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by Carlo Svaluto Moreolo

Utilities may look dull and complex at a first glance, given their predictability and heavy regulation, but this is one of the most exciting sectors to invest in. Whether it is M&A, rising commodity prices or its defensive nature driving investors towards it, the utility sector has not disappointed. The FTSE 350 Gas, Water & Multi-utilities index has more than doubled since bottoming in 2003. Even after a tough year for equities, the FTSE 350 Utilities index has returned 30% since May 2007.

This success is essentially because privatising utility companies, a small industrial revolution orchestrated by Margaret Thatcher’s government in the early 1990s, was a great idea. By being owned by investors, focused on profits the specialised utility companies can run efficient operations for their customers and successful investment stories for their shareholders. This could not be achieved without the regulators, nightmare and saviours of the sector, who ensure customers are serviced properly while guaranteeing shareholder returns.

Recent developments suggest the near and medium-term future should be rosy too. M&A propelled share price rises across the sector, especially through 2006, with private equity players and infrastructure funds bidding for water companies, attracted by predictable cashflows. More recently investors have turned to utilities as a haven in potentially stormy markets.

Ups and downs of regulation

The risk profile of the sector is low and therefore attractive, as the companies involved are highly cash-generative and provide a vital service. The market does currently discount the risk that companies might find it difficult to fulfil their complex debt requirements in such difficult credit markets, but clear cashflow patterns make utilities highly bankable. Revenues are predictable given the regulation of the sector, which allows firms higher levels of gearing.

Regulation is sometimes seen as a double-edged sword. Watchdogs could become overzealous and make life for companies too difficult with a lot of red tape. This is what some water companies fear at the upcoming 2009 price review, when regulator Ofwat decides by how much companies can raise bills. The round of consultation closed at the start of the year and Ofwat clearly wants some complex regulatory changes. The utilities are not happy and Northumbrian Water has criticised the regulator for using too many sticks and too few carrots. It is worried that the new proposals may throw up uncertainty in the market as several details have yet to be developed.

The proposed changes so far include the introduction of ‘menu regulation’ for capital investment, which will mean companies are less free to choose what investments they make.

Northumbrian also argues that the draft review methodology makes no mention of the increased energy costs the water companies also face.

The regulator may come across as heavy handed, having fined in the past year companies such as Severn Trent and Thames Water, for poor services and irregularities. Yet just a few weeks ago Ofwat has called for the UK water and sewerage sector to be opened up. Releases of news about fines have been relative drops in the ocean for the companies involved and the share prices have barely flinched.

Returns on investment

Regulatory reviews occur usually every five years for each sector (electricity and gas distribution, electricity transmission, and water). Just about everything is set out by regulatory reviews, from cost of capital to the level of cover for dividend payments, which is a bonus for investors as it means they are almost guaranteed. Companies in turn have to ensure a certain level of efficiency and investment. With operating costs, the whole review translates into the level of increases in customer bills over each regulatory period that the companies are allowed to implement

The companies’ concerns in the case of the 2009 water review may be justified, but investors know the review process is a game of give and take, which usually ends with the companies achieving beneficial changes. In practice, in past years the system has been efficient and provides the stability to the sector that makes it such a haven. At the last review in 2004, the industry was allowed to raise bills by an average of £46 over five years or 18%. Northumbrian for instance was allowed a 12% average increase in bills, and profits between 2005 and 2007 have increased 49% to £148 million.

But if everything is decided beforehand, why should investors get excited? The trick is that if utility firms manage any further investment above what is required, and if they beat the benchmark for efficiency levels, they will enjoy the additional returns. This is essentially the reason why utilities have enjoyed good growth over the past few years, and are likely to continue doing so. Much of the UK’s power transmission and distribution network, let alone the water distribution systems, is old. The need for investment remains, regardless of how many people come to live in the UK, so while utility firms cannot overcommit to repair or refurbish systems, additional investment will drive the growth of their top line and profits.

