Northwest Natural Gas Company (NWN)

Founded in 1859, Northwest Natural Gas (NWN) is the largest standalone local gas distribution company in the Pacific Northwest. The company has over 740,000 customers, 14,000 miles of pipeline infrastructure, and $3.0 billion in total assets.

Northwest Natural Gas operates in two segments:

Just over 50% of the company's customers are residential, with commercial and industrial clients making up the rest. 

With 62 consecutive years of annual dividend increases (second longest streak in America), Northwest Natural Gas is a dividend king.

Regulated utilities often make incredibly stable income investments thanks to their wide moats and the relatively recession-resistant nature of their sales and cash flow. These businesses are essentially regulated monopolies with locked in customer bases (they are often the only service provider in their territories) and guaranteed returns on equity and rate base (the utility's assets that regulators' allowed return on equity is applied to). 

In exchange for having regulators set the rates they can charge their customers, regulated utilities enjoy guaranteed profitability, very stable cash flow, and incredibly stable dividend growth so long as they deliver on their projects. They are also among the least volatile stocks on Wall Street (Northwest Natural Gas has been about 50% less volatile than the S&P 500 over time).

However, a good utility still needs to have conservative and disciplined management and constructive relationships with regulators. Northwest Natural Gas is led by CEO David Anderson who has been with the company for 14 years and has over 30 years of experience in the regulated gas industry.

Constructive regulatory relationships require strong operational execution, meaning Northwest Natural Gas needs to serve its customers well in order for regulators to view its proposed growth project proposals and rate cases (requests to raise rates) more favorably. Fortunately, Northwest Natural Gas has an excellent track record of strong execution and customer service. For example, in 2017 the company was the top Western gas utility in J.D. Power's Gas Utility Residential Customer Satisfaction Study for the fifth year in a row. And in 10 of the last 11 years, Northwest Gas has been number one or two in those customer satisfaction surveys.

Regulators are also more likely to take a favorable view of a utility's rates and growth plans if they serve the state's long-term goals. For example, Oregon has a goal of lowering its CO2 emissions by 35% by 2035 (compared to 2015 levels). A big part of this comes from replacing coal power plants with gas-fired ones (gas emits 50% less CO2 per unit of energy). Northwest Natural Gas is now completing its $132 million North Mist gas storage expansion project, one of the company's largest ever. The project is under a 30-year contract with Portland Gas & Electric, one of the states biggest power distributors. 

North Mist is expected to be fully online by the end of the year, and this single project will increase the company's rate base by 4.4%.

Despite its relatively tiny size (less than $800 million in annual revenue), Northwest Natural Gas enjoys industry-leading profitability with an operating margin near 25%. This is largely thanks to the above-average returns its regulators allow the utility to earn, which have helped create a safe and steadily rising dividend over the decades. 

The company's impressive dividend growth streak is also a function of management's conservatism with debt. Northwest Natural Gas enjoys a strong balance sheet and an A+ credit rating from Standard & Poor's, which provides it with access to low-cost borrowing. That's an important advantage in a capital-intensive industry such as this.

Going forward, the company plans to continue growing via two main strategies. First, Northwest Natural Gas has about $800 million in new approved infrastructure investments between 2018 and 2022. This spending is expected to increase the company's base rate by about 25%. 

Next, Northwest Natural Gas is diversifying into water utilities, which began with the acquisition of two small water companies in Oregon and Idaho in late 2017. These deals added 6,500 customers. In May 2018, the utility announced the purchase of two small Washington state water companies which added another 1,100 customers. 

While its water business remains small, the U.S. regulated water industry is incredibly fragmented with about 160,000 local municipal systems. This means that over time Northwest Natural Gas could be able to continue adding small bolt-on acquisitions to grow its water business and diversify its operations by geography. As another bonus, water utilities typically enjoy even more consistent sales and cash flow than natural gas utilities (more on this in the risk section). 

Over the coming decade, Northwest Natural Gas seems likely grow its EPS at a low to mid-single-digit pace thanks to continued population and economic growth in the Pacific Northwest. 

While that should keep the utility's dividend growth streak alive and well, there are still several challenges facing the company that might make it a subpar long-term income investment. 

While Northwest Natural Gas enjoys a local monopoly in its operating regions, the nature of its business model still leaves a lot to be desired.

First, Northwest Natural Gas, like most regulated gas utilities, is a highly region-specific business. This means its top and bottom line growth rates are determined by a combination of the population growth rate of its regions (about 2% per year), as well as the health of the local economy (for commercial and industrial customers). 

While the company does periodically make small acquisitions to grow its customer base (such as two Washington-based water utilities in May 2018), Northwest Natural Gas simply doesn't have very strong organic growth capabilities. In 2017, for example, the company grew its customer base by 1.8%.

