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Industry Analysis: Natural Gas Utility
The Natural Gas Utility Industry includes domestic companies that provide distribution service to residential, commercial and industrial customers. Although company-specific issues influence operating results, wide variations in weather and swings in the economy also have an impact. Additionally, these capital-intensive businesses are regulated by federal, state, and sometimes local authorities, which determine the maximum rates of return they may earn. Stocks in this group are best suited to conservative, income-oriented investors.
Major Operating Influences
The macroeconomic environment plays a role in this sector's performance. Commercial and industrial demand for natural gas tracks the overall business cycle. If the economy weakens, large customers cut production and pare their gas consumption. On the other hand, if the economy is expanding, customers step up their purchases.
Weather is a factor that affects demand for natural gas, especially from small commercial businesses and consumers. Of course, annual revenue and income are subject to seasonal temperature patterns, with demand highest during the winter heating months. Unseasonably warm (raising air conditioning requirements) or cold weather can cause much volatility in quarterly operating results. Many states have weather-adjusted rate mechanisms in place to protect consumers from extreme surges in gas prices.
Rate cases are a key issue for Natural Gas Utilities. Federal authorities set wholesale service tariffs and state regulators determine retail distribution rates. Adequate returns on common equity are necessary to keep these businesses viable. Higher rates are sought to cover the cost of expansion, storm damage and/or cover the cost of maintaining reliable service. To promote good relations with customers and regulators, managements endeavor to keep operating and service costs low. At times, political pressure can push authorities to limit rates of return, to the detriment of utilities.
For the most part, regulators attempt to strike a fair balance between the interests of shareholders and customers. Nonetheless, the risk to shareholders becomes elevated when a rate case requesting a large change in tariffs is considered. Federal and state mandated energy-efficiency programs affect usage. But regulators often provide incentives to utilities to effectively implement such initiatives, without hurting profitability.
Prevailing interest rates are an important consideration for investors. The construction and maintenance of distribution networks require lots of capital in the form of debt and equity. Generally, when rates are rising (falling), regulators set higher (lower) returns on assets. At times, there may be a lag between interest rate trends and the allowed rates of return. Long-Term Debt Ratios are typically above the 50% mark, indicating that debt financing is more economical for utilities, thanks to their dependable revenue streams, than equity funding. Dividend yields need to be high enough for these equities to compete with alternative investments, particularly U.S. Treasury bonds.
Utilities in expansion mode may provide noteworthy share-price appreciation potential. Indeed, the level of national or regional housing starts can be an indication of a company's growth prospects. The residential market accounts for the largest portion of revenue. Heating and cooling degree days, versus the historical averages, give an indication of what amount of revenue and income might be reported for each quarter, and whether a utility will over or under earn its allowed return in a certain year. Regulators will monitor year-to-year trends in operating results to assure that tariffs are at fair levels.
The Utility Array
Value Line research reports on companies in this industry follow the format for utilities. That is, the statistical array includes lines for Long-Term Debt Ratio, Common Equity Ratio, Total Capital, and Net Plant. Note, though, that Natural Gas Utility arrays do not include AFUDC (Allowance for Funds Under Construction) % To Net Profit, as do those of electric utilities, which require greater physical plant investment.
Usually, the capital structure is weighted more towards debt, since most often the cost of debt for utilities is cheaper than the cost of equity. Banks are willing to lend to utilities at low rates because revenue streams are predictable and regulation assures a positive return on assets. The ratios are based on Total Capital, including all debt and common and preferred equity. Yearly Net Plant figures give investors an indication as to how fast a utility is growing. Companies with modest Long-Term Debt Ratios have more flexibility to expand internally or externally. A very high debt ratio may indicate operating problems.
Investors should also review a utility's Return on Common Equity, or net profit divided by common equity. This measure shows how capable management is of achieving the regulated allowed return. Operating cost control is often the key to earning a solid return. But successive harsh rate rulings can be an overriding factor.
Natural Gas Utilities are subject to economic, weather and regulatory risks. On balance, though, this mature sector, delivering an essential service, produces steady, annual, low single-digit revenue growth and mid single-digit share-net advances. Return on Common Equity is typically in the high single-digit-to-mid-teens range. Natural Gas stocks offer modest beta coefficients, high Price Stability scores, above-average Earnings Predictability, and good Financial Strength ratings. They provide appealing dividend yields and ample share-price downside protection during weak economic times.