Steve Lucas, finance director of National Grid, explains how the model works for his company: ‘A business such as National Grid, which is 95% regulated, has an asset base which is what its allowed returns are calculated upon. The more we increase our assets base, the higher our returns will be.’ Lucas believes investment is needed as the country changes the profile of power supply. National Grid, for one, has recently built gas inter-connectors and LNG facilities for gas coming to the UK.

He adds that green energy is another positive trend for the sector. ‘When it comes to new onshore or offshore renewable generation, sometimes power has to be transmitted to different ends of the country and the networks need to be reinforced, which is a great investment opportunity.’ Both larger companies, such as Scottish and Southern Energy, and smaller players already have active renewable energy investment programmes, and as they gear up their portfolios their generation will need to be connected to grids and distribution systems.

Lucrative M&As on the horizon

Another cause for excitement is that M&A activity may come back into fashion. British Energy, the nuclear generation giant, is talking to other companies for a possible sale of its assets. This comes as the UK government tries to kick off an investment programme for new nuclear energy capacity, as nuclear may be an answer to carbon dioxide emissions and the need for new capacity. British Energy has access to the best sites, and other companies want a slice of the cake. Bidders are coming from all over Europe and Centrica is also a strong candidate. Most probably, the market will witness a consortium bid for British Energy, with the government selling off its stake.

Looking at other segments of the industry, private equity mavericks may not have access to debt to fund deals any longer, but less highly leveraged infrastructure funds are still capable of doing deals and it would be no surprise if any of the water companies were approached.

While rising commodities are a danger as they increase companies’ operating costs, they could also be seen as a catalysts. Customers rightly complain about rising bills and will always do so. However, there is little utility companies can do to offset the rise in their costs, particularly if the sharp increase in commodity prices proves to be a more established trend, it will be generally accepted that rising prices, which are the utilities’ raw materials, are almost entirely passed on to customers. Regulators know that the primary focus for companies is running a smooth, efficient business, and this cannot be done if companies scramble to keep bills low while overlooking their capital requirements. For this reason their revenues are virtually guaranteed making exposure to the utilities sector vital for any portfolio.

Key indicators

The economics:

• Demand for energy

• commodity prices

• cost of finance

• level of investment required on networks

• level of return on assets regulators allow

• regulatory reviews – water prices to be set for 2010-2015, transmission and gas distribution price controls set for 2008-2013

TOP ANALYSTS

Lakis Athanasiou – Evolution Securities

All depends on oil

It would be fair to say Lakis Athanasiou is among the very best analysts in the utilities sector. His experience, opinionated views, and the scope of his research are exceptional.

Athanasiou started his career with Mobil Oil, working on the UK refining industry, then did a lot of work as a consultant for private firms and the World Bank. He joined the City at the end of the 1990s, working first at UBS and then setting up a top-rated team of utilities analysts at Commerzbank. He joined Evolution Securities, where he is currently working, last December after a few years at Collins Stewart.

Athanasiou can give the inside track on the sector, whether it’s water, transmission/distribution or generation. You only have to pick one of them and he’ll give you a strong steer.

About the water sector, he reckons Ofwat has always been very generous with companies, even though returns on water companies’ assets have diminished over time.

On Ofwat’s call for more competition, he says: ‘Ofwat’s overemphasis on competition is a worrying trend. The regulator should worry more about the firms’ capital structure.’ About the generation sector, and the nuclear opportunity, Athanasiou says it simply depends on oil prices. ‘What’s the long term trend? If oil prices go back below $40, the nuclear programme will be scrapped. If they stay above $70, no matter what the capital expenditure is, nuclear will be hugely profitable.’

Colin Pollock – Credit Suisse

Big deals still on

Perhaps M&A activity won’t be as strong this year as it has been in the past two, but deals are still on the cards, Colin Pollock of Credit Suisse suggests, as ‘trade buyers still have strong balance sheets and infrastructure funds are still in the market.’

