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Utility Gas Distribution Stock Outlook: A Promising Long Term

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Demand for Gas Distribution services is growing across the United States due to increasing consumption of the clean-burning natural gas. The expected increase in natural gas production in the Marcellus and Utica shales will require construction of new gas pipelines in the region, as the capacity of existing pipelines in the region will be filled up in next few years.

The focus to lower emission in the United States and rising natural gas imports in China and Japan will be the biggest drivers of demand for natural gas. The existing and new gas distribution pipelines will create a link between natural gas production areas and storage facilities with consumers and export facilities.    

Moreover, increasing shale production calls for expansion and additions to the existing pipeline infrastructure. We expect the existing natural gas pipeline operators in the United States to conduct more open seasons to gauge commercial demand for new natural gas pipelines.

Per a Pipeline and Hazardous Materials Safety Administration release, at present 2.21 million natural gas pipeline are in operation in the United States compared with 1.47 million miles in operation three decades ago. The natural gas pipelines are going to expand further in the near future.

Industry Performance Vs. the S&P 500

Looking at shareholder returns over the past year, it appears that the broader economic recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospects. The ongoing increase in interest rates might have taken a toll on investors’ confidence despite ample domestic growth prospect of the industry.

The Zacks Gas Distribution Industry, which is a 19-stock group within the broader Zacks Utility Sector, has underperformed the Zacks S&P 500 Composite but outperformed its own sector over the past year.

Over the last 12 months, the stocks in this industry have collectively gained 10.7%, the Zacks S&P 500 Composite has rallied 11.1% while the Zacks Utility Sector has declined 4.7%.

                                                            One-Year Price Performance



 

Gas Distribution Stocks Look A Tad Expensive

Since utility companies have a lot of debt on their balance sheets, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive gas distribution companies, the EV/EBITDA is a better valuation metric because it is not influenced by changing capital structure and ignores the effect of noncash expenses. 

Considering the underperformance over the past year compared with Zacks S&P 500 Composite, the stocks in the industry look a tad expensive now. However, this little premium is justified given the long-term prospect of this industry. The industry currently has a trailing 12-month EV/EBITDA ratio of 13.29x, which is above the median level of 13.07x.

The space looks a tad pricey when compared to the market at large as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.49x and the median level is 11.36x.
 


 

The premium to the broader market expanded materially from the end of first quarter of 2018, as the chart above shows, and has remained at this elevated level ever since.

Solid Earnings Outlook Could Drive Prices Higher

Gas Distribution companies enjoy the benefits of long-term contracts from the producers to transport natural gas or NGLs, which give a clear visibility of earnings. In addition, rising demand and higher production of natural gas will lead to steady increase in demand for pipeline services, thereby improving the prospects of pipeline operators. The increasing export of hydrocarbon gas liquids also has a positive impact on demand for gas distribution.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion shows that investors have been willing to pay up for these stocks so long, potentially limiting further upside from the current levels.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is its earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

                                                Current Year EPS Estimate Revisions

As you can see here, the $2.68 EPS estimate for 2018 is flat since May but is up from $2.67 at the end of April and $2.45 this time last year. In other words, the sell-side analysts covering the companies in the Zacks Utility Gas Distribution industry have been steadily raising their estimates.

Zacks Industry Rank Indicates Strong Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued outperformance in the near term.

The Zacks Utility Gas Distribution industry currently carries a Zacks Industry Rank #47, which places it at the top 18% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Gas Distribution Promise Long-Term Growth

The long-term (3-5 years) EPS growth estimate for the Zacks Utility Gas Distribution industry appears strong. The group’s mean estimate of long-term EPS growth rate has been increasing since February 2018 to reach the current level of 8.4%, which is lower than the Zacks S&P 500 composite level of 9.8%. Given the current positive trend in the gas distribution industry it leaves much room for improvement over the long run.


                                        Mean Estimate of Long-Term EPS Growth Rate


 

In fact, the basis of this long-terms EPS growth could be the recovery in the top line that gas distribution companies have been showing since the end of 2016.

 

Another important indication of solid long-term prospect is the improvement in the group’s return on equity (ROE), which is a key metric for evaluating gas distribution stocks.

To Sum Up

We could notice a significant increase in production of natural gas and usage of the same in United States. In addition, other nations across the globe and gradually increasing their usage of this clean burning fuel. All these activities are driving the necessity of additions and improvement in the gas distribution infrastructure of the United States.

This natural gas industry does face challenges from the renewable space, but its stability as a fuel source is much more established and thanks to the complex network of pipelines, end users are getting natural gas when required. In addition, the regulated nature of the pipeline operation also offers stability to earnings.

While none of the stocks in our gas distribution universe currently hold a Zacks Rank #1 (Strong Buy), below are three stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).

(You can see the complete list of today’s Zacks #1 Rank stocks here.)

Atmos Energy Corporation (ATO - Free Report) : The consensus EPS estimate for this Dallas, TX-based natural gas distributor has moved 0.5% higher for the current fiscal year, over the last 60 days. The stock has gained 9.4% over the past year.

                                                              Price and Consensus: ATO

Chesapeake Utilities Corporation (CPK - Free Report) : The consensus EPS estimate for this Dover, DE based diversified energy company has moved 1.4% higher for the current year, over the last 60 days. The stock has gained 6.3% over the past year.

                                                           Price and Consensus: CPK



Northwest Natural Gas Company (NWN - Free Report) : The consensus EPS estimate for this Portland, OR based gas distribution and storage company has moved 0.9% higher for the current year, over the last 60 days. The stock has gained 8.8% over the past year.

                                  Price and Consensus: NWN


 

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