Wednesday, 24 July 2013

Investing in Regulated Businesses

And British Sky Broadcasting

The visible hand of the regulator, image courtesy Wikipedia

The water and energy regulators discussed in the last two articles take a logical, generally long-term approach, to controlling their respective industries. The Office of Communications (Ofcom) lives in a very different world. Ofcom regulates the TV and radio sectors, fixed line telecoms, mobiles, postal services, plus the airwaves over which wireless devices operate. With 735 employees and a budget of 120 million pounds paid for by the industries it controls, Ofcom has the resources to get into every corner of each of its markets. Consider four recent pronouncements from its website:
1. 11 July 2013 - Ofcom announces new prices for landline and broadband prices. Prices are to fall by between Consumer Price Index (CPI) - 0 to CPI - 12% per annum.
2. 3 July 2013 - Ofcom announces that switching fees between broadband suppliers will fall from 50 pounds to 10-15 pounds.
3. 13 June 2013 - Ofcom decrees that there must be a post box within 1/2 mile of at least 98% of all 'delivery points', understood as being letterboxes of addresses.
4. 17 May 2013 - Ofcom announces that, in addition to monitoring the number of subtitles on TV, it will begin producing subtitle quality reports every 6 months.
No economic justification is given for any of these diktats.
Other recent announcements by Ofcom include research into nuisance calls, the award of the re-advertised FM local radio licence for Warminster, research into online password security risks, and a request to the UK’s advertising regulators to review the rules that limit children from being exposed to alcohol advertising on TV. After 50 rounds of bidding (yes fifty) for the 4G mobile auction, Ofcom names the four winners. They paid 2.3 billion pounds that will be recouped by these firms via higher charges from their customers. Large firms caught up in Ofcom's web include BT, Vodafone, ITV, BSkyB, and the Royal Mail.
Ofcom promotes competition by forcing companies in monopoly businesses to let other providers access to their markets via wholesale pricing.
1. BT was forced by Ofcom to create Openreach, which gives competitors access to its fibre optic super-broadband network. This is costing BT 2.5 billion pounds and it is a national objective for both the past and present governments. Ofcom controls both retail and wholesale broadband pricing.
2. Ofcom is arbitrating a complaint by BT that BSkyB is not giving it fair access to its Sky Sports 1 and 2 channels. The outcome of this dispute will have long-term repercussions on the business of both companies, though BSkyB can only be the real loser.
Unlike Ofwat and Ofgem, Ofcom has generally discarded the use of financial returns of the businesses under its control. While this disinterest in return on investment gives greater leeway to these companies, it also allows Ofcom to take decisions, which could prejudice the company concerned.
Any investor considering the purchase of shares in any company subject to Ofcom would be wise to:
1. Review recent Ofcom research papers and decisions. These are available from Ofcom's website.
2. Imagine how Ofcom might regulate new activities. Regulators become more controlling as they age.
3. Prior to the initial public offering by Royal Mail, Ofcom is already working out how it should be controlled.
4. Listen to the concerns voiced by politicians. Ofcom, like other regulators, has a sensitive ear to its political bosses.

British Sky Broadcasting (BSkyB)

British and Irish Lions Vs All Blacks, courtesy Wikipedia

BSkyB has built up a 13-billion pound business from providing TV coverage of sports that previously cost the viewer nothing. The company has 10.8 million household subscribers that provide 82% of its revenue. This is a classic subscription business. The company has spent large sums to set a new market in sports and to build up a subscriber base by offering a unique service - TV sports and entertainment channels not available on Free TV. BSkyB cross-sells other services, presently broadband, telephone and betting. Advertising completes the revenue stream.

Revenue sources are:
1. Subscribers to the TV and broadband service paid 5.6 billion pounds in 2012. These revenues have been growing by 10.3% per annum since 2008.
2. Wholesale revenue from third parties, competitors such as Virgin Media and BT, that paid 351 million pounds in 2012. These have been growing by 18% p.a. since 2008.
3. Advertising, 440 million pounds in 2012, which has been growing by 5.8% p.a. since 2008.
4. Installation revenues of 98 million pounds that have been declining by 22% p.a. in the last 5 years.
5. Other revenues, such as betting, that amount to 309 million pounds. This has been growing by 8.3% p.a.