Pollock holds a degree in electrical engineering and prior to joining Credit Suisse’s equity research department two years ago, worked in utilities M&A at Credit Suisse and Rothschild. He reckons that, other than the M&A drive, the sector has changed quite dramatically following the sharp rises in commodity prices. ‘Utilities have to take a clear, more sophisticated view on risk management.’

Higher commodity prices mean margins are under pressure unless these are ultimately passed to consumers. This is an opportunity, Pollock believes, rather than a threat. ‘Affordability of bills and risks of government intervention are weighing on sentiment at the moment, but we believe ultimately firms will seek to pass wholesale price increases through to customers’.

Also, there is a ‘huge amount of investment required’ that will favour the economics of the sector in the medium term, even if commodity prices flatten out, Pollock adds.

Global carbon trading and alternative energy are two other big opportunities. Yet, he admits that the market is, wrongly, over-discounting refinancing risk, due to rising debt costs.

Iain Turner – Deutsche Bank

Nuclear faith

Iain Turner, five-star analyst (Starmine) at Deutsche Bank, does not doubt the UK government’s commitment to nuclear power, or that nuclear plants will be built: ‘I am sure nuclear is going to happen. If we are serious about carbon we have to build nuclear capacity. There are a few issues that need to be resolved, like planning, but it is an inevitable development unless we suddenly change our minds about carbon emissions.’

Turner has been at Deutsche Bank for ten years, after two at UBS. But he began by working directly in the UK utility sector, as he was a corporate strategist before becoming an analyst.

He has strong views about water, too. The water companies have complained to Ofwat that new requirements at the next review are too complex and punitive. But he says: ‘The water sector is mature now and needs strong incentives to perform. Companies have for instance talked up their capital expenditure requirements and the proposed modifications are addressing that. They are pretty sensible. The incentives for companies to be efficient for example haven’t been strong enough and they need to be ramped up.’

Turner agrees too that the equity market is too pessimistic about companies’ abilities to refinance debts, perhaps because it doesn’t strictly follow the credit markets. He cites National Grid: ‘it’s clear that if you are a sensible company, with strong backing by the regulator, you are going to be able to raise funds in the credit markets.’

BEST BUYS

National Grid - Focus and change

The owner of the UK’s electricity transmission network is one of the safest plays in the current economic climate. In 2007 it announced a more focused strategy in a year of transformation. It got rid of some non-core operations, such as its wireless business, and re-focusing on the UK and the US, selling off some Australian assets. In the US National Grid bought KeySpan, a huge business servicing the north-east, including New York City. The acquisition is now integrated and provides a solid platform for growth.

Full-year results to March showed a 24% rise in pre-tax profits to £1.8 billion and the dividend was raised 15% to 33p.

Going forward, the company should continue growing as it invests in its UK and US assets.

An ongoing share buyback programme, progressive dividend policy, and special payouts from asset sales return cash to shareholders. The shares touched a high around 856p late in 2007 and have since fallen to around 728p, following the main indexes, but there’s a possible boost. Germany’s E.ON has said it is looking for a buyer for its transmission assets, and it’s pretty clear National Grid is considering it.

Currently the shares trade at a discount to other utility companies on a PE of 12.3 – unjustified given the quality and potential growth of the company.

British Energy - Suitors line up

The UK’s largest power generator put itself up for sale in March, after the government made noises about wanting to sell its 35% stake. The company has access to the best sites for potential new build, and many European utilities want to play a role in the proposed expansion of UK nuclear generation. Germany’s RDW and E.ON, EDF of France, Iberdrola of Spain and the UK’s Centrica are all interested, and are exploring ways to come up with a sensible bid.

One of the likely possibilities is that a number of consortia will bid together. Evolution Securities analyst Lakis Athanasiou sums up the ‘fundamental drivers’ of the deal: the government wants to get as much cash as possible for its stake, more than one player wants to develop new nuclear, and all of them want to ‘alleviate any competition issues arising’.

