NorthWestern Corporation: Little Utility On The Prairie (NASDAQ: NWE)
I make most of my investments in individual stocks within the limits of my retirement ambitions in a Roth IRA, but on very rare occasions I consider an individual stock a reasonable investment for another reason. Finished My working life I have funds set aside for my children’s future needs, and these are mostly held in the form of US government CDs and I-bonds, with a small allowance held in a brokerage account . In these brokerage accounts, the funds are actually mostly cash, but some have been invested in index funds tracking the S&P 500 (TO SPY) and Nasdaq (QQQ). However, over the past few months, I’ve decided I’m comfortable putting a small portion of their funds into a stock I’ve already purchased for my Roth IRA, the NorthWestern Corporation utility (NASDAQ: NWE). For my children’s purposes, I seek relative safety with some dividends to sweeten the pot, as my time horizon for needing the funds to be recovered is getting shorter and shorter.
This company supplies natural gas and electricity to the north-central plains states of Montana, South Dakota and part of Nebraska, with the majority of its 750,000 customers located in Montana, including including Yellowstone National Park. It has about 750 MW of Peak capacity, which is not enough to meet about half of the market demand, so he buys all that is needed from other sources. NorthWestern’s power generation portfolio includes hydro, wind, coal and natural gas; it has negligible solar. Between the energy assets it owns and its contracted supply, the company can say that around 55% of the electricity it sells comes from non-carbon sources.
Like utilities across the United States, it attempts to walk a tightrope between meeting the energy needs of the areas it serves, investing in the transition to more renewable sources in a timely manner, while maintaining affordable energy prices. The company recently announced its goal of net zero carbon emissions by 2050.
As the chart shows, 28% of the portfolio is coal, and it’s worth noting that NorthWestern is in the middle of arbitration related to a coal-fired power plant in Colstrip, Montana. This facility has a total of 4 units – two older units that are to be closed and two newer units that remain operational. Northwestern has a partial stake in those assets, and some of the other owners are pulling out, and the question comes down to whether NorthWestern can increase its stake.
Along with the potential to access more capacity from these coal-based assets, NorthWestern is in the midst of a five-year, $2.4 billion plan to increase capacity with a combination of new projects and strengthen additional capacity at existing sites, with one project scheduled to break ground this month despite delays to some premises opposition and his own mistakes by following the correct authorization process. The $2.4 billion needed for miscellaneous investments comes from multiple sources – internal liquidity, new debt issuance and additional equity, including $321 million of new equity issued in November 2021. Still, the transition will be costly to make and Fitch ratings downgraded NorthWestern from BBB+ to BBB a few weeks ago, while maintaining a stable outlook. Specifically, Fitch noted,
The downgrade reflects lower-than-expected debt metrics due to a significant regulatory lag during a period of strong capital spending. Fitch expects FFO leverage metrics to be around 6.0x through 2024 before strengthening to around 5.3x in 2025-26 as capital spending declines and major projects come into service.
Review of 2021 results and 2022 estimates
Management shared full-year 2021 results in mid-February, with revenue growth of 15% over 2020, or $1.37 billion in revenue, a combination of higher prices and a stronger demand, bearing in mind that 2020 comparisons on the demand side were affected by Covid-19. Nonetheless, it was a solid year, with gross margin at 27.5%, flat but helping to boost earnings per share from $3.06 in 2020 to $3.60 in 2021.
Inflation is definitely influencing strategic business decisions, and not just around natural gas prices or contracting for additional capacity from other sources. Most notably, NorthWestern withdrew from a planned investment in Aberdeen, South Dakota, due to the significant increase in costs, a figure estimated to be 50% higher than originally planned as described by Brian Bird in the third quarter 2021 earnings call.
The broader point is that 2022 is not expected to deliver the same or better EPS than 2021, but rather the suggested forecast is between $3.20 and $3.40. Bearing in mind that the drop in earnings per share is the result of a combination of a higher number of shares and some margin compression, it still leaves NorthWestern with a forward P/E of around 18x for 2022. For comparison, Seeking Alpha has the industry median at just over 20x, so even though the stock price has been flat since the release of the lower EPS guidance for 2022 in February, NorthWestern remains slightly discounted compared to the sector.
