Investment Review: Northwest Natural

Over the last few years, Northwest Natural’s (NYSE:NWN) share price has neither been kind to shareholders nor SA authors taking a bullish stance. The share price has been bouncing along the bottom in the mid to low $40s for quite a while now. Nevertheless, I am bullish about the enduring nature of the company and the current share price. There is room for the share price to increase from current depressed levels. But most of all, I am bullish about the dividend yield, a dividend yield in excess of 4% and paid by a Dividend King with over 60 years of annual dividend increases. Expect consistent but tiny ongoing increases in the dividend. But in this low interest rate climate, a 4% yield from a Dividend King is a very useful way to deploy any spare cash. Seeking Alpha Premium now provides dividend grades. DGI investors interested in “buy and hold forever” stocks might find this comparison to Coca-Cola (NYSE:KO) of interest

What I am saying above is for an investor looking to park cash and earn a return, Northwest Natural appears to be a far better choice than one of the more popular Dividend Kings such as Coca Cola. For additional information on interpretation of dividend grades, please see here.

Please read on for my in-depth analysis of the past, present and potential future financial performance of Northwest Natural.

Looking for share market mispricing of stocks

What I’m primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the “E” in P/E is distorted by the impact of COVID-19. And, if the P/E ratio is suspect, so too then is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to end of 2022, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.

Table 1 Detailed Financial History And Projections

Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2022 for share prices, P/E ratios, EPS and DPS and EPS and DPS growth rates (note estimates are shown for analysts’ EPS estimates out to 2024 where available, but these are considered not as reliable). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7% per year through the end of 2022 (see line 12), based on buying at Nov. 3 closing share price level. The table shows to achieve the 7% return, the required average yearly share price growth rate from Nov. 6, 2020, through Dec. 31, 2022, is 3.24% (line 41). This growth rate is lower than the target 7% return due to estimated dividends receivable. Northwest Natural has a current dividend yield of 4.37% (line 37). Table 2 below summarizes relevant data flowing from the assumption of a target 7% total return.

Targeting a 7% Return

Table 2 – Targeting a 7% returnTable 2 provides comparative data for Northwest Natural, assuming share price grows at rates sufficient to provide total rate of return of 7%, from buying at closing share price on Nov. 6, 2020, and holding through end of 2022. All EPS estimates are based on analysts’ consensus estimates per SA Premium.

Comments on Table 2 are as follows:

Part 1 – Consensus EPS (Case 1.1) (lines 1 to 12)

Part 1 shows the amounts the share price would need to increase to achieve a 7% rate of return through end of 2022. From Part 1, it can be seen that adding projected EPS growth rate to a dividend yield can give an approximation of potential total return, subject to changes in P/E ratio and growth in the dividend yield on cost.

Part 2 – Required change in P/E ratio to achieve Target 7% return (lines 21 to 23)

Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to end of 2022, to achieve the share price level at the end of 2022 necessary to achieve the targeted 7% return. For Northwest Natural, the P/E ratio at buy date can decrease by 15.8% through end of 2022, and the 7% return will still be achieved. Being able to achieve a targeted return despite a reduction in the P/E ratio would normally be regarded as a positive. However, due to the distortions of earnings and sentiment, due to the COVID-19 pandemic, it’s difficult to judge whether the change in P/E ratio is a positive, or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre COVID-19 starting point.

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Part 3 – Projected change in P/E ratios from 2019 to 2022 (lines 31 to 46)

In Part 3, I start with the share price at Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The end point is projected share price at end of 2022, when it’s assumed the market and earnings are no longer materially impacted by the COVID-19 pandemic. For Northwest Natural, the share price could decrease by $26.87 from $73.73 at Dec. 31, 2019, to $46.86 at end of 2022, and, as detailed in Part 1, at $46.86, the targeted 7% rate of return would be achieved. For Northwest Natural, there are a number of givens in our assumptions. Using these givens, the change in the share price for Northwest Natural, from Dec. 31, 2019, to end of 2022, can be expressed as mathematical formulae as follows:

(A) Change in share price, due effect of EPS growth rate, equals share price at beginning multiplied by (1 plus average yearly EPS growth rate) to the power of number of years invested

= $73.73*(1+2.3%)^3 = $78.85

(B) Change in share price due change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio)

= $78.85*(1-40.6%) = $46.86

The increase of $5.12 ($78.85 minus $73.73) due to the average yearly EPS growth rate is cumulative, and share price will continue to increase; the longer the shares are held and the growth rate continues. The decrease of $31.99 due to a change in the P/E ratio ($78.85 minus $46.86) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.

Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.

Understanding The Dividend Growth Income+ Club Approach

Total Return, Dividends, Share Price

The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price – the only way. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.

Changes in Share Price

Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock specific.

“Equity Bucket”

Earnings are tipped into the “Equity Bucket” for the benefit of shareholders. It’s prudent to check whether distributions out of and other reductions in the “Equity Bucket” balance are benefiting shareholders.

Northwest Natural’s Projected Returns Based On Selected Historical P/E Ratios Through End Of 2022

Table 3 below provides additional scenarios projecting potential returns based on selected historical P/E ratios and analysts’ consensus, low and high EPS estimates per Seeking Alpha Premium through end of 2022.

Table 3 Summary of relevant projections Northwest Natural

Table 3 provides comparative data for buying at closing share price on Nov. 6, 2020, and holding through the end of 2022. There are a total of nine valuation scenarios, comprised of three EPS estimates (consensus, low and high) across three different P/E ratio estimates. Comments on contents of Table 3 follow.