Athanasiou values the company’s existing assets at 550p, and adding up the new nuclear option and a modest level of gearing to fund the acquisition, a buyer would look at 825p, more than 13% up from the current 730p price. This is based on long-term electricity prices of £44 a megawatt and crude oil price of $55 a barrel. He thinks that a contested bid at these levels could reach 890p but says that higher long-term oil and power prices could boost the value to as much as £12.

KSK Power Ventur - Shares ride soaring sales

The Aim-listed Indian developer of power generation assets, has seen its shares rocket since the listing at the end of 2006. This year alone they have almost doubled to the current 630p, as the company’s sales and profits soared.

Energy demand in India is growing along with the economy and increasing generation capacity is vital. KSK has achieved a strong position in this market, through forging relationships with clients and financiers.

The model consists of sourcing off-balance sheet debt and equity and securing energy off-take contracts with clients that are mostly industrial firms, to which it sells energy at attractive prices. The project finance model means that KSK bags revenues both during the construction and operations of the plants.

A joint venture with Lehman Brothers has given it a boost, but the management has a nine-year track record of delivering power plants. As of December 2007 the company had 210 megawatts of operational capacity from six power plants and 7000 megawatts either under construction or in the pipeline.

In the six months to December the company quadrupled turnover to $13.5 million. It is currently studying a potential Indian IPO and it is floating an asset management business on Aim.

STEER CLEAR

Drax - Under a sooty cloud

The main business is operating the UK’s largest coal-fired power plant, near Selby in Yorkshire, which doesn’t bode well with green energy on the agenda.

The company said last December it had to focus on compliance with the Large Combustion Plant EU directive, coming into effect this year and essentially requests polluting plants to reduce harmful emissions. Drax bosses then said ‘we expect this legislation to provide a challenge for the power generation industry’. Soon after the company ruled out a proposed special dividend saying high and volatile coal and power prices would hit the P&L, and added that due to the credit crunch a refinancing of its debt had to be scrapped. Full-year results in March confirmed these fears with pre-tax profits down 29% to £449 million.

Since bottoming at 486.75p in January, the shares have performed strongly in better trading conditions in commodity prices, and currently trade around 697p. The shares appeared to be tracking the UK dark green spreads, the gross income from selling power after subtracting coal prices and carbon allowances. These have widened sharply but analysts suggest this may be over. Dark green spreads are likely to fall in 2008, with firm coal prices, unless the bull run in oil prices continues. This means Drax’s operating profit could shrink throughout the year, taking the share price down. Another boost, the chance that Centrica may seek to buy the company, is less likely now Centrica appears to be a suitor for British Energy.

Pennon Group - Sinking against its sector

The shares were trading above 700p a year ago but have slipped in 2008, falling 6% since January to 639.5p.

Pennon invests in water and sewerage services and waste management, with assets of around £3 billion, and operates through two subsidiaries, South West Water operating water and sewerage services in Devon, Cornwall and parts of Dorset and Somerset, and Viridor, the group’s national waste treatment and disposal business.

The company announced in March it had bought Shore Recycling, an electrical and electronic equipment waste recycling firm, in a £23 million deal. This Scottish firm will expand the waste management business but the news failed to impress the market. Since then the government has turned down South West Water’s applications to discharge effluent into the Atlantic after a public inquiry.

Management said in February that full-year results, to be released on 5 June, would be in line with expectations, but the shares look too expensive, trading at a 2008 PE of more than 18 versus a sector average of less than 13, and the forward dividend yield of 3.11% is lower than the sector’s 4.7%. In the past three months analysts have upped 2008 estimates but downgraded forecasts for 2009.

Clipper Windpower - Costs take wind from its sails

Since joining Aim in late 2004, shares in the California-based wind energy firm have risen from 200p at float to 900p last May, since drifting back towards 600p.

