Nicor Should Heat Up
We believe that natural gas distribution outfit Nicor's (GAS: $45.56) current stock valuation—below its industry peers—combined with its strong balance sheet and a dividend yield that is higher than its peers, make the shares very attractive. We see the company's shipping and unregulated energy businesses driving its earnings growth while its utility business provides a solid earnings base.
After reaching an all-time closing high of $53.22 on Apr. 25, 2007, the stock has declined 15% compared with a 7% rise in the Standard & Poor's 500 Gas Utilities Index and a 1.8% increase in the S&P 500-stock index. We believe the recent sell-off has provided a compelling purchasing opportunity for investors.
We expect Nicor shares to benefit in the next 12 months from the higher multiples we see in store for the natural gas utility group and from the stock approaching peer valuations. Our recommendation is 5 STARS (strong buy).
Illinois Service Territory
The primary business of Naperville (Ill.)-based Nicor is gas distribution through Nicor Gas, one of the nation's largest distributors of natural gas. The company also engages in several unregulated businesses. Tropical Shipping, a leading transporter of containerized freight in the Bahamas and the Caribbean region, is of growing importance to Nicor, with unit revenues accounting for 13% of the company's total, and operating earnings making up 23% of the total in 2006. In 2001, Tropical accounted for 12% of Nicor's total operating income. Nicor also owns several energy-related ventures.
Nicor Gas serves nearly 2.2 million customers with its 2,100 employees. Its service territory encompasses most of the northern third of Illinois, excluding the city of Chicago, and has demonstrated relatively steady growth in customers. Residential customers account for 91% of total customers, commercial customers 8%, and industrial customers 1%. Residential customers make up 46% of natural gas volumes delivered, commercial customers 28%, and industrial customers 26%.
Nicor Gas customers have the option of becoming transportation-only customers by purchasing their own gas supplies and having that gas delivered by Nicor Gas. Residential transportation customers make up 8% of total residential customers. Commercial and industrial transportation customer rates are higher, at 32% and 46%, respectively. Typically, only the largest commercial and industrial customers switch to transportation-only service. The 46% of industrial customers that switched represent 96% of the total natural gas deliveries to the customer class.
Operates the Chicago Hub
Larger transportation customers also have options that include the use of Nicor Gas' 150 billion cubic foot (Bcf)-owned and 40 Bcf-contracted storage system and the ability to choose varying supply backup levels. The choice of transportation service as compared to gas sales service results in less revenue for Nicor Gas but has no direct impact on net operating results because the cost of gas purchased by Nicor Gas for its customers is passed directly on to the consumers by means of a purchased gas adjustment rider.
The gas distribution unit's heating-degree-day total is 5,830 annually. The company estimates that a 100 degree-day variation from normal would have a $1.6 million impact on Nicor Gas' net income. Typically, about 75% of its sales occur during the October through March time period.
Nicor Gas also operates the Chicago Hub, which provides natural gas storage and transmission-related services to marketers and other gas distribution companies. The Chicago area is a major market hub for natural gas, and demand exists for storage and transmission-related services by marketers, other gas distribution companies, and electric power-generation facilities. However, starting in the fourth quarter of 2005, a rate order requires that Chicago Hub revenues be passed directly through to customers as a credit to the purchased gas adjustment rider.
Facing Changing Global Trade
Nicor Gas has faced a business environment that includes high commodity prices and related demand erosion, as well as increased costs of doing business. To sustain its financial performance, we believe the utility plans to manage controllable cost increases, improve operating effectiveness, evaluate potential rate relief mechanisms, and focus on both customer service and employee performance.
The company's Tropical Shipping unit is one of the largest containerized cargo carriers in the Bahamas and the Caribbean, a region characterized by modest market growth and intense competition. The company, with 10 owned vessels and eight chartered vessels, is a major carrier of exports from the East Coast of the U.S. and Canada to these regions. Its shipments consist primarily of southbound cargo, such as building materials, food and other necessities for developers, manufacturers, residents, and businesses in the Caribbean and the Bahamas.
