NorthWestern: Mid-Pandemic Update On This 4.8%-Yielding Utility

Summary

• NWE is an electric and gas utility serving an area of the Rocky Mountain region/middle America that enjoys above-average population growth.
• The company maintains a strong, investment-grade balance sheet with no near-term debt maturities and ample liquidity.
• COVID-19 certainly had a negative impact on the utility, with both revenue and earnings taking a big hit in the first half of the year.
• In the second half of the year, however, the utility's performance should rebound strongly, which is not being priced into the stock.
• NWE's 4.8% yield plus its expected growth rate of 4-5% results in an attractive dividend growth investment opportunity.
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Investment Thesis

NorthWestern Corporation (NASDAQ:NWE) is a publicly listed, regulated utility operating in Montana, South Dakota, and Nebraska. The stock has been beaten down this year, shedding 30% off its price from investor reaction to the damage done by COVID-19. But how much has the coronavirus pandemic (and the associated business curtailments) negatively affected NWE?

I would argue that, despite substantial damage done by COVID, the stock price does not come close to pricing in the utility company's likely recovery in the months and years ahead. At 15x expected 2020 earnings and a 4.8% dividend yield, NWE looks attractive for long-term dividend growth investors.

Image Source

Mid-Pandemic Business Update

I first gave my pitch for NWE as a dividend growth investment in an April 27th article here on Seeking Alpha. In that piece, I listed these points as NWE's strengths:

"...a strong, investment-grade balance sheet; a long history of stable earnings growth; below-average customer power prices; a growing portfolio of carbon-free assets; ample liquidity of $286.4 million (including $56.4 million in cash); and a growing, consistently covered dividend."

Each of these points remains true today. Since April, the liquidity situation has improved, although the percentage of that in cash has fallen. Total liquidity stood at $368.5 million at the end of June, while the company held $7.5 million in cash.

So far in the first half of 2020, revenue from NWE's electricity segment is down 6.1% year-over-year, while revenue from the gas segment is down 12.4%. Meanwhile, net income and earnings per share are both down an astounding 40%. The good news is that COVID-19-related business restrictions continue to ease in NWE's service area, giving hope that the second half of the year will be much better than the first.

The primary risk COVID-19 continues to pose is delays — in regulatory proceedings as well as in the development of capital projects. These delays could have financial impacts on the business.

One advantage NWE's power production portfolio has is its large reliance on green energy. Around 58% of the portfolio is already derived from renewables such as hydro, wind, and solar. Moreover, by the early 2030s, the utility will have retired several of its coal-fired plants, thus further reducing its reliance on "dirtier" energy sources.

Source: NYSE Virtual Investor Conference

NWE is committed to at least 90% carbon-free power production in its primary state of Montana by 2045. Its operations in the state were already 65% carbon-free in 2019.

One thing to notice is that NWE derives a large portion of its total electricity generation from long-term contracts rather than its own power production assets. In other words, instead of getting all or most of its power from assets like a wind farm or natural gas-fired plant, it gets about 30% of its power from other owners of electricity generation assets.

Given the sparse population of the states in which NWE operates, as well as the some of the large shared power plants, this isn't terribly surprising. But it also opens NWE up to potential price volatility or mismatches between power demand and power capacity.

The utility's gross margin is roughly 80% electric and 20% natural gas. It provides electricity in Montana and South Dakota as well as natural gas in these two states plus Nebraska.

85.6% of electric customers are in Montana, while the remaining 14.4% are located in South Dakota. Meanwhile, 69.1% of natural gas customers are in Montana, while 16.3% are in South Dakota and 14.6% are in Nebraska.

Each of these states is projected to enjoy faster population growth than the national average over the next five years.

Source: NYSE Virtual Investor Conference

Moreover, since 2008, NWE's service area has consistently experienced faster customer growth than the national average, for both electricity and natural gas.

Source: NYSE Virtual Investor Conference

With good financial and asset management, a utility can almost always turn above-average customer growth into above-average earnings growth.

From 2013 to 2019, non-GAAP EPS growth averaged 5.4% per year. The dividend has risen slightly faster than that in the last ten years, which has led to a steadily, if slightly, rising payout ratio from 2016 to 2019. In 2020, largely because of the pandemic and business restrictions, the payout ratio is set to edge up to 71.2% — just above the high end of NWE's target range of 60-70%. In the first half of the year, the payout ratio has been elevated at 83.9%.

