Southwest Gas

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Southwest Gas is a natural gas utility that primarily serves residential, commercial, and industrial customers in Arizona, Nevada, and California through regulated distribution networks.

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.

Southwest Gas’s business revolves around the distribution of natural gas through its vast network of pipelines, and is subject to a high level of regulatory oversight.

Business Overview

Revenue Distribution:

Natural Gas Distribution: Southwest’s core business involves the distribution of natural gas to residential, commercial, and industrial customers across its service areas in Arizona, Nevada, and California. This is the primary revenue driver for the company.
Utility Infrastructure Services: Through its Centuri segment, Southwest provides regulated utility infrastructure services. This segment mainly focuses on infrastructure work for other utilities and transportation infrastructure projects.

Trends in the Industry:

Transition to Clean Energy: The energy industry is undergoing a significant transition towards renewable and cleaner sources of energy. However, natural gas still plays a vital role in the energy mix for the foreseeable future, as well as for integration into renewable solutions. There is an ongoing debate regarding the future role of natural gas in a decarbonizing world and the necessary investments into infrastructure.
Regulatory Landscape: The utility business is heavily regulated, and a good working relationship with regulatory agencies is essential. Regulatory actions can directly impact tariffs and, consequently, the revenue and profitability of companies like Southwest Gas.
Capital Investments: Utility companies require continuous investment in infrastructure to maintain reliability and safety, upgrade networks, and expand services. This involves sizable capital expenditures.
Market Expansion: As the economy rebounds and population increases in the Sun Belt, there is an increased demand for new energy connections, prompting infrastructure expansion and capital spending.
Volatility: Natural gas prices can fluctuate widely, impacting customer bills and potentially requiring hedging strategies by utilities to manage price volatility.
Demand: The demand for natural gas is sensitive to seasonal changes, weather conditions, and economic trends.

Competitive Landscape:

The company primarily operates as a regulated natural gas distribution utility within specific geographic regions and is a natural monopoly with limited competition in its specific area.
While competition is minimal in its core business, the company needs to remain efficient in terms of costs, service quality, reliability to keep regulatory rates reasonable and to keep its customer base.
The utility infrastructure business has competition from other companies that specialize in building these kinds of services.

What Makes the Company Different:

Established Infrastructure: Southwest Gas possesses a vast network of pipelines, enabling it to distribute natural gas efficiently throughout its service territory.
Regional Focus: The company’s operations are concentrated in the rapidly growing Southwest region, leading to increasing market opportunities.
Decades of Experience: Having been in business for 90+ years it has had experience navigating economic cycles and establishing a regulatory track record.

Financials In-Depth

Income Statement:

Revenues for the most recent quarter were $1.2 billion, a considerable increase year-over-year. A combination of increased rates, gas sales volumes, and distribution system growth helped push revenues up. However, this was offset by higher operating costs.

The increase in revenues was driven by a regulatory rate increase and customer growth, while lower energy prices and increased competition in the pipeline services segment slightly offset the increase.

Operating margins are improving, even as the cost of gas declines from the 2022 highs, however they have been offset by increases in other costs.
Net income for the most recent quarter is $63 million.

They have posted profits despite higher operating costs, including cost of purchased gas and materials, and administrative expenses.

There was a decline in net income for Q1 2023 due to higher interest rate and increased amortization.

Balance Sheet:

The company is quite capital intensive, with a significant amount of assets in property, plant, and equipment.
Southwest Gas has a moderate level of debt, with about 57% of its debt being long-term debt, and the rest being short-term debt or other debt equivalents. Their debt has a high rate of variable interest, and their floating interest rate is tied to SOFR.
They are planning on reducing their debt to better balance their capital structure, which shows proactive management.
The current maturities of long-term debt are mainly in 2024 and 2025, with approximately $700 million of debt coming due each of the next two years.
They have a decent amount of cash on hand, with ~$300 million, which is more than their usual level of cash.

Cash Flow:

Cash flow from operations was $289 million for most recent quarter, driven by their strong operating performance and customer growth. The company’s cash flow has been used to fund growth and acquisitions. They also continue to deploy a significant amount of capital on infrastructure and energy efficiency programs.
Net debt reductions and stock repurchases for the recent quarter have created negative cash flow in investing and financing activities.

Recent Controversies and Problems:

Their 2024 outlook is very much dependent on the pending rate adjustments in Arizona and California. Management has put up expectations of full annual recovery in their operating results. They have indicated their rates are set to stabilize and will increase in 2024, but they are still awaiting approval from their regulatory bodies.
They have faced difficulties due to higher natural gas prices, as it has negatively impacted margins. They are actively working to mitigate these effects.
There are concerns in the broader market about energy transition and whether natural gas infrastructure will be relevant in the future.
Management seems to be concerned about higher debt rates and has communicated that they will seek to reduce debt, as soon as their cash flows allow it.
The company has faced increasing litigation and legal costs.

Moat Analysis: 2 / 5

A moat is a durable, competitive advantage that protects the company’s ability to maintain profitability.

Limited Competitive Threat: Southwest Gas’s greatest advantage is its existing distribution network, especially in its core natural gas distribution business. It is a near-monopoly, and competition is usually limited due to high capital expenditure, regulatory hurdles, and overall scale requirements for building such infrastructure.
Regulatory Licensing: Operating in a regulated industry is both an advantage and a disadvantage. On one hand it protects them from competition, but on the other hand their returns are capped by regulators. This creates a narrow moat.
Customer Retention: Customers tend to be sticky, they do not switch from suppliers easily. This allows the company to be more profitable, and have a narrow moat because of it.

Overall, Southwest Gas has a narrow moat, though it is vulnerable to regulatory and technological changes, making it difficult to earn exceptional returns or to be a high conviction investment for the long term.

Risks to the Moat and Business Resilience

Regulatory Changes: The company’s rates are set by regulators; unfavorable decisions can reduce revenues and profitability significantly. Further, regulatory oversight might restrict operational flexibility and business opportunities.
Market Volatility: Commodity companies like Southwest Gas can be impacted negatively if gas prices remain volatile. They might need to implement hedging strategies to avoid these fluctuations in the price.
Technological Disruption: Although natural gas is likely to play a key role in the coming years, changes in customer preferences and adoption of renewable alternatives might decrease the need for their service and erode any competitive advantage. This can come from advances in electric vehicles and alternate energy production.
Environmental Concerns: Heightened attention to environmental issues and government policies aimed at reducing greenhouse gas emissions can have a large influence on the gas industry.
Geopolitical Risks: Supply and demand imbalances of natural gas due to geopolitical factors can impact their operations. If prices of natural gas get too high, they might face competition from other energy sources.
Financial Risk: Changes in interest rates, or any other unexpected liability can lead to a decline in the profitability or value of the company.

Understandability: 2 / 5

Southwest Gas operates in a straightforward sector, but its operations, financing, and regulatory aspects make it moderately difficult to understand completely. The accounting can get a bit complex because it is a utility. Further, to understand the business dynamics and projections you need to have specialized knowledge about the energy and natural gas industry.

Balance Sheet Health: 3 / 5

Southwest Gas has a manageable level of debt but would need to reduce its long-term debt to achieve a better level of liquidity and stability. The asset mix is appropriate given that most of its assets are long-term in nature. Also, there was an adequate level of cash on hand. Overall, balance sheet health looks healthy.