BSkyB has more than twice the number of subscribers of its nearest competitor, Virgin Media (recently acquired by Liberty Global). The company has an excellent record of earnings and cash generation. Consider:
1. Earnings per share have increased by 16% p.a. in the last 4 years.
2. Net margins (profit before tax/revenues) were 18% in 2012.
3. Return on capital employed (debt + equity) is currently running at 26%.
4. 5-year operating cash flows (after deducting capital expenditure and interest payments) totalled 3.4 billion pounds, twice covering the dividend payout and leaving 1.7 billion for share buybacks, acquisitions and debt reduction.
5. BSkyB bought back 697 million pounds of shares in 2012 and it has announced a further 500 million buyback for 2013.
6. Net debt of 1.3 billion pounds in 2012 could be paid back with 1.3 years' operating cash flow.
7. The balance sheet is clean of defined benefit pension scheme liabilities.

BSkyB shares (in blue) have handsomely outperformed the FTSE All Share (in green) in the past 5 years:


Graph courtesy of Yahoo, click to enlarge 

BSkyB's shares, currently at 842p, are valued on a forward price earnings ratio of 14 and a forward yield of 3.5% (the year-end is 30 June and results will be announced shortly). My valuation model values BSkyB shares at 1100p.*
*Earnings per share growth 10%, return on capital employed 26%, an average PE ratio of 17, and 12.2% discount rate based on BSkyB's cost of debt of 5.2% plus 2% for operating risk and 5% as a margin of safety, for the years 2014-18. 

Liberty Global valued Virgin Media (acquired February 2013 for 15 billion pounds) at about twice the current value of BSkyB: 

What Liberty paid for Virgin M.
 BSkyB at 842p
57 times
16 times*
3.7 times
2.0 times*
Price per subscriber
3,400 pounds
1,250 pounds*
*For the year ending 30 June 2012 

The low price put by the market on BSkyB shares is probably due to the Murdoch effect. The Murdochs are mistrusted in the UK and the Murdochs control 39% of the voting stock in the company. James Murdoch is a director (he stepped down from being Chairman). In June 2010, News International offered 700p for the shares in BSkyB and the Board replied that it would not sell for less than 800p. News International pulled out of negotiations at the time the phone hacking scandal by newspapers owned by News International caused a public outcry in the UK.

Other factors counsel caution:
1. BSkyB's credit rating is BBB+ (S & P). This is only three notches above junk.
2. Ofcom and BSkyB are at loggerheads about what competitors should pay for access to BSkyB's sports channels. The issue is currently with the Competition Appeal Tribunal. An adverse ruling would have an adverse effect on BSkyB's business.
3. Liberty Global's recent acquisition of Virgin Media at a fancy price must now be justified. BSkyB subscribers and BSkyB ties with the sporting world will be two of their targets. The new CEO of Liberty's Virgin Media subsidiary is a former BSkyB executive.
4. BT has spent close to 1 billion pounds to compete with BSkyB's football offering.
5. Improved technology could cause BSkyB's satellite dishes and boxes to become redundant.
[NOTE: the next article will appear on 7 August]


Wednesday, 17 July 2013

Investing in Regulated Utilities (part II, Energy)

And Centrica PLC

The visible hand of the regulator, courtesy Wikipedia

The previous article discussed the water utility companies, which are subject to the price controls, capital expenditure and performance targets of the regulator Ofwat. The regulations for energy companies are more complex than for the water utilities.
Government policy towards the energy companies is complicated because:
1. The UK has agreed to meet reduced carbon emission targets. And this is expensive:
·         The UK must move away from fossil fuels. The cost of renewable energy sources are, with the exception of hydroelectric power, higher than for fossil fuels - gas, coal or oil.

·         Energy saving is costly in the short term. For example, subsidies for building insulation take years to payback.
2. The UK is a major producer of fossil fuels.
3. The Government burnt its fingers with nuclear power. The cost of decommissioning all the nuclear plants in the UK was estimated by the Public Accounts committee, in February 2013, at 100 billion pounds. The government has indemnified British Energy for the vast majority of this decommissioning cost.
4. Unlike water, energy prices fluctuate wildly and are determined at the international level.
5. The energy business is nearly 9 times the size of the water business by revenue. The cost to the householder of gas and electricity far exceeds the cost of water and sewage.
The government offloaded these concerns onto the energy regulator the Office of Gas and Electricity Markets (Ofgem). With 593 staff, Ofgem monitors and controls 10 energy companies. The energy sector is split between activities which are economically regulated (energy distribution networks) and activities which are market-based (energy production and retailing). The latter are still subject to Ofgem's service and social objectives. And Ofgem is not reluctant to impose heavy fines.