As a guideline, management is aiming for fairly conservative EPS earnings growth in the range of 3% to 6% per year relative to the 2020 baseline. The current dividend of $2.52 represents about 75% of earnings, and while the dividend has grown fairly reliably, I expect dividend growth to be slower than earnings growth.
NorthWestern Value and Revenue Profile
Prior to settling on NorthWestern, I was of the view that utilities were all going to have more or less the same strengths and weaknesses, such as fairly safe bond-like stocks with a relatively high degree of safety and good credit ratings credit, low or limited growth prospects and reasonably competitive returns. Other than those outliers like PG&E (PCG) beleaguered in California, I assumed there was little difference between one utility and another, so I was surprised when I started looking at the kind of diversity I found; for example, I was stunned to find in PPL Corporation (PPL) an American utility that also supplied power to parts of the UK (it has since sold the UK assets and got out this company).
I started by looking at my local gas and electric provider, and thought it generally ticked all the boxes – a 3.7% return, a BBB rating from Fitch, and nothing to suggest that it would generate tremendous growth. Since I didn’t want to invest without doing at least a modicum of due diligence, I started looking at other utilities for comparisons, and that’s when I started to realize that the landscape of utilities was much more diverse than I had imagined, and at the time I made the final decision on one, NorthWestern was where I landed.
If I started again today, I would look at the same general settings:
- Debt versus equity for a sense of credit risk, knowing that utilities may need to take on large debt loads to fund capital expenditures, especially in a time of transition away from fossil fuels.
- Valuing EV to EBITDA, simply as a way to see how well a utility is using its non-cash assets to generate profit, and finally
- Dividend yield, more or less like a sort of tie-breaker; If all else were equal, I’d go for higher yield over lower yield, knowing that even utility dividends aren’t sacrosanct.
What these screens help me do, in theory, is try to maximize revenue with acceptable risk while hoping not to pay too much. There are far too many utilities for me as an individual to stay on top of, but based on these criteria, NorthWestern continues to look like a winner. It is attractively priced, has lower credit risk ratings and offers a slightly higher dividend yield. While there can certainly be peers that compare more favorably, overall NorthWestern performs well on these measures.
On those strengths, I would still choose NorthWestern, at least among those picks. Still, knowing that the company intends to take on additional debt as part of its $2.4 billion investment equation, I’m eager to see where debt coverage has been in the past. and what impact additional debt would have.
So while the debt-to-equity ratio has decreased as equity has increased, long-term debt has also increased, some $250 million year-over-year through 2021, and debt additional debt that has not yet been issued could certainly increase debt coverage. back the other way. This might not have been too much of a concern in an ultra-low rate environment, but assuming rates continue to rise through 2022 and combined with somewhat lower credit quality, the question of the burden of debt could become much more relevant and will be something to keep an eye on. However, given that the $2.4 billion in investment plans are to be spread over 5 years, the net impact on its debt servicing capacity might not be so significant.
During times of severe market turbulence, utility stocks have a reputation for being defensive holdings, a reputation that is widely supported due to the fact that they are a necessity for consumers through all economic cycles. and that they provide reliable and predictable cash flows. Although this restraint is coming under increasing scrutiny, in the case of NorthWestern the risk is somewhat reduced compared to the much higher indebtedness of some other utilities. Even assuming that debt will most likely increase in coming years, NorthWestern will not rely exclusively on the bond market to fund its growth needs. I think the biggest risk is that NorthWestern has underestimated the amount of investment needed to achieve its goals, especially at this time of rather sky-high inflation. Management has already demonstrated that it is willing to walk away from projects that become too expensive, but if each project starts to significantly overrun costs, then something will have to give. However, at the moment, given the combination of an attractive valuation, good debt coverage and a reasonably covered dividend that pays better than several peers, I like NorthWestern as part of a selection conservative defensive in an income-oriented portfolio.