Clipper’s business of selling wind turbines has been growing, along with its portfolio of wind farms, but poor margins led to a loss of £96.6 million in 2007. After high component costs, it said ‘normalised’ EBIT margins should be achieved next year. This year, consensus is losses will fall to £5.5 million meaning the shares’ valuation metrics are too expensive. Yet, in March the company announced it had bagged £25.2 million issuing 4.7 million new shares at 537.5p each. Later JP Morgan’s private equity arm put in $150 million. Despite ongoing news of projects and deals the shares have performed poorly. The latest news is that Finn Hansen, senior vice president of operations, and Brent Dehlsen, chief operating officer, are becoming non-execs. In the past three months, analysts have cut 2008 pre-tax profit estimates by an average of £17.2 million and £22.5 million for 2008 and 2009 respectively: a signal to sell.

RISING STAR

Lightning in a bottle

Steady growth and solid track record puts power provider Rurelec on the map

Peter Earl’s burgeoning energy businesses in South America and around the world really captivate the attention. He is the managing director of Aim-listed firms Rurelec, a Bolivian power project developer and generator, and IPSA, the South African independent power provider, as well as the founder of private power business Independent Power Corporation (IPC).

Earl’s knowledge and experience of world energy and politics, and his enthusiasm for his own businesses, make him well worth listening to. He started at the Boston Consulting Group advising state-owned companies and working with ministries of finance and central banks in Abu Dhabi, Albania, Kuwait and Saudi Arabia. He became an expert in cross-border takeovers, which earned him appointments by the World Bank and the United Nations Development Programme as an adviser on privatisations in Latin America and Eastern Europe.

He’s electric

He also had a key business partner, in Lord Colin Moynihan, former energy minister under Margaret Thatcher, and member of the team that carried out the privatisation of the UK’s state-owned power firms. By 1995, they had founded IPC, having acquired a 50% stake in a huge power plant in Kazakhstan, and it has since owned, developed and operated 3,400 megawatts of power projects around the world. Earl’s Aim ventures Rurelec and IPSA were set up with IPC as their parent company.

Rurelec owns the largest generator in Bolivia, Guaracachi, which supplies 40% of the country’s electricity demand. It has registered good earnings growth with turnover up 449% to £20.7 million in 2006, and is on its way to become a top player in the South American market. ‘We want to become a utility there, rather than simply an independent power provider. However, we are always adding capacity, as the market Rurelec operates in is really strong. Argentina has grown at 8% for five straight years, and Bolivia, Chile and Peru are growing quickly too. Electricity demand is usually 1.5 times GDP so you have to build plants pretty damn quick just to keep up with it.’

A strong demand growth story is not enough for Earl. ‘We build power plants where the regulatory system is bankable, or in South Africa where we have contracts with big bankable companies who enter into a 15-year contract with us to buy power,’ he says ‘We are fairly choosy with the countries we operate in. We will not operate in Brazil because of the regulatory risk or Ecuador and Venezuela where the political risk is higher.’

As well as the earnings growth, what is phenomenal about Rurelec is that it has added around 20% of capacity a year for the past three years (25% last year). Earl says this was achieved through the company’s own cash and through project finance. Rurelec’s banking partners in South America secure off-balance sheet debt or issue bonds to finance the projects. Its major partners are Chilean Banco De Credito and the Andean Development Corporation (CAF). ‘We recently did a $20 million bond issue, with a ten-year maturity, at 8.5% and unsecured. At one point we were borrowing at better rates than Citibank,’ he says. ‘We’ve got a good track record of building profitable power plants on time, and are securing project debt while there is a banking crisis in the rest of the world.’

Cash cow

Another exciting prospect for Rurelec, which could soon turn into a cash cow, is the company’s carbon credit business. The UN has just awarded Rurelec its first carbon credits for one of its projects, almost 150,000 tonnes per year of C02 reductions which the company can sell. Earl says ‘this underpins the fact that all our new plants are super green. It will become another income stream and it will be much easier for analysts to forecasts how much money we will be making.’

That said shares in Rurelec or IPSA have not reflected the potential they offer so far. ‘Share prices do not always reflect the fundamentals,’ Earl points out. ‘Rurelec closed at 62.5p, up almost 5p on the day as we announced our carbon credits. We should be closer to £1.50 to track the equivalent Chilean power companies. The problem is that we are not well known in the UK except to the large institutions.’

