This article appeared in the February 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
High, sustainable yields main attraction in utilities sector.
By Nathan Bell, Intelligent Investor
There is nothing better than low interest rates for utilities companies with high debt. Take a seemingly boring utility such as Spark Infrastructure, for example, which owns a highly geared portfolio of electricity networks in Victoria and South Australia.
As rates fall, its interest costs fall too, allowing Spark to take on more debt and increase distributions to shareholders. What's more, investors fed up with measly term deposit rates are willing to pay more for the inflated dividend stream, leading to rapid share price growth.
The intoxicating combination of capital growth and yield has lit up stocks such as Spark. In 2014 the S&P/ASX All Ordinaries Accumulation Index increased 5 per cent, while the Utilities Accumulation Index increased 16 per cent and the Telecommunications Services Accumulation Index rose 21 per cent.
Electricity retailers such as AGL Energy and Origin Energy are suffering from the switch to solar power, but with interest rates potentially falling further in 2015, the appeal of utilities shows no signs of abating. Investors would be wise to temper their expectations, given such strong share price appreciation recently, but let us sift through the various utility sectors to see if there is any value.
(Editor's note: Do not read the following ideas as stock recommendations. Do further research or your own or talk to a financial adviser before acting on themes in this article).
Anyone who has parked at an airport knows why airports make such wonderful businesses. Whether you are a passenger, airline or retailer, you know you will have to pay at monopolies such as Sydney Airport.
Sydney Airport and its cousin across the Tasman, Auckland International Airport (AIA), both expect to serve twice as many passengers by 2030 thanks to larger populations and the growth of newly affluent Asian tourists. That makes a growth rate of 5 per cent and when you tag on the regular airline fee rises of 1 to 3 per cent a year, earnings growth is all but guaranteed.
Sydney Airport is our preferred pick. It's more profitable, trades at a lower valuation and, despite carrying a lot more debt, the interest costs are lower and the average maturity date of the debt is eight years, compared to just three for AIA.
Unfortunately neither are cheap. Sydney Airport and AIA's share prices increased 24 per cent and 20 per cent respectively in 2014, but they yield 5.3 per cent and 4 per cent respectively and should handily beat term deposit rates over the next decade.
Despite successfully buying infrastructure stocks since the GFC, Intelligent Investor has continually underestimated another great monopoly - toll road operator Transurban Group. It operates almost every major toll road on the east coast and increases profits by acquiring roads (often after the previous owners have gone bust) and integrating them into its network to improve traffic flow while eliminating duplicate management costs.
That said, we are still scratching our heads over the company's recent purchase of Queensland Motorways for $7.1 billion, which is 34 times free cash flow and more than twice what the road sold for in 2011. It will take a stellar effort to make that acquisition work and with Transurban trading on a 4.2 per cent yield, we are prepared to wait for a lower share price before upgrading our recommendation.
More efficient energy use and the spread of renewable energy options, such as solar power, are short-circuiting the profits of the traditional electricity industry. After 100 years of growth, electricity volumes are falling.
Origin Energy's retail and generation business suffered a 24 per cent fall in operating earnings for the year to 30 June 2014, while AGL's retail division clocked a 10 per cent fall. Neither company will be able to grow at anything near the rates investors have become used to.
AGL's share price fell 10 per cent in 2014 but that is not enough yet to compensate for the risks, in Intelligent Investor's view.
Origin, however, has a 38 per cent share in the Australia Pacific Liquefied Natural Gas (APLNG) project, which is expected to generate $900 million a year in free cash flow when it reaches full production in 2017. It is almost 90 per cent complete, but often on projects of this scale the last 5 per cent can cause a major cost blowout.
Fortunately, Origin recently refinanced $6.6 billion of bank debt and increased its borrowing capacity by $750 million, bringing its total undrawn debt and cash position to $5.5 billion, without any major repayments due until 2019. This protects Origin from lower oil prices or a cost blowout.
Origin's stock price fell 17 per cent in 2014 and, along with a 4.5 per cent yield, today's price offers decent upside for risk-tolerant investors, provided the oil price in Australian dollars does not fall further and stays there for years.
While electricity retailing has been tough, some electricity distribution businesses that own the poles and power lines have been rallying. In 2014 Spark Infrastructure's share price increased 33 per cent in addition to paying attractive dividends.
A repeat performance in 2015 will be difficult. Regulators have clamped down on "gold plating", where operators upgrade their assets unnecessarily to earn a higher regulated return on the money spent. The Australian Energy Regulator (AER) is also reducing how much electricity networks can earn over the next five-year regulatory cycle starting in mid-2015.
In any case, like other stocks in the sector, such as AusNet Services, Spark trades at a massive 40 per cent premium to its regulatory asset base. In layman's terms, that is a lot.
TPG Telecom versus Telstra
Telstra's fixed-line voice and broadband revenues are now 16 per cent lower than three years ago, while TPG's have grown 60 per cent. TPG's cheaper prices and its customer service have helped it to consistently take market share.
While politicians have been arguing over the NBN, TPG is building its own fibre-to-the-building network. With accompanying deals that offer unlimited data at speeds of 50 megabits per second for $60 a month, we expect TPG to gain plenty of new customers in 2015.
Telstra, in contrast, is looking abroad and wants to earn a third of its revenue overseas by 2020. It is aiming to grow its Asian Network Applications and Services (NAS) business by making acquisitions, similar to its stake in Chinese car sales vendor Autohome, and expand into "eHealth Solutions".
With interest rates low, there is plenty of money chasing opportunities, especially highly cash-generative online businesses with an Asian growth story. Acquisitions will not come cheap and we are sceptical of any business that wants to dilute its strong market position at home in favour of waving its chequebook around in more competitive markets abroad.
It was only a decade ago that previous Telstra chief executive Ziggy Switkowski resigned after his Asian expansion strategy lost $3 billion.
On the surface, Telstra's current price-earnings ratio of 16 and yield of 5.1 per cent looks attractive. But there will be more competition in its key mobile business in 2015 and other parts of its business are in permanent decline. TPG offers better growth prospects but, after rising 32 per cent in 2014, the stock trades on a price-earnings multiple of 29, so it's no steal either.
Value in utilities is scarce but if interest rates fall to 2 per cent or less, most of the stocks mentioned could still produce attractive returns as investors bid up their prices.
Given the market's preoccupation with yield, you are more likely to find bargains by looking for what the market is not interested in: stocks that do not pay high dividends but offer capital growth for a reasonable amount of risk.
About the author
Nathan Bell is Research Director of Intelligent Investor Share Advisor (AFSL 282288).
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