollars.

Source: TIKR.com

Interest expense has stayed pretty steady around $40 million annually for the past three years, and is expected to stay there for this year and next given low borrowing rates. However, NWN is spending roughly 30% of its EBIT on interest expense alone, which is a huge sum for any company. Put another way, for every three dollars of operating profit, NWN is spending about one of those dollars on servicing debt. That's a very large overhang on the company's earnings that is difficult to get out from underneath, and is exacerbated by NWN's abysmal FCF generation.

The bottom line

Unfortunately, this all adds up to a fairly grim growth outlook in my view, as NWN continues to execute on rate increases in its gas utility business, but its capital structure and acquisition strategy fall short. Earnings growth, as seen below, simply hasn't been good enough to justify a stock that is trading for 25 times normalized earnings for 2021, so I'm very cautious on this one, despite its exemplary dividend track record.

Source: TIKR.com

EPS is expected to fall this year, but heading into 2021, should normalize back on its ~4% annual growth track. Given its acquisition strategy, I don't doubt that NWN can continue to grow EPS at low-single-digit rates indefinitely. However, for a 3% yield and 4% growth, I simply cannot see paying 25 times earnings.

The opportunity to buy this Dividend King has come and gone, and for that reason, I think investors should look elsewhere. NWN may continue to go up but the valuation has reached levels that are untenable, and for that reason, I see better places for your hard-earned investment dollars to go.

Analyst’s 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.

Comments

[coastalcruiser]

What's your opinion on it now that has fallen further and is raising their dividend. .05?

[pj-03020812]

First time I see an article giving negative outlook. Thanks for being honest.
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