Consensus, low and high EPS estimates

All EPS estimates are based on analysts’ consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low, to most likely, to high based on analysts’ assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as Northwest Natural. I believe the “low” estimates should be considered important. It’s prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.

Alternative P/E ratios utilized in scenarios

  1. The actual P/E ratios at share buy date based on actual non-GAAP EPS for Sept. 30, 2020, TTM.
  2. A modified average P/E ratio based on 16 quarter-end P/E ratios from Q4-2016 to Q3 2020 plus current P/E ratio in Q4-2020. Average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
  3. A median P/E ratio calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded.
  4. The actual P/E ratios at Feb. 21, 2020, share prices based on FY 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent, and after FY 2019 results had been released. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic.
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Reliability of EPS estimates (line 17)

Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are four analysts covering Northwest Natural through end of 2022. In my experience, a range of 1.4 percentage points difference in EPS growth estimates among analysts is an unusually small difference.

Projected Returns (lines 18 to 39)

Lines 25, 32 and 39 show, at a range of historical P/E ratio levels, Northwest Natural is conservatively indicated to return between 13.5% and 15.6% average per year through end of 2022. The 13.5% return is based on analysts’ low EPS estimates and the 15.6% on their high EPS estimates, with a 14.6% return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios. At the high end of the projected returns for Northwest Natural, the indicative returns range from 35.7% to 38.1%, with consensus 37.0%. The difference between best and worst cases is an indication of a degree of uncertainty in analysts’ estimates and the stability of historical P/E ratios. While the current P/E ratio is 21.24, the historical P/E ratios (lines 5 to 7) range from 20.89 to 31.28.

Review Of Historical Performance For Northwest Natural

Northwest Natural: Historical Shareholder Returns

In Table 4 below, I provide details of actual rates of return for Northwest Natural’s shareholders investing in the company over the last six years.

Table 4

Table 4 shows returns have been mostly negative for investors buying shares in Northwest Natural over the last six years. For five of the cases above, returns have been negative, ranging from negative (5.0)% to negative (38.5)%. The three remaining investor returns have been in the mid- to low-single digits, ranging from 1.1% to 5.2%. The rates of return in Table 4 are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to fourth quarter 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.

Checking Northwest Natural’s “Equity Bucket”

Table 5.1 Northwest Natural Balance Sheet – Summary Format

Table 5.1 shows shareholders’ equity increased by $2 million over the 3.75 years, January 1, 2017, through Sept. 30, 2020. This increase in equity plus an increase in net debt of $373 million was used to fund an increase of $376 million in net assets used in operations. Further analysis of the utilization of earnings, equity and debt is provided in Table 5.2 below.

Table 5.2 Northwest Natural Balance Sheet – Equity Section

I often find companies report earnings that should flow into and increase shareholders’ equity. But often the increase in shareholders’ equity does not materialize. Also there can be distributions out of equity that do not benefit shareholders. Hence the term “leaky equity bucket.” This does not appear to be a concern with Northwest Natural.

Explanatory comments on Table 5.2 for the period Jan. 1, 2017, to Sept. 30, 2020:

  • Reported net income (non-GAAP) over the period totals to $229 million, equivalent to diluted net income per share of $7.80.
  • The non-GAAP net income excludes $134 million of net expense items, regarded as unusual or of a non-recurring nature, in order to better show the underlying “core” profitability of Northwest Natural. These items decreased GAAP EPS over the 3.75-year period by $4.62 per share compared to the reported non-GAAP result. For Northwest, almost the entire net adjustment can be attributed to a non-cash impairment charge in relation to Gill Ranch prior to its disposal.
  • Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund – these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders’ equity at any point in time. For Northwest Natural, these items were not material.
  • There were share issues to employees, and these were a significant expense item. The amounts recorded in the income statement and in shareholders’ equity, for equity awards to staff, totaled $25 million ($0.85 EPS effect) over the 3.75-year period. The market value of these shares is estimated to be similar to the amount recorded against income.
  • By the time we take the above-mentioned items into account, we find over the 3.75-year period, the reported non-GAAP EPS of $7.80 ($229 million) has decreased to $3.20 ($96 million) adjusted net income from operations, added to funds available for distribution to shareholders. Dividends for the period totaled $7.12 per share ($210 million, exceeding the $96 million adjusted net income from operations available for distribution). I believe in this instance it is appropriate to add back the non-cash impairment charge of $4.62 in assessing earnings available for distribution as dividends. On that basis, the dividend payout ratio over the last 3.75 years would average ~90%.
  • Issues of staff shares, assessed at estimated market value, increased equity by an estimated $22 million over the 3.5-year period. Exercise of warrants and public issues raised a further $94 million to make a total of $116 million capital raised.
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It is worthy of note that capital expenditure over the period totaled $790 million, exceeding depreciation of $336 million by $454 million. As earnings were used primarily for dividends, it could be deduced this $454 million was funded from the $116 million capital raised and the $373 million increase in net debt.

Summary and Conclusions

The market appears to be having difficulty with rationally setting share prices at present as a result of the distortion of usual market metrics due to the impacts of the COVID-19 pandemic. With detailed analysis, it can be seen an investment in Northwest Natural shares at present price has the potential to provide high-single to low-double-digit returns. This level of total return, including a fairly well assured dividend yield in excess of 4%, makes for an attractive buy opportunity.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.