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Summary Electric and natural gas utility NorthWestern reported Q2 earnings that beat slightly on adjusted EPS, despite missing big on revenue. The company has expanded its renewable energy capacity in recent years to take advantage of its service area’s abundant hydro and wind resources. The company’s share price has also declined YTD even as its acquisitions have supported its earnings. While NorthWestern’s shares appear to be undervalued, there is a substantial risk that a strong El Nino will reduce hydro output and natural gas demand in its service area. I recommend that potential investors wait for adverse weather impact to provide a more attractive buying opportunity before initiating a long investment in NorthWestern. Northern Plains electric and natural gas utility NorthWestern Corp. (NYSE: NWE ) reported Q2 earnings in late July that beat slightly on EPS despite missing substantially on revenue. The company’s share price has largely declined in 2015 to date after racking up six straight years of steady gains (see figure). Interestingly, the company’s earnings haven’t slowed even as its share price has, suggesting that bearish investment sentiment resulting from a looming interest rate hike by the Federal Reserve is the cause of the latter’s poor performance. NorthWestern has been investing heavily in renewable energy in recent years, acquiring hydro and wind capacity in Montana and South Dakota, respectively. These acquisitions have coincided with falling energy prices and the prospect of weather-related disruptions to supply, however. This article evaluates NorthWestern as a potential long investment in light of these broader macroeconomic and weather conditions. NWE data by YCharts NorthWestern at a glance Headquartered in Sioux Falls, South Dakota, NorthWestern operates electric and natural gas segments that serve utility customers in Nebraska, South Dakota, and Montana. Its electric segment utilizes a mixed portfolio of coal, natural gas, hydro, and now wind to generate electricity that it transmits and distributes to 416,000 customers in all three states. The electric segment has been expanding its renewable generation capacity of late, purchasing 633 MW of hydroelectric capacity in Montana in late 2013 and agreeing to purchase 80 MW of wind power in South Dakota last July. The recent wind purchase, which is expected to close in Q3 with a price tag of $143 million, also includes the rights to a co-located 50 MW expansion site. These acquisitions will allow NorthWestern to easily meet the renewable portfolio standards in Montana and South Dakota, the latter of which is non-binding. Roughly half of the company’s total generation capacity is either renewable or in support of renewable capacity. The company’s natural gas segment transmits and distributes natural gas to 276,000 customers across its service areas. The segment is unique in that it also produces much of the natural gas that it distributes to its customers. It produces enough natural gas to meet 25% of its needs in Montana, for example, and is investigating potential acquisitions in the current low-price energy environment that will allow it to increase this share to 50%. Q2 earnings report NorthWestern reported Q2 revenue of $270.6 million, up 0.1% YoY and missing the analyst consensus estimate by a substantial $45.8 million (see table). The company attributed its low numbers to the presence of warm weather during the cold part of the quarter, which reduced its natural gas retail volumes by 14% compared to the previous year despite an increase to its customer numbers over the same period. Higher temps were prevalent across its service area, with the company reporting 16% fewer heating degree-days in total. These factors ultimately caused the natural gas segment’s revenue to decline by 15% compared to the previous year. The electric segment offset some of this decline, reporting a 7.5% YoY increase to its own revenue on higher retail rates and customer numbers. NorthWestern Corp. financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 270.6 346.0 312.9 251.9 270.3 Gross income ($MM) 191.0 233.6 204.9 157.3 157.8 Net income ($MM) 31.0 51.4 37.2 30.2 7.8 Diluted EPS ($) 0.65 1.09 0.85 0.77 0.20 EBITDA ($MM) 97.9 119.7 88.7 61.0 55.5 Source: Morningstar (2015). The company’s gross income came in at $191 million, up from $158 million YoY, as its cost of revenue declined by more than revenue on lower energy prices (see figure). The natural gas segment reported a 9.4% YoY decline to gross income, as the presence of reduced demand and its reliance on own production to meet much of this demand limited the decline to cost of revenue. This was more than offset by the electric segment, however, which reported a 31% YoY increase to its own gross income. Much of this increase was the result of generation from its Montana-based hydroelectric capacity showing up on its income statement; the segment’s gross income remained flat if this income source was excluded. The segment’s gross margin (gross income/operating revenues) did increase from 58% to 71% over the same period, however. Henry Hub Natural Gas Spot Price data by YCharts NorthWestern’s net income rose to $31 million from $7.7 million in Q2 2014, resulting in a diluted EPS of $0.65 versus $0.20. Much of the increase was the result of an insurance settlement payout, without which the company’s net income was $23 million on an adjusted basis versus $9.8 million YoY. Adjusted diluted EPS came in at $0.48, up from $0.25 over the same period and slightly beating the consensus estimate of $0.45. The company increased its quarterly dividend by 20% to $0.48 on the strength of its performance (resulting in a 3.8% forward yield), which also saw its free cash flow increase to $26.3 million from -$48.0 million YoY. Finally, management also took advantage of a favorable interest rate environment to refinance $150 million of debt due in 2016 with $200 million of 10- and 30-year mortgages at a substantially lower rate. Outlook NorthWestern’s decision to add wind capacity should prove to be a smart investment moving forward. The North Plains is one of the windiest places in the U.S. on a sustained basis (see figure) and has been home to much of the nation’s rapid wind farm growth over the last decade as a result despite its plentiful access to cheap natural gas and small population. The company’s service area overlaps with