As the present price controls for energy distribution end in March 2015, the regulator published in 2013 a new model to set pricing and controls for the 2015-2023 period. In Ofgem's words ( Strategy decision for the RIIO-ED1 electricity distribution price control):
" RIIO-ED1 is the first electricity distribution price control to reflect the new RIIO (Revenue = Incentives + Innovation + Outputs) model. RIIO is designed to drive real benefits for consumers. It will provide the companies with strong incentives to step up and meet the challenges of delivering a low carbon, sustainable energy sector at a better value for money than would have been the case under our previous approach."

More explicitly, Ofgem defines the 'challenges' as
1. Ensuring that the networks can connect and manage the new low carbon technologies and generation required for GB to meet its carbon targets
2.The need to manage their own environmental impact
3.Social issues, notably the need to address fuel poverty and the treatment of vulnerable customers.
It is, perhaps, not surprising that, with so many staff to work on the price and service controls for 2015-2023, Ofgem's proposals are complex and, to an outsider, incredibly bureaucratic and imprecise. About the only solid data in the 58-page document is the proposed return on equity for the industry, which will be set between 6 and 7.2%. This is low. By controlling the return on equity, instead of return on regulated asset values, the regulator intends to control directly shareholder returns.
This complexity is illustrated by Ofgem's chart on price controls for energy distribution:

The four UK quoted energy companies are engaged in the following energy businesses:
Gas, nuclear, wind
Coal, biomass
National Grid
Coal, gas, water, wind, biomass
*Subject to quality, service and social controls by Ofgem. **Subject to price controls too by Ofgem.

The wise investor will:
1. Review energy companies' annual reports for their abundant references to Ofgem.
2. Want to separate the business of distribution, which is subject to strict price controls, from the rest of the energy business (exploitation, production, retail and other), which is not.
3. Recognise that the new pricing structure and service regime, which is due to be announced in 2014 to begin in 2015, could have a serious impact on returns for companies engaged in distribution. By far the largest is National Grid.
4. Keep a weather eye on the statements of politicians and the Department of Energy and Climate Change.

Centrica PLC

Centrica sidesteps Ofgem's economic controls imposed on energy distribution by not having a distribution business. The company's business is split between:
1. UK retail gas and electricity (British Gas), which is subject to Ofgem's control via promoting market competition and setting service standards. Ofgem does not set prices. This business accounted for 40% of Centrica's operating profit in 2012. Centrica, according to the 2012 Annual Report, is concerned about the "regulatory creep" in this business. Operating profits are stagnant.
2. Centrica Energy's exploitation of energy sources that include gas, nuclear and wind. This is not subject to Ofgem and the business accounts for 45% of operating profit. Nuclear and wind have proved to be very poor investments (see below). Gas is very profitable and comes from secure sources, mainly in the North Sea. This is the main source of growth.

3. A UK storage business that relies for its profit on buying gas in the summer, when prices are low, and selling gas in the winter, when prices are higher. This accounts for 3% of Centrica's operating profit. Given shrinking summer-winter margins, Centrica will not invest in this business without 'government intervention'. Operating profits are declining.

4. A North American retail gas and electricity business subject to US and Canadian regulators. This accounts for 12% of operating profits. Centrica is aiming to increase its investment by add-on acquisitions. Operating profits are slowly improving.
Centrica is a profitable and financially strong company.
1. The company's net debt is a manageable 68% of equity, and Moody's gives Centrica's long-term debt an A3 credit rating.
2. Five years' operating cash flow (including capital expenditure) of 6.5 billion pounds paid for equity dividends of 3.4 pounds leaving 3.1 billion for acquisitions and buying back 500 million stock, announced in February this year.
3. Return on equity these last 5 years (2008-12) averages a healthy 18%.
4. Dividend per shares has increased by 8% per annum these last seven years.
Earnings per share, however, show a disturbingly uneven flow:
Earnings per
Earnings per
*As reported in the accounts. **Management figure adjusting for a large number of items.

In 2006, Centrica's management laid out four priorities for the business.
"1. Transform British Gas. 2. Sharpen the organization and reduce costs. 3. Reduce risk through increased integration. 4. Build on our growth platforms." (From Centrica's 2009 Annual Report).
Shareholders do not seem to have benefited from this plan. Centrica's share price (in blue) has underperformed the Gas and Water 350 utility index (in green), in recent years.

Courtesy Yahoo, click to enlarge.

