The history of utilities is packed with examples of management getting badly burned by investing outside regulated operations, recalls Roger Conrad, utility sector specialist and editor of Conrad's Utility Investor.
That tends to keep stocks of companies that do at big discounts to their peers, as Southwest Gas Holdings (SWX) is at 15.7 times expected next 12 months earnings.
To some, the distributor of natural gas to 2 million customers in Arizona, California and Nevada dug itself a deeper hole this week, acquiring Riggs Distler & Co for $855 million in cash.
Expected to close in Q3, the purchase broadens the reach of Southwest’s utility construction unit Centuri to the Northeast and Mid-Atlantic regions, bringing new opportunities for electric services, renewable energy and 5G communications projects.
Southwest expects immediate accretion to earnings. But its move immediately drew the ire of major credit raters, with Moody’s and Fitch shifting outlooks to negative and S&P putting its BBB+ mark on credit watch for a potential cut.
The big three credit rating agencies were no doubt pushed by Southwest’s intent to fund its purchase entirely with new debt at the Centuri unit. But S&P and Moody’s appear to take issue with unregulated operations increasing to 34 percent of EBITDA, with a likely increase to 38 percent through 2024 given management’s stated plans to accelerate business growth.
A larger Centuri increases potential cyclicality of Southwest Gas’ earnings. That’s despite 80 percent plus of post-merger revenue coming from contracts and multi-year master service agreements with regulated utilities, arguably as secure a cash source as governments.
But added risk to shareholders is more than mitigated by the fact that Southwest’s regulated utilities (customer growth rate 1.7 percent) alone fund the dividend, with revenue decoupling smoothing out quarterly earnings volatility. And whatever added volatility we see should be dwarfed by ramped up growth at Centuri, especially if infrastructure dollars flow from Washington in coming months as now appears likely.
Most exciting is the greatly increased likelihood of transforming M&A, as Centuri becomes much more capable of standing on its own feet in a potential spinoff. I’m adding Southwest Gas to the Aggressive Holdings as a buy up to a highest recommended entry point of $75.