Northwestern Energy

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Northwestern Energy is a regulated utility company providing electricity and natural gas services primarily in Montana, South Dakota, and Nebraska.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Northwestern Energy operates as a regulated utility, meaning their prices are set by state regulatory commissions, and they have a geographic monopoly in the regions they serve.

Business Overview

Northwestern Energy (NWE) operates as a regulated utility company, primarily engaged in providing electricity and natural gas services. It functions as an integrated electric and natural gas distribution provider across Montana, South Dakota, and Nebraska, targeting residential, commercial, and industrial customers.

Revenues:

NWE’s revenue streams are largely determined by the regulated rates set by respective Public Utility Commissions of the states they operate in.

  • Electric Operations: Generated $790 million in revenues for the three months ended September 2023, and $2.5B for nine months ended September 2023. This segment entails generating and purchasing electricity, as well as transmitting it and distributing it to their customers. This segment is subject to the Federal Energy Regulatory Commission (FERC) and the Public Service Commission for each state in their operating footprint.
  • Natural Gas Operations: Generated $323 million in revenues for the three months ended September 2023, and $1.1B for nine months ended September 2023. This business segment entails the production, purchase, gathering, storing, transmission, and distribution of natural gas to their customer base. The prices and production are also regulated.

The utility industry is undergoing rapid transformations, largely due to the push for clean and renewable energy, changes in regulations and compliance standards, and an increasing demand for electricity.

  • Clean Energy Transition: There’s a clear shift towards renewable energy sources, placing companies in transition.
  • Infrastructure Modernization: Increasing demand for power has pushed a need to modernize electrical and gas distribution networks to be more efficient and reliable.
  • Regulatory Pressures: Increasingly strict regulations about environmental compliance and reliability are forcing utilities to invest more money and resources.

Competitive Landscape:

NWE operates in a very specific market that is more influenced by regulatory and contractual agreements rather than pure competition. It is a vertically integrated utility company so it controls many aspects of the energy and gas supply.

Because of the regulated nature of the utility industry, barriers to entry are extremely high for new entrants, meaning they have limited competition in most cases, especially geographically.

  • Local Monopolies: NWE operates as a local monopoly, so while they compete with other utilities for investors, they are the only company providing services to customers in its region.
  • Technological Challenges: Upstart energy suppliers and companies may try to compete with newer technologies. But these smaller companies must pass multiple legal, financial, logistical hurdles, often making it tough to directly compete.

What Makes NWE Different?

NWE is a rather standard utility company, providing regulated services in states with varying regulatory processes. Here are a few things that differentiate it.

  • Geography: NWE’s primary operation is in Montana. This geographic focus is unique among many other public utilities in the US.
  • Infrastructure: A strong and extensive infrastructure throughout their service footprint makes it difficult to quickly displace them as the main provider.

Financial Analysis:

Revenue:

  • For the three months ended September 2023, revenues were $1.1B and for the nine months ending September 2023, revenue was $3.6B.
  • Revenues have increased compared to 2022, but due to a variety of factors including higher fuel costs and regulatory lag, the bottom line was greatly affected.

Profitability:

  • Net income was $20.3 million for the three months ended September 2023 and $148.3 million for nine months ended September 2023. This is down considerably from prior periods.
    • This was mainly due to higher interest and gas supply expenses. The company had to write off $112.6 million for its Colstrip Unit 4 plant alone.
  • Operating margins vary wildly depending on the quarter, due to weather, regulatory conditions, and supply prices, making it difficult to predict.
  • ROIC is decent but not in the double-digit range that is preferred to call the business a wide-moat company. This is mainly due to high amounts of capital invested and higher operating costs.

Balance Sheet

  • Has a large amount of assets (around $7B) and liabilities (around $4.4B) on the balance sheet.
  • Tangible equity is around $2.6B and preferred equity is around $3.1B.
  • Debt-to-equity ratio is about 1.69:1
    • This high use of debt may be an indication of the capital intensive nature of its operations, as well as its regulatory-determined revenues.
  • The debt maturity schedule is a concern, since there is a significant amount due in the coming 3-5 years.
    • The high interest rate environment could significantly affect profitability if refinanced at higher costs.
  • A significant portion of debt is at variable interest rates, increasing the exposure to interest-rate increases.

Free Cash Flow (FCF)

Since NWE is a capital-intensive business, Free Cash Flow generation is difficult. Also, profitability is sensitive to energy price changes, changes in regulations, and other factors.