A big part of this plan led Centrica to spend 2.3 billion pounds, financed by a mammoth rights issue, to buy 20% of British Energy in 2008. The other 80% is owned by EDF (Electricité de France). British Energy owns the nuclear power stations in the UK with 4 new plants envisaged. This investment accounts for 40% of Centrica's net assets. And Centrica does not control it. In the 4 years that have elapsed since buying 20% of British Energy, the business has produced a net loss of 37 million pounds (including a 231 million pound impairment in 2012). The impairment wrote off Centrica's investment in new nuclear plants whose cost had risen alarmingly. By pulling out of the new plants, Centrica is left with its investment in the nuclear plants currently operating.
Centrica's investment in wind farms has fared little better. It has made profit of 23 million pounds in the last 4 years on an investment of 533 million pounds. This is a return on wind farm investments of 1% per annum.
In 2012, Centrica acquired a stake in the Norwegian sector of North Sea gas for $1.6 billion.  In all, Centrica raised 5.8 billion pounds in equity and borrowings between 2008 and 2012 to acquire upstream assets in gas, nuclear and wind.
Centrica's policy of acquiring upstream assets with which to feed its retail operations makes sense. However, the enormous misuse of capital in nuclear and wind farms has dragged down earnings per share, diluted existing shareholders and increased debt. As the responsible Chairman and CEO are still in office, it is hard to know what they will do in the future.
At the present share price of 374p, Centrica is on an historical price earnings ratio of 16 and the stock yields 4.4%. Investors would do better to look at the better-managed SSE PLC in this sector - see





Wednesday, 10 July 2013

Investing in Regulated Utilities (part I, Water)

And United Utilities PLC

The visible hand of the regulator, image courtesy Wikipedia

Investors are attracted to utility companies for their steady income by way of dividend payouts. Although utility shareholders have made windfall gains from takeovers, investors expect capital gains to be modest. The FT's Gas, Water and Multiutility Index (in blue) have performed as one would expect these past 10 years. The shares that make up the Index (Centrica, Dee Valley, Igas energy, Modern Water, National Grid, Pennon Group, Renewable Energy Generation, Severn Trent and United Utilities) have proven to be less volatile and to produce less of a capital gain than the FTSE 250 (Midcap) Index (in green):

Graph courtesy of Yahoo, click to enlarge

Once the higher dividend yield of the utility companies is included (currently from 4 to 5.5%, compared to 2.7% for the FTSE 250), their overall return over 10 years is very similar to the 250 companies that make up the Midcap Index.
So far so good. But regulated utility companies are very different to non-regulated companies. Given that regulated utilities are often providing unique services to the public, government appointed regulators have extraordinary powers to ensure that the public are protected from monopoly pricing. This can be disconcerting for investors.
The water regulator, Ofwat, is in the process of determining the conditions and price controls for the water utilities from 2015 to 2020. Ofwat makes clear its main objectives:
"Our main duties are to:
  • protect the interests of consumers, wherever appropriate by promoting effective competition
  • enable efficient water and sewerage and water only companies to carry out and finance their functions
One of the ways we deliver our duties is to set the price, investment and service package that customers receive." (Ofwat website) 

Ofwat explains how the new price regime will take into account past efficiency gains by the water companies:
"Once price limits have been set, companies can make higher profits at no expense to the customer by outperforming the assumptions we make when we set price limits through efficiency and innovation. They earn these higher profits until the next price review, when the benefits are passed to customers through lower prices." 

In the past review, both United Utilities (by 13%) and Severn Trent (by 10%) reduced their dividend because Ofwat set prices that annulled the efficiency gains from the previous regulatory period. These gains had been passed on to shareholders. 

As each water company has to present a plan to meet Ofwat's objectives, it is impossible for the individual investor to assess how Ofwat's new price mechanism will affect the water companies' profitability. And to complicate matters, Ofwat will be setting separate prices for wholesale, domestic retail and business retail customers. 

The average dividend cover for the past three years provides some measure of the leeway the four quoted water companies have to absorb a more restrictive pricing regime:

Water company
Dividend yield*
Dividend cover*
Price Earnings Ratio**
Dee Valley
Severn Trent
United Utilities
                *Average over the past 3 years. **Current price/average 3-year earnings per share 

The latest dividend cover for each company and the latest dividend shows a growing payout on a declining cover:

Water company
Dividend yield*
Dividend cover*
Price Earnings Ratio*
Dee Valley
Severn Trent
United Utilities
                *In the latest year. **Pennon suffered losses on its non-regulatory business in 2012. 