abundant wind resources and I wouldn’t be surprised to see it take advantage of the additional 50 MW capacity option in the event that Congress extends wind’s Production Tax Credit. Wind energy has been one of the few resources to prove competitive with fossil fuels in recent years and NorthWestern has additional backup natural gas capacity available to support such an expansion. In the shorter term, it remains to be seen how accretive the acquired capacity will be to the company’s earnings, as this will ultimately depend on South Dakota’s rate case decision that is due by the end of 2015. Source: EIA (2012). The company is also pursuing $100 million of additional natural gas investment so that it can supply 50% of the natural gas that its customers in Montana consume. It expects to incur roughly $1.5 billion in additional capex through the end of 2019 that will support future rate increases. The majority of these expenditures will be spent on infrastructure maintenance and upgrades. One area that investors should keep an eye on is the state of the economy in the company’s service area. The large fall to the price of energy that has occurred across the board since the second half of 2014 has negatively impacted the Northern Plains’ economy in the form of higher unemployment rates (see figure), which has benefited in recent years from the exploitation of unconventional fossil reserves. While NorthWestern’s customer numbers have yet to reflect this recent weakness by declining, multiple quarters of low energy prices could ultimately cause these numbers to plateau or even fall, offsetting some or all of the positive impact of rate increases on the company’s earnings. Montana Unemployment Rate data by YCharts Weather factors present the largest headwinds to NorthWestern’s earnings over the next few quarters, however. The West Coast drought that has been capturing headlines over the last year has also been appearing as far east as Montana. As of this month the western half of the state is classified as either “Moderately Dry” or “Severely Dry”, while much of the eastern half of the state is classified as “Slightly Dry.” Management stated during the Q2 earnings call that the drought conditions weren’t affecting its hydro operations in the state yet due to the fact that its capacity is widely distributed across the state. The drought conditions are of concern, however, because they are likely to grow worse over the next two quarters. NOAA recently announced that an especially strong El Nino is developing and, given its magnitude, it is now expected to last through the spring. Past El Nino events have resulted in reduced precipitation in Montana, as the winter storm track has been pushed into the south half of the U.S., with levels falling to an average of 75-80% between November and March of those experienced in normal years (see figure). Reduced river levels resulting from lower snowpack development can cause hydro generation to fall sharply, much as is already occurring in California. This, in turn, leads to higher average variable power costs that limit EPS, especially if not offset by higher rates. Source: NOAA . Compounding the potential impact of El Nino on Montana’s hydro generation this winter and spring is its impact on winter temperatures in NorthWestern’s service area. Past El Ninos have resulted in higher-than-normal temperatures in Montana, South Dakota, and north Nebraska, reducing the number of heating degree-days experienced during the winter and early spring. Montana has historically experienced the warmest temperature increases during El Nino events, especially in Q1. The impact of El Nino on NorthWestern’s earnings could be significant, as Q4 and Q1 have historically been when the company has earned the large majority of its annual earnings (see figure). Weak winter and spring demand for natural gas resulting from a historically strong El Nino would likely cause the company’s earnings to fall on a YoY basis, especially if it coincides with higher average variable power costs resulting from reduced hydro generation. NWE EPS Diluted (Quarterly) data by YCharts Valuation The consensus analyst estimates for NorthWestern’s earnings have remained relatively flat over the last 90 days. The consensus an analyst estimate for diluted EPS in FY 2015 has fallen slightly from $3.17 to $3.16 while the estimate for FY 2016 has increased slightly from $3.38 to $3.41. Based on a share price at the time of writing of $50.80, the company’s shares are trading at a trailing P/E ratio of 19.2x on an adjusted basis and forward ratios of 16.1x and 14.5x, respectively. The forward ratios have fallen significantly since peaking at the beginning of the year and are approaching multi-year lows (see figure). Even accounting for bearish sentiment on utilities resulting from a likely interest rate hike by the Federal Reserve before the end of the year, NorthWestern’s shares appear to be undervalued at present on the basis of the consensus analyst earnings estimates. That said, the estimates for FY 2016 in particular have not fallen over the last 90 days even as meteorologists have increased the expected strength and duration of the El Nino event in Q4 2015 and Q1 2016. NWE PE Ratio (TTM) data by YCharts Conclusion NorthWestern Corp. reported Q2 earnings that beat slightly on EPS despite missing big on revenue. The news briefly interrupted a steady decline to the company’s share price, although it has since re-approached its YTD low. Meanwhile, the company’s earnings have marched steadily higher, as it has invested in new capacity while also benefiting from reduced energy costs, resulting in share valuations that are approaching multi-year lows. While it is tempting to recommend the company as a long investment on those grounds alone, potential investors should be aware that meteorologists expect this year’s El Nino to be historically strong through spring. Historically, weather conditions in the company’s service area have been both warmer- and drier-than-normal during past El Nino events, indicating that there is a strong likelihood that both hydro output and natural gas demand will be reduced during the important Q4 2015 and Q1 2016 earnings periods. I encourage potential investors to wait for potentially disappointing earnings in the coming quarters resulting from adverse weather conditions to provide a better buying opportunity. Scalper1 News
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