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Summary Montana has a healthy, stable population that pays its utility bills. Hydroelectric generation acquisition changed the company for the better. The acquisition did increase leverage. Debt is manageable, but free cash flow should go to paying down debt. NorthWestern Corporation (NYSE: NWE ) is an electricity and natural gas provider that serves the energy needs of hundreds of thousands of customers in Montana, South Dakota, and Nebraska. Unlike many utilities that have diversified into non-regulated activities, NorthWestern remains a pure-play regulated utility. Management has been wise, making strong moves to diversify away from coal-fired generation in a bid to lower regulatory risk. In turn, investors have rewarded this move, with shares returning roughly double the return of the broader utility index since the September 2013 announcement of the purchase. Will this long-term outperformance continue? Renewable Energy Diversification Those that have followed my work know that I have been especially critical of utilities that have not begun to meaningfully diversify away from coal, shifting power generation into cleaner plays such as natural gas and hydroelectric generation. Coal will continue to play an important, but shrinking, role for most utilities in providing stable energy generation for some time. We all know that sometimes the wind doesn’t blow or the water doesn’t run. But its days of dominance are numbered and utilities must position themselves for a future where coal is not the primary source of power generation, primarily due to continued pressure from environmental regulation. From what I’ve found, utilities in the Midwest have been especially guilty of ignoring renewables. NorthWestern Corporation, operating right next door to many of these slow-to-adapt utilities, has not been ignoring industry trends. The $900M acquisition of eleven hydroelectric facilities from PPL Montana was a game-changer for the company, shifting more than 50% of available base-load generation to renewable water and wind. Hydroelectric is a great source of power for utilities to meet light-load requirements on most operational days. There is no fuel cost to worry about, which reduces operational headaches, and the assets are obviously quite clean when it comes to greenhouse gas production and waste. Best of all, NorthWestern got these facilities for a steal of a price. Montana In Focus The vast majority of NorthWestern’s earnings comes from its Montana operations. When you think of Montana, you probably think of something like this: ‘ * Wildnatureimages.com This honestly isn’t too far from the case. Montana is a vast state, with low population density and a high concentration of people over the age of 65. However, this doesn’t make it a poor market for a utility. The unemployment rate has remained under the U.S. national average for many years (currently at an incredibly low 4.0%), and population growth remains stable. * NorthWestern Energy Investor Presentation Along with this, bad debt write-offs for NorthWestern are incredibly low, even during the recession where you would expect a jump in defaults. With more than 80% of Montana revenue coming from residential customers, low unemployment and bad debt write-offs creates a situation of high stability and predictability when it comes to company earnings. For utility owners, this should be far more important than chasing growth potential. Steady as she goes is the name of the game. Operating Results (click to enlarge) Electric operations revenue growth has accelerated, especially for full-year 2015, due to approval of increased rates related to the hydroelectric acquisitions that have come into effect. Gas operations revenue has fallen, but like with all natural gas utilities, this is a function of the underlying commodity price rather than a lack of demand. As natural gas prices have fallen, the cost of gas passed along to consumers as part of rider agreements falls as well, resulting in lower revenue. Investors should remember, however, that NorthWestern’s fixed margin per unit of gas sold remains the same. Lower gas prices mean higher gross and operating margins for the natural gas division, which we can see coming down in 2015’s estimated full-year results. (click to enlarge) As I usually do with utilities, I look to see that operational cash flow can cover capital expenditure requirements and dividend payments. If not, the utility is likely stuck in a cycle of taking on debt to cover its obligations. For NorthWestern, total cash flow from operations will grow greatly in 2015, eliminating some of the slightly larger deficits we saw in 2013 and 2014, likely a result of larger capex requirements for its new hydroelectric facilities. Overall, leverage for NorthWestern has gone up as a result of its hydroelectric and wind acquisitions, which cost a touch over $1B. Total long-term debt now stands at $1.8B, putting its net debt/EBITDA ratio at around 4.5x, which is on the high side but manageable for the time being. Management here has been traditionally cautious – all of NorthWestern’s debt is non-callable, long-term fixed rate debt. The company does have $455M of debt coming due by 2019 ($150M 2016, $55M 2018, $250M 2019), which it will have to refinance. I’d expect this to price around 4.5% on mid-term extensions (coming due in 2030) which will actually reduce the company’s interest expense somewhat given the 6%+ coupons these issuances have carried. Conclusion Overall, NorthWestern is a well-run utility. Management seems to be taking all the right steps and the 3.75% annual dividend yield is solid. 12.5x ttm EV/EBITDA is on the high side, but the company likely carries a premium given the strong growth performance and future earnings profile. I wouldn’t be a buyer at current prices, but I’m keeping the shares on my watchlist. Scalper1 News
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