One way that the water companies have found to improve their 'efficiency' compared to Ofwat's assumptions is to borrow at low interest rates. This reduces their weighted cost of capital. Hence, the water companies have relied heavily on loan financing to meet their capital requirements and to pay generous dividends, with the result that they are all heavily indebted:

Water company
Net Debt/Equity
3-year cash flow pounds mn*
Years  to pay off debt
Dee Valley
Severn Trent
United Utilities
                *Operating cash flow less capital expenditure for the last 3 years 

It is hard to see how these water companies will survive without issuing new equity. Some indication of the size of the equity issues that might be required to restore their balance sheets can be judged by the following table:

Water company
Pounds mn
Net Debt
Market Capitalization
Possible capital requirement*
Possible shareholder dilution%
Dee Valley
Severn Trent
United Utilities
                *New equity to reduce debt to 200% of equity and/or to cover the present cash dividend for 5 years, allowing for present cash flows. 

These are rough and ready numbers, but they do suggest that the new pricing review will be met with a call for new equity and/or a cut in the dividend payout.  

Investors should be very cautious when assessing these water companies. It would be wise to wait. Consider: 

1. Possible rights issues or placings will reduce the earnings per share and value of these companies' shares. 

2. Dividend payouts are likely to fall. United Utilities and Severn Trent reduced their dividend payouts by 13% and 10% respectively after the last Ofwat review. All four water companies will have great difficulty in maintaining their payouts. 

3. The uncertainty over the 2014 Ofwat review will depress water company prices. 

4. Against this, the recent (rejected) bid for Severn Trent valued the company at a 15% premium to the present price. This will help to sustain present prices. 

The water companies have until December 2013 to submit their plans to Ofwat. Ofwat will announce its new price mechanism during 2014.



United Utilities PLC

Tap water, image courtesy Wikipedia 

United Utilities (UU) shed its electricity business and a series of other businesses by 2008 and returned 1.5 billion pounds to shareholders. Since then, UU is a pure water and waste water business that covers the North West of England. All its business is subject to the price controls, capital commitments and other requirements of the regulator Ofwat 

UU's large capital expenditure, amounting to 3.5 billion pounds in 2009-14, is the equivalent to more than 2 years revenues. Hence, UU's management are as much engaged in managing new plant and infrastructure as they are in the sales, service and maintenance side of the water business. 

UU's share price (in blue) is back where it was 5 years ago:

Graph courtesy Yahoo, blue line for United Utilities, green line for the FTSE 250 Midcap, click to enlarge. 

Investors often see utility companies like UU as an alternative to bonds. The Ontario Municipal Employees Retirement System, the Kuwait Investment Office and the Universities Superannuation Scheme of the UK bid for Severn Trent. Two of the three bidders are in need of long-term income, which is something that water utilities can deliver. If necessary, these institutional investors can assume the utility's debt, which would be another source of income for their members. But the same conditions do not apply to individual investors.  

UU shareholders face an unappetizing future: 

1. In the latest Annual Report, management refers to the decline in both the retail and commercial demand for water.  

2. This year UU increased its dividend payout, but this just brings it back to where it was in 2009. 

3. Earnings per share have shown no consistent increase in the last 5 years. 

4. Net debt stands at 319% of equity and, in the last 5 years, operating cash flow (including capital expenditure) of 380 million pounds has failed to cover dividend payments of 1,235 million pounds. 

5. For a company that relies so heavily on debt, UU cannot be happy that S & P rate their long-term debt as BBB-. This is the lowest investment grade rating.  

6. In the current climate of austerity, it is unlikely that Ofwat will look favourably on improving the returns to investors. To the contrary, Ofwat has stated that, "These separate price controls will create stronger and more targeted incentives on the customer facing services companies provide. This will drive companies to deliver better customer service at a lower cost." (Ofwat's website). 

7. Rising 10-year gilt yields hit UU in two ways. They increase UU's cost of debt and they shrink the difference between what investors can earn from AA government debt and what they receive from UU in the form of dividends.

Assuming that UU does not reduce its dividend and that trading results remain about where they are gives, according to my valuation model*, a value of around 600p for UU's shares. They currently trade at 711p. *Assumptions: no earnings per share growth, 15% return on equity as now, dividend yield as now (4.8%), equity per share continues to increase by about 6% p.a., and the stock market values UU on an average P/E ratio of 16.5. Discount rate used is 11.3% - UU's cost of debt is 4.3%, 2% for operating risk and 5% for a margin of safety.  

Even at 600p, the prudent investor will consider: 

1. The possible repercussions of a reduced dividend and/or share issue on UU's share price. 

2. A possibly unsatisfactory price regime imposed by Ofwat for 2015-2020. 

3. Defined pension scheme assets and liabilities, each valued at 2.4 billion pounds, are large in the context of UU's business. Adverse changes in assumptions would cause a further draw on UU assets.