Source: NYSE Virtual Investor Conference

Then again, when taking a long view of EPS and the dividend, it doesn't appear that NWE is performing any worse than its established quarterly pattern:

Data by YCharts

Compare the above EPS chart to NWE's most recently updated non-GAAP EPS guidance range of $3.30 to $3.45. In other words, management expects earnings to come in between the range of what it earned in 2017 and slightly (3 cents) more than what it earned last year. For 2021, the analyst consensus is for EPS of $3.61, a 7.1% jump from the midpoint of 2020's guidance.

Put differently, analysts expect a strong rebound for NWE coming out of the pandemic.

One potential reason for this is the marginal trend of people leaving first-tier coastal cities to move to second- and third-tier middle-American cities. With small populations, it wouldn't take many people choosing to move to Montana, South Dakota, or Nebraska (perhaps returning to where they grew up) for it to have an upsized effect on these states' population growth rates.

One attractive draw for out-of-staters: cheap utility bills. NWE's customer bills for both electric and gas are consistently lower than the national average.

Source: NYSE Virtual Investor Conference

As older (largely coal) power plants are retired and replaced with state-of-the-art natural gas plants and lower-upkeep renewable power assets, NWE should be able to continue its trend of lower-than-average customer bills.

The company has also been able to keep up a substantial capital investment program while deleveraging in recent years. Of course, "deleveraging" here doesn't refer to paying down debt, but rather to lowering its debt-to-capital ratio — from over 55% in 2015 to ~51% in 2019.

Source: NYSE Virtual Investor Conference

Also notice that NWE has no debt maturing until 2023, and most of its debt doesn't mature for another 20 years. The company's credit rating for senior unsecured notes of A- from Fitch and BBB from S&P signify a strong balance sheet. Interest coverage, though it's taken a dip this year, is holding up at about the same level as it was ten years ago.

Data by YCharts

The long-term trend of operating cash flow has been upward, although it does tend to dip and jump from year to year.

Source: NYSE Virtual Investor Conference

Though operating cash flow has not been high enough to cover maintenance capex and the dividend since 2015 (despite being practically break-even in 2018), it has been enough to cover maintenance capex every year of the past decade.

What's more, given that NWE projects capital investment to slow over the next five years, it seems plausible that operating cash flow could once again cover both within a few years.

Source: NYSE Virtual Investor Conference

For utilities, though, it is normal to see negative free cash flow. This is a capital-intensive industry that enjoys a unique, legal monopoly over its service area. As such, it is constantly able to raise equity and debt capital for growth purposes, although it is nice to see cash flows cover maintenance capex and the dividend.

Of course, there remains the risk of higher-than-projected equity issuance if more investments are needed or in the case of negative regulatory decisions. If one of these scenarios manifests, then positive free cash flow is unlikely anytime in the near future.

Conclusion

NWE has had a bad first half of 2020. There's no doubt about that. Not only did the pandemic take a significant bite out of previously expected earnings, it also caused an earnings miss in Q2 based on post-outbreak analyst consensus estimates. What's more, the utility's heavy reliance on contracted power production, rather than its own owned portfolio of generation assets, could potentially put the company is bad situations in which rolling contracts over becomes expensive. Fortunately, that has not been NWE's experience in recent years.

On the other hand, NWE looks well-positioned in growing states that are less likely than many other states to enforce strict lockdowns and business restrictions again. As such, these areas should experience a faster-than-average economic recovery coming out of the pandemic. Faster economic recovery means more businesses opening and expanding, more houses being built, and more new residents being attracted to the area. This, of course, would be very positive for NWE.

At 1.2x book value and 15x 2020 earnings, NWE's stock looks cheap.

Data by YCharts

At a starting dividend yield of 4.8%, NWE would only need to raise its dividend by 4% per year to arrive at a yield-on-cost of 7.1% after ten years. That is slightly above my minimum projected 10-year YoC threshold of 7% for conservative dividend growth companies. A 4% average annual raise would be lower than the previous decade's ~5.5% average annual raise.

Even assuming slower EPS growth over the next decade — 5% per year on average, versus the 6.5% average annual pace of the last ten years — a dividend growth rate of at least 4% looks very achievable.

As such, NWE strikes me as an attractive dividend growth investment.

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Disclosure: I am/we are long NWE. 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.