And unlike regulated electric utilities, gas utilities can see surprisingly high volatility in their sales and earnings. This is due to several factors including the state of the economy, weather (seasonal variability), and the price of natural gas (highly volatile). Northwest Natural Gas's revenue dipped by 22% and 12% in 2010 and 2012, respectively, and can rise or fall by double-digits any given quarter, for example. 

Slow overall growth is the main reason why Northwest Natural Gas's impressive streak of dividend increases has been marred by an incredibly slow growth rate (just 1% to 2% per year).

The company also faces regulatory risk from its three key regulatory bodies: the Oregon Public Utilities Commission, the Washington Utilities & Transportation Commission, and the Federal Energy Regulatory Commission (for its gas storage business). These regulators set the returns on equity and returns on rate base (affecting rates Northwest Natural Gas charges its customers), and there is no guarantee that future rate cases will turn out favorably for the company. 

For instance, in December 2017 the company filed a rate case (which can take up to 10 months to receive a decision on), its first in six years. This was with Oregon regulators to increase its rates by 6% (revised to 4% later) and to boost its allowed returns on equity from 9.5% to 10%. 

The company expects a decision by October 2018, with any new rates to go into effect in November. The fact that the company files rate cases so infrequently means the chances are high it will receive approval for higher rates. However, it also means that Northwest Natural Gas has very limited ability to increase the rate it charges customers (less than 1% per year on average).

Then there's the Tax Cuts and Jobs Act of 2017. While this lowered the corporate tax rate from 35% to 21%, it won't be a big help to Northwest Natural Gas. That's because by law regulated utilities must pass on tax savings to their customers. 

What tax reform will do, per management's warning, is eliminate a bonus depreciation allowance that might end up raising the company's taxes going forward. That in turn could negatively impact its cash flow and force even slower dividend growth. The impact of tax reform has already forced the company to reduce its latest rate case request with the Oregon Public Utilities Commission from 6% to 4%. As a result, management is guiding for a 2018 dividend EPS payout ratio of 85% which would be among the highest it has ever had.

Which brings us to perhaps the biggest problem with Northwest Natural Gas as an income growth stock. Specifically, the slow-growing nature of this business means that, while its dividend growth streak is among the longest in America, its growth rate is also one of the weakest.

For example, in the last five years the company has been raising its payout at just 1% annually, and over the last 20 years the annual average increase has been 2%. The utility's slow pace of dividend growth is a function of the company's high payout ratio (over 80%) and the slow growth rate of its earnings. 

The high nature of the company's payout ratio, combined with the relatively small size of the utility, means that Northwest Natural Gas is retaining very little earnings. This forces it to rely more on debt and equity markets (sell new stock) to fund its growth plans. 

In the past five years, the company's share count has increased by an average of 1.8% per year as the company periodically issues new shares to fund its growth. Selling equity to fund growth is normal for regulated utilities; however, because of how small Northwest is ($1.7 billion market cap), it is likely that management is going to want to stay conservative with the firm's dividend growth. 

That's so it can bring down its payout ratio and retain more earnings to become less reliant on fickle equity markets for its long-term growth potential. This is especially true now that management has said that it considers expanding its water business a key growth driver. Future water utility acquisitions will likely require lower payout ratios, and each one comes with its own execution risk (including not overpaying for new assets).

As a result, investors should expect slow dividend growth (that doesn't keep up with inflation) to continue for at least several more years. And even if Northwest Natural Gas's good relationship with regulators continues and it is granted above-average returns on investment, 1% to 3% annual dividend growth is among the lowest payout growth you can find among dividend aristocrats or kings. 

Northwest Natural Gas's dividend growth potential is also much lower than the payout growth rate of most regulated utilities which frequently grow their dividends at 4% to 5% per year. In other words, while Northwest Natural Gas represents a low-risk income investment, the limitations of its regional concentration, slow growth, high payout ratio, and relatively low yield make it a subpar income investment compared to many other regulated utilities.

Regulated utilities are known for their long track records of consistent dividend increases. That's thanks to their status as government-sanctioned monopolies with a captive customer base and guaranteed returns on investment. As a result, regulated utilities enjoy sufficiently high and profitable cash flow that can be used to pay secure and steadily rising dividends over long periods of time.

Northwest Natural Gas, thanks to its constructive relationship with regulators and management's good track record of disciplined capital allocation, has managed to deliver 62 consecutive years of rising dividends to shareholders. 

However, the company's regional concentration, limited growth opportunities, and high payout ratio mean that Northwest Natural Gas is likely to continue delivering only token dividend increases to income investors for the foreseeable future. Therefore, investors looking for sources of generous income that can also grow fast enough to protect their purchasing power might want to look elsewhere.