Perhaps Rurelec and IPSA would benefit from a main market quote. ‘That could happen if they merged with a similar portfolio of profitable, cash producing power plants,’ he says although there are no firm plans to do so. What is certain, however, is that with Earl’s experience it is reasonable to expect that both companies will achieve their goals and if this happens a rise in the share prices will not be far behind.

30 second Rurelec

• Added 20% of capacity a year for the past few years

• 2007 interim dividend was increased 11%

• Bolivian subsidiary Guaracachi supplies 40% of the country’s demand

• Awarded 150,000 of carbon credits a year for its Argentinian facility

• Secures funds for new power plants through project debt from local banks

• CEO Peter Earl earned a reputation advising on electricity privatisation deals in the 1990s

CHARTING THE SECTOR

The value of playing it safe

The FTSE 350 Utilities index has seen huge returns in recent years: if that’s boring then chartists can enjoy being bored to tears

by Simon Griffin

The utilities sector perhaps surprised many with the extent of the growth it achieved during the 2003 to 2007 general market bull run. In that time, the FTSE 350 sector index registered a return of 143%, that’s an annualised compound rate of growth of nearly 20%, not bad for a ‘boring’ sector.

Certainly the chart shows that a bull channel dominated the market with the index climbing above the channel return line late in 2006, then falling back into the channel in June last year before mounting a further test of resistance from the channel return line and the previous highs close to 5200 at the end of 2007.

The chart over the past 18 months will have undoubtedly encouraged some to call a double top pattern which would target a move down to 3600, however, this pattern would certainly not be confirmed before the index dropped and closed below 4400 (4310 for safety). To the contrary, helped by the rising trend in the RSI momentum measure, it seems that this latter level is holding solid and leading to a minor bullish saucer shaped base developing, though the cautious will await a close above 4600 before focusing on the potential for gains back toward 5200.

What happens if and when this level is re-tested, will be critical to the longer-term direction of the sector but it could be that in uncertain times its ‘safe but boring’ status might yet continue to drive the sector forward.

National Grid (NG.)

BUY - 726p

TARGET - 792p

STOP LOSS - 703p

As the largest sector constituent by capitalisation, the chart of National Grid is mimicking the sector index. Back at the end of March we prematurely turned positive on the stock at 722p but were stopped out by low ticks that saw it close at 691p. Nevertheless the shares have continued to base off the potential ‘neckline’ of the large double top that has been developing over the last eight months.

This defines the key level at which the picture turns bearish, should it be conclusively broken below. So, it gives bulls an excellent level at which to place protective stops. The line is currently just below 700p so any close below 685p would point to further significant weakness toward 525p.

However, having made a symmetrical channel downside excursion to the upside one seen a year ago, the shares have moved back above their 50-day average once more and show all the signs of commencing a recovery with a move above 755p set to recover the bull channel base line, which had previously been solidly supportive since December 2004.

Not far north of this level, currently at 765p, is the 200-day average, the regaining of which would add to positivity. It would not be surprising to see the shares once more above 800p.

Drax Group (DRX)

BUY - 724p

TARGET - 670p

STOP LOSS - 850p

This is a great traders’ stock, for in its relatively short life, it has all but doubled in its first 18 months and then subsequently declined in waves during the following three years back to retest its launch lows.

This rise and decline have been nicely defined by the two moving averages we like to focus on (the 50- and 200-day) with their relative relationship defining the overall trend, having bearishly crossed at the end of 2006. The chart also has a clear bear trend line drawn off the highs seen since the peak at 972p in August 2006 and the ‘memory’ of the market is exhibited by the importance the shares place whenever 722p, 585p or 487p are approached. The recent break above both the 200-day average and the bear trend line is obviously positive.

This would complete the target derived from the recent bull pennant that developed on the chart as the 200-day average came under pressure. There is a risk that a correction back to 638p might transpire. However, if 722p is successfully tested, further gains would then likely then focus on 850p.