Tropical Shipping has benefited from favorable economic conditions and tax-related benefits. However, the shipping segment, in our view, faces the possibility of lower volumes due to changing global trade patterns, higher fuel prices and other operating costs, stricter homeland security requirements, higher U.S. import tax rates and, in certain ports, pricing pressures due to competition. To address this environment, Tropical has made a strategic decision not to compete for certain low-margin business. In addition, the company plans to continue expanding the business, partly through strategic niche acquisitions; focus on cost control; take advantage of new trans-shipment opportunities; and to improve service delivery, reliability, and asset utilization.
Diversified Model a Plus
Nicor owns several energy-related ventures, including three retail companies that market energy-related products and services, and one wholesale natural gas marketing company. Combined, these companies make up the other energy ventures (OEV) segment. They are also becoming more important to Nicor's earnings growth; In 2006, OEV represented 13% of operating income and 7% of revenues, compared with 3% and 2%, respectively, in 2001. We see continuing strong earnings and revenue growth in this segment.
In our view, Nicor's diversified business model provides the company with the ability to achieve slightly better-than-peer-average earnings per share (EPS) growth. The company's three reporting segments provide both a stable base at the utility business, we believe, as well as a growth platform at the shipping and other energy ventures businesses.
Operating earnings at the shipping unit increased at a compound annual growth rate (CAGR) of roughly 23% between 2001 and 2006, while operating earnings at other energy ventures posted a CAGR of about 40% over the same period. The operating earnings growth at these unregulated businesses has mostly offset an average decline of about 10% annually at the utility business. With the earnings of the unregulated businesses rising substantially in relation to total earnings, we expect that they will become increasingly important in driving earnings growth at Nicor.
Considerable Financial Flexibility
We expect the price for an average natural gas utility stock in our coverage will appreciate by about 7% over the next 12 months, assuming no changes to the fundamentals of the companies. As a result, we believe that Nicor's stock has the potential for a 7% gain built into it. In addition, we expect that the company's discount valuation and substantially higher-than-peers dividend yield of 4.1% will attract investors to the stock. Therefore, we see additional multiple expansion on top of the peer group gains we foresee. We believe that Nicor's fundamentals are solid and that the company's strong balance sheet provides it with considerable financial flexibility.
We expect Nicor's EPS to achieve a three-year CAGR of about 8%, roughly even with the company's peers. Our 2007 and 2008 EPS estimates are $2.86 and $3.05. Our S&P Core EPS estimates of $2.57 and $2.74 in 2007 and 2008 reflect pension adjustments.
We believe a very strong balance sheet gives the company considerable financial flexibility. In our opinion, this flexibility should allow Nicor to begin raising its dividend again beginning in 2009 as we see the dividend payout ratio falling below 60%, to a level close to the peer average. Additionally, the company is authorized to repurchase shares totaling $21.5 million. With debt-to-capitalization currently near 40%, we believe Nicor is in a good position to resume share repurchases should it so desire. However, the company has not repurchased any shares in the past few years.
Nicor's stock recently traded at 15.9 times our 2007 EPS estimate, or a 9% discount to the company's gas utility peers. Given the company's financial flexibility and peer average earnings growth expectations, we believe the stock should trade roughly in line with its peers. Our 12-month target price of $53 reflects our expectations for a 12-month peer target p-e of about 18.7 times 2007 EPS. Our peer target multiple reflects our expectation for normal multiple expansion over a one-year period.
Positive Corporate Governance Practices
Our view of Nicor's corporate governance is generally positive. Some of the practices we view favorably are that the board is controlled by a super-majority of independent directors, the performance of the board is reviewed regularly, the audit and compensation committees are entirely comprised of independent outside directors, the company does not have a poison pill, and officers and directors have a vested interest in Nicor, owning a combined 1.1% of the outstanding stock. However, an area of concern for us is that the chairman of the board and chief executive officer roles are filled by the same person, which we believe presents a potential conflict of interest.
Risks to our recommendation and target price, in our view, include the potentially unfavorable resolution of ongoing regulatory issues, slower-than-projected growth in unregulated operations and increasing gas prices that could lead large customers to switch to alternative energy sources.