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Northwestern Corporation: Great Business Fundamentals

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.

New Jersey Resources: Next Year Is Key For Its Future

Summary The company is in a prime location, located near ample natural gas reserves. The company has not had a rate case filing in several years, leaving net income stagnant. Bottom line growth has instead come from the Energy Services business, which is non-regulated and prone to swings in profitability. New Jersey Resources (NYSE: NJR ) is a relatively under-followed energy holding company. The company’s primary business is regulated natural gas distribution to roughly 500,000 customers in New Jersey, but the company also has started to grow its pipeline and storage businesses and has built a small clean energy generation portfolio. Shares have rallied firmly the past year as the company has garnered some more exposure, but the company is still woefully under covered by analysts and retail investor ownership remains low. Is there an opportunity present to snap up shares before visibility inevitably improves? Location, Location, Location Low natural gas prices highly benefit New Jersey Resources. New Jersey is positioned right next door to the Marcellus/Utica shale, which has dramatically increased the natural gas reserve base available to all gas utilities in the Northeast, including New Jersey Resources. By extension, this means cheap natural gas prices for New Jersey Resources customers. Happy customers make for happy utilities as cheap prices for consumers reinforces support for the public utility commission to back any infrastructure investments the company wants to make. At the same time, the company’s other businesses (midstream/storage) are set to benefit as healthy demand growth increases demand for additional pipeline build out and storage availability. From a customer growth perspective, several locations in New Jersey are commutable to and from New York City or Philadelphia. As much as state residents seem to despise the state, proximity to some of the country’s top metropolitan areas will keep residents around, if begrudgingly. The state has maintained steady population growth over the past five years, in line with national averages. New Jersey Resources has done better than that, as the company operates in only three counties in New Jersey: Monmouth, Ocean, and Morris. (click to enlarge) * NJR Investor Presentation, Service Territory Breakdown New Jersey Resources appears to have its regulated downstream utility operations in ideal New Jersey locations. Ocean County has continued to be the population growth leader in New Jersey, posting healthy increases yearly. The company also has the opportunity to likely easily add roughly 50,000 existing New Jersey residents over the next few years, converting those that are still using propane/electricity for heating while being within or very near New Jersey Resources lines. Operating Results Revenue has largely been flat over the past five years due to falling natural gas prices. Like most natural gas utilities, the cost of natural gas is passed on to consumers through agreements with the public utility commission. High natural gas prices mean higher revenues but lower margins as the utility’s profit share per cubic foot sold is fixed. Compounding problems, New Jersey Resources has not had a base rate case filing in years. Base rate cases adjust the base rate charged to customers and are necessary when the utility has faced rising costs. Thankfully, this will change within the next few months, with the pre-hearing beginning in November. By early second half of next year, we should have a decision that should yield revenue increases for the company. Operational costs for New Jersey Resources have expanded since 2007 (the time of the last case) so the company should have an extremely straightforward filing. Operational cash flow has improved considerably in the past two years as New Jersey Resources recovered from some one-time charges that took place in 2012/2013. Operational cash flow expansion has primarily come from solid results from the Energy Services operating segment, which saw net income more than double. Energy Services takes advantage of pricing differences between regions or time periods, selling excess natural gas inventory when prices are high and building additional stock when prices are low, either through direct sales or through entering derivative contracts. In general, the more volatile natural gas prices are, the more profitable this division becomes. Poor performance in this division could cause future earnings volatility. I would prefer to see net income growth from regulated utility operations, which has only grown 1.3% since 2012. Unfortunately, we won’t see this until we see the results of the rate base case expansion. Debt has remained very low, with net debt of only $814M at the end of Q2 2015. Investors must keep in mind that New Jersey Resources does not generate much in the way of EBITDA currently ($200M in 2014) so leverage still exists even given the relatively low size of debt for a utility. Conclusion The upcoming rate case will be key to the company’s long-term success. Long term, the company will need the cash flow support from that base case. Shares trade expensively for a utility (12.79x EV/EBITDA, 18.5x 2016 EPS estimates) and a bulk of the earnings growth of the past few years has relied on a non-regulated Energy Services business that could prove volatile. Investors should be cautious and watch the rate case proceedings carefully.

Piedmont Natural Gas: Steady, Reliable Income

Summary Dividend history is incredibly stable – 3 or 4% annual raises for more than a decade. Market area (Carolinas and Tennessee) is one of the bright spots in the United States. Shares won’t double overnight, but they don’t have to in order to reward shareholders well. Piedmont Natural Gas (NYSE: PNY ) is a large, pure-play natural gas distribution company with a wide berth of operations across the Southeastern United States. The utility has been growing steadily, with earnings and the dividend tracking along at nearly 5%/year for the past twenty years. Consistency has been the name of the game here. This measured growth has been attributable to the favorable rate environment along with population growth strength in the Southeast coupled with the buildout of pipelines surrounding the Marcellus/Utica shale formations in the Northeast. Natural gas development and production in the United States has been and continues to be incredibly strong, yielding abundant supply and relatively stable pricing for gas utilities like Piedmont Natural Gas, especially over the past five years. This strong, consistent operating performance has yielded shares that have been less volatile and consistently outperformed the broader utility index. Will the future be as strong as the past? Operating Results Revenue is down, as has been the case for many natural gas utilities. This is because utilities dealing with lower natural gas prices have to pass the vast majority of the associated cost benefits passed along to consumers in the form of lower utility bills. Excess consumer demand from cheap energy rarely offsets the associated drop in revenue. Further compounding top-ine issues, weather has been at best normal and at worst seasonally warm in the company’s service areas. Decoupling agreements with the utility commission and strong local population growth have done their best in managing to keep growth flat. The company’s small but highly profitable non-regulated businesses have also done well, helping to improve overall operating margins over the 2011-2015 timeframe. (click to enlarge) Piedmont continues to invest significantly in its pipeline infrastructure through capital expenditures. This has continued to result in cash flow deficits, most obviously in 2013/2014. The company notes that it is pushing for new regulatory mechanisms such as IMR tariffs and accelerated rate requests to allow quicker recovery of its cash outlays. The majority of these initiatives went into place in 2013 and the company has made significant strides in getting back to cash flow neutral between its operating and investing activities. Unfortunately the shortfalls in 2013 and 2014 almost doubled long-term debt from $675M in 2012 to nearly $1.4B today. At 3.3x net debt/EBITDA, however, the company is only moderately leveraged and will have no problem covering interest expense on this cheap fixed-rate debt (blended rate is 3.85% fixed rate). While negative consistent overspending in the cash flow statement is generally a sign of mismanagement, in this case it was simply the case of a company investing in its non-utility power generation service delivery projects. Going forward, I expect cash flow shortfalls to be small and investors need not be concerned yet. Conclusion I view Piedmont Energy as an excellent choice in its peer group compared to overvalued alternatives like Atmos Energy (NYSE: ATO ) ( analyzed here ) or lower yielding options like Southwest Gas (NYSE: SWX ) ( analyzed here ). Dividend growth has been incredibly consistent, plugging along at either 3 or 4% increases every year for more than a decade. At a 3.22% yield as of today, the income being thrown off isn’t anything to sneeze at either. Investors might find themselves falling asleep if they hold the stock in their portfolios. For income investors, that is quite often a good thing rather than a bad thing. While I wouldn’t go running to pick up shares at current levels, current shareholders are likely quite happy with the results they’ve been getting and will likely continue to get. I’m not going to disagree with that sentiment. If you’re long, keep on holding and enjoy what is likely to be one of the most stable companies investors have access to in publicly-traded markets. Share this article with a colleague