Investing in utility companies is quite common among defensive investors. People will always need electricity and heat, and this sector is therefore resistant to macroeconomic crises. Moreover, utility companies tend to pay high dividends. Most of them are great cash machines without many uncertainty factors in the horizon. The sector is mature with modest growth. The market is aware of these facts, and most utility stocks are therefore fairly valued in today's bull market.
The majority of readers on this site are Americans, and their portfolios are probably filled with domestic stocks. As a Danish investor, I enjoy sharing my views on European companies. Europe is filled with bargains due to the global economic crisis and the European debt issue. The fear is still to be found on this continent, and with fear follows pessimism and cheap valuations. When it comes to European utility stocks and high dividends, Fortum Oyj (OTCPK:FOJCY) is definitely worth taking a look at.
The company is headquartered in Helsinki, Finland, with a market capitalization of approximately €12.6 billion and 10.400 employees. Fortum is also listed on the American OTC market. Dividends are accrued annually as is the norm for European companies. Fortum produces and distributes power, electricity, and heat throughout Northern Europe and parts of Russia. Furthermore, the company runs and maintains several power plants, mainly in Finland. This utility company is far from ordinary since the power sources are in fact renewable and CO2-friendly. This Finnish giant was established in 1998 and has, through mergers and acquisitions, expanded its business far beyond the Finnish borders. 50.8% of the shares are owned by the Finnish government and thus constitutes a strong backup for the company.
The competitors have high costs in relation to CO2 quotas as opposed to Fortum, since 90% of its production is CO2-neutral. The goal is to have an all CO2-neutral production. Water, wind, hydro, solar, and nuclear power are the main power sources. After the Fukushima disaster it was further concluded that Fortum's nuclear power plants are safe. The nuclear subject is marked with uncertainty because of the general mistrust toward this energy source, despite the fact that nuclear power plants are extremely safe and efficient. 75% of the company's revenue is obtained from the Nordic countries where Finland and Sweden are the biggest revenue sources. Russia constitutes 17% of the revenues while Poland, the Baltic Rim, and Great Britain are minor sales sources. The divisions are divided into heat, power, electricity, and the Russian market as its own division:
- The power division consists of power generation and power trading as well as expert services for power producers. The production takes place in Finland, Sweden, and Great Britain while the expert services are offered worldwide. Fortum is the third-largest power producer in the Nordic countries and among the 15 largest in Europe and Russia. This division constitutes 35% of the total revenues. Fortum sells its power mainly to the Nordic power exchange called the Nord Pool Spot.
- The heat division consists of combined heat and power (CHP) generation, district heating activities together with business-to-business heating solutions in the Nordic countries and the Baltic Rim. Approximately one million homes in the Nordics are heated by Fortum. The company owns 18 CHP plants and several hundred heat boilers. This division constitutes 23% of the total revenue and Fortum is the leading heat supplier in the Nordics and Baltics. Poland and the Baltics are growing markets.
- The electricity division is divided into distribution and sales. Finland, Sweden, and Norway are the main markets and Fortum provides electricity to 1.2 million customers. Fortum is the second-largest electricity sales operator and the largest seller of CO2-free electricity in the Nordics. This segment constitutes 25% of the total revenue.
- Finally, there is Russia, which has gotten its own division in the annual reports due to the focus on growth on this market. This division consists of both power and heat generation in Russia. This is a growing market with a revenue increase of 28% in the last two years.
Also worth mentioning is the insinuation of a possible entry into the Asian markets since there is a vast growth in demand for energy on this continent. The recent actions from EU has made the European energy market more free, and the utility companies have therefore been forced to adapt the new environment. The short-term consequences are an overcapacity of power plants, impairments, and unsatisfactory financial results, but with the liberalization comes a considerable potential for long-term earnings growth. Most investors do not seem to have the required patience, and substantial declines in stock prices have therefore occurred. Fortum, however, has done quite well compared to its peers E.ON (OTCQX:EONGY) and RWE (OTCPK:RWEOY).
Fortum has a consistent and reliable income stream, as shown below:
Click to enlarge image.
Fortum delivered a satisfactory result in 2012 despite a demanding business environment and low expectations. Macroeconomic uncertainty about future growth rates of the global energy demand and the historically high water reservoir levels puts additional pressure on prices in the Nordics compared to 2011. Even though there are challenges in the industry, one should notice the stable development even through the first years of the financial crisis.
Furthermore, the profit margin is great and the return on equity seems sufficient. The company has paid €1.0 per share the last five years, which results in a current dividend yield of approximately 7%. The dividend policy states that the company aims to pay a dividend that corresponds to an average payout ratio of 50% to 60%. I do not expect increased dividends at the moment, but I can live with a 7% yield in the coming years.
Due to the reliable earnings, Fortum can acquire quite a lot of debt, thus creating a gearing of 72% and a debt/EBITDA ratio of 3.1x. Even though the company has a vast amount of debt they seem to have strict control over the interest costs with an interest coverage ratio of 7.5x. Fortum's long-term credit rating with S&P was recently downgraded from A to A-, while Moody's affirmed the A2 rating.
Fortum has launched an efficiency program in the autumn of 2012. The goal is to increase the cash flow by more than €1 billion during 2013-14 by reducing capital expenditures, divesting non-core assets, reducing fixed costs and by focusing on working capital efficiency. These actions will increase the efficiency of the core processes and lead to cost reductions. Fortum releases its half-year report on July 19. I hope to see some debt reductions together with satisfactory earnings.
With an earnings estimate for 2013 of €1.32, Fortum currently trades at a forward P/E ratio of 10.8x. Together with a P/B value of 1.16x the company looks like a worthy candidate for the patient investor with a hunger for high yields. I will gladly pay a 16% premium for the equity in a company with such a sustainable business concept, since we need sustainable solutions for the growing world population. It is also my belief that renewable energy will play a bigger role in the future, and that the public together with the politicians will continue to be supporters of renewable energy as opposed to outdated and polluting energy sources.
Fortum has an enormous growth potential not just in Europe, but also in the rest of the world. Management speaks openly about the possibility of expansion toward the Asian market, and in time they will probably get there. I cannot predict the future, but I think Fortum is one of the companies that will be around to the end of days due to their focus on sustainable energy production. Meanwhile, let us enjoy the soaring dividend, a sufficient margin of safety, and a substantial upside potential.