Thursday, 09 September 2021 13:43

Utilities - high income with growth

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Investing in utility companies is the equivalent of buying “Water Works” or “The Electric Company” on a monopoly board.  It’s not the excitement of owning Mayfair, but they pay a steady income to their owners.  Utility owners on the ASX also enjoy relatively high levels of income, some as high as 6%, within a stable business.

Utilities according to Hugh Dive, Portfolio Manager at Atlas Funds Management are characterised as businesses that have some form of monopoly, extensive capital to construct their assets, steady demand and varying degrees of government regulation.

 

Gerald Stack, Head of Infrastructure at Magellan Financial Group likes to illustrate the idea of utilities by referencing electricity.  There are four distinct aspects to the provision of electricity starting at power generation.  The electricity is then transported over high voltage transmission lines before the voltage is reduced and transported over distribution lines to consumers.  The final stage is that electricity is marketed to consumers through retailers.  

Only the transmission lines and the distribution lines are considered utilities by Magellan as they are the only parts of the electricity chain that are monopolies.  Generators and retailers are excluded by Magellan as they are subject to competition and are therefore generally not considered utilities.  This is an important aspect of investing in utilities, as investors owning parts of the chain that are subject to competition and price changes, will receive a different outcome.

Stack believes that investors should own utilities for their predictable, reliable profitability which typically means that dividends are also reliable and predictable.  

Dive says that utilities can provide a hedge against market falls.  During the sharp 21% ASX fall in March 2020, regulated utilities were among the least impacted stocks on the ASX.  Spark Infrastructure and APA Group only declined by 4% while Ausnet posted a 1% gain.

Investors can gain exposure to Australian utilities via ASX companies including Spark Infrastructure (powerlines and transmission), Ausnet (gas pipelines, powerlines and transmission) and APA Group (gas pipelines).  Alternatively investors can access exposure via Infrastructure funds, which also have the benefit of being able to seek global opportunities.

Dive and Stack both agree that the main risks to investing in utilities relate to regulation and interest rates.

Investors need to understand that utilities can earn income that is regulated, or revenue which is contracted.  Typically regulated income allows the utility to earn what the regulator assesses as a fair rate of profit and usually the regulatory regime is fixed for a period before being reviewed.  For example electricity distributors in Australia usually operate under 5 year regulatory periods.  Contracted revenue occurs when there is a legal contract for services between the utility and the end user.  

Investors also have to feel comfortable with the jurisdiction they are investing in.  Australia, UK, US and Canada are generally considered regions where investors have comfort in the regulatory framework and can obtain recourse through the legal system.  Some developing countries require more caution in this area.

Utilities are often financed with a significant amount of debt, therefore a change in interest rates can have a material impact on operating profits without the protection afforded by regulation, according to Stack.  However the regulatory regime will normally allow for protection from the impact of changes in interest rates so that profitability is largely unaffected.  Changes to interest rates can not only impact operational profits, but also the assessment of fair value of the utility by the markets.  Generally lower interest rates result in higher utility values and of course the reverse applies.

A significant pick up in inflation that could lead to central banks raising interest rates could lead to a reduction in appetite for investment in regulated utilities.

While utilities are traditionally known as an income play for investors, there is potential too for growth.  The need for communities to reduce carbon emissions to ‘net zero’ offers significant opportunities for electric utilities.  Key steps in the transition include significant increases in the amount of renewable energy and the electrification of economies including electric cars.  Renewable energy projects and the need to increase the capacity and reliability of the electricity grid offer significant investment opportunities.

High income with growth, it’s little wonder that the utilities sector is starting to attract takeover attention.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article appeared in the 8th September 2021 edition

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