  • The company had cash from operating activities around $343 million in the three months of September 2023 and $752 million for the nine months.
  • Due to large amounts of reinvestment, free cash flow may be limited in most periods.
  • There is an inconsistency in FCF as the company makes acquisitions, divestures, and changes in capital structure.

Recent Concerns/Controversies

  • Montana Wildfires and Natural Disasters: NWE stated that the wildfires and other storms in their operating region were a main source of the company’s unprofitability for Q3 2023.
  • Rate Hikes: The company has been asking for rate hikes to cover for the rising cost of capital, and to improve profits. This could harm its relationship with some regulatory commissions and have negative consequences for future valuations.
  • Colstrip Unit 4 Impairment: The write down of their Colstrip Unit 4 plant by $112.6 million is a major headwind for the business as their previous projections did not play out as expected. Management is working on mitigating this, and trying to see if they can benefit from energy transition programs.

Moat Rating: 2 / 5

While NWE enjoys a local monopoly in its operating regions, which should provide it with a source of earnings and profits that is tough to replicate, they are a regulated utility, which limits upside potential. They have the scale advantage due to their operations over the years. In a more competitive market with a lot more freedom over pricing, this would constitute a wide moat. However, due to regulation, it’s not as big an advantage. Because of the capital intensive nature, the company cannot generate a very attractive rate of return on invested capital, which is a big negative.

Their moat would be narrow because of a few things:

  1. They have economies of scale as it’s very expensive to build electrical transmission lines.
  2. They have local monopolies in their regions because of regulations.
    • New entrants can’t simply compete with them because of the local regulations in place.
  3. They are hard for customers to switch from, because of the infrastructure involved.

Their moat is easily penetrable because:

  1. They do not have high returns on invested capital and don’t have pricing power because of the regulatory limitations.
  2. They are prone to political and regulatory risks that can heavily impact their business.
  3. The industry and market forces are also moving to clean and renewable energy sources making existing infrastructure and energy production sources obsolete.
  4. Management is not very exceptional and they have had a history of overspending and poor capital allocation.

We rate NWE’s moat as a 2/5. They have a narrow moat because of barriers to entry, but those are weak because it’s based on regulations rather than economic moats.

Legitimate Risks That Could Harm Moat

  • Regulatory Risk: Changes in regulations, rate increases, or adverse judgments by regulatory bodies could significantly reduce the company’s revenue and profitability.
  • Interest Rate Risk: The high amount of variable debt is a risk when rates increase and the need to refinance at higher rates will reduce profitability and hurt the business.
  • Commodity Price Risk: NWE is susceptible to higher supply costs of natural gas and fuel. In a high fuel cost environment, the company’s profits can diminish greatly.
  • Competition: Though they are a local monopoly, smaller companies could potentially come and take away some market share by using new tech and focusing on niche markets that larger companies may find unprofitable.
  • Technological Disruption: Newer technologies like solar, wind, and battery storages, might drastically cut the need for distribution-based electrical networks.
  • Environmental Issues: Environmental and carbon regulations may further cut into company earnings through higher expenses. It may also limit their growth opportunities.
    • The growing demand for green energy may push consumers to use other sources.

Business Resilience

NWE has decent business resilience.

  1. Their business is a local monopoly.
  2. They provide essential products that people and businesses depend on.

However, they are also susceptible to a variety of risks as described above. If enough of those materialize, they may be financially distressed.

Understandability: 3 / 5

NWE is a relatively straightforward business to understand, with few complexities. However, it is a utility, so there are some difficulties regarding the accounting rules and all the necessary regulations that they need to follow. These are the reasons for a 3 out of 5.

Justification for the Rating

  1. The business is generally simple to understand, being a utility that provides energy, something that most people use in daily life.
  2. The business model is easily understood as they are a regulated utility.
  3. The regulatory landscape complicates the business model, because it requires special attention to state and federal regulations.
  4. There are multiple complex accounting conventions in place, making it difficult for non-accountants to understand the financial implications.

Balance Sheet Health: 3/5

NWE’s balance sheet is relatively sound, but it does have some elements that make it just a 3 out of 5.

Justification for the Rating

  1. There is a high debt-to-equity ratio of 1.69:1, meaning they are at risk of a high interest rate environment.
  2. Many assets are tied up in fixed assets, making them hard to sell in times of distress.
  3. There is no significant excess of liquid assets.
  4. The company has been facing higher fuel and operating costs, which have put pressure on the balance sheet.
  5. Although their current ratio is fairly okay, it should be more stable and more well-covered.
  6. They also hold some equity investments in other related companies that may be very risky.

Overall, there are more positives than negatives, but it’s not something that can give the investor maximum confidence in the business.