European Regulated Energy Utilities - Dividend Gems Protected By A 'Moat'

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Includes: ENLAY, NGG, RDEIY, SNMRY, TEZNY
by: Tarek El Sherbini

Summary

Regulated activities provide a Warren Buffett style ‘moat’ that protects European energy utilities from any competition and guarantees a certain level of income for the business - and dividends for shareholders.

Europe has a number of solid energy utility regulated monopolies that offer attractive dividend yields, and are shielded from competition and from other market risks.

Shares of Italian utility companies, along with the overall Italian market, have suffered particularly from the political instability resulting from the recent elections.

While new policy risks should be taken into account, opportunities could have arisen from the recent turmoil.

Following significant drops in their share prices in the past few months, regulated European energy utilities are now providing good value for money. Low valuations and high dividend yields for financially strong regulated energy companies provide compelling investment prospects, especially for yield-seeking investors. In addition to having higher dividend yields than their US counterparts, suppressed interest rates in Europe provide European regulated utilities with better financial prospects in the foreseeable future. The following are some companies I find attractive in that sector.

Terna (OTCPK:TEZNY) - Italy's electricity transmission monopoly.

Terna has enjoyed ample free cash flows over the past three years, allowing it to comfortably cover increasing dividend payments. Net debt to operating cash flows is reasonable around 4.7x, and interest coverage is a very comfortable 14x, giving it a strong investment grade credit rating of BBB+, one notch above the Italian government’s credit rating. Terne is a very profitable business, with net profit margin of more than 30%, and return on equity of 18%. Market capitalization to operating cash flow is 5.3x. The share price is off 20% since last November, but it is still 37% up on a 5-year period.

Snam (OTCPK:SNMRY) - the leading gas utility in Europe.

Snam operates an extensive gas pipeline network and storage and LNG assets, mainly in Italy, France, the UK and Austria. Following a share price drop of 30% since November of last year, Snam now pays a dividend yield of 6.2% - seemingly a safe level since ample free cash flow was generated in the past 3 years to cover dividend payments. Current market capitalization to operating cash flow is quite reasonable at 6.5x. Net debt/operating cash flow is more than 6x - on the high side - but with ultra low interest rates in Europe, interest coverage ratio is more than 13x, allowing Snam to enjoy a solid investment grade credit rating of BBB+. Net profit margin of 35% is one of the highest in the sector, not only in Europe or globally. ROE is on the high side as well at 11.7%, and ROI at 7%.

Enel (OTCPK:ENLAY) - Europe’s largest power company by market capitalization.

Enel is 23.6% owned by the Italian government, and is well diversified through operations across 37 countries across all continents. Enel is also diversified in its business focus; almost half of Enel’s 84GW of installed generation capacity comes from non-fossil fuel sources, making it well-placed for the increased focus on renewables. The new Italian government wants to reach 100% power generation from renewable resources by 2050, which might mean more fiscal incentives for renewables businesses. Enel generates a 5.2% dividend yield, and return on equity of 11%, with a slightly high net debt to operating cash flow of 4x. The share price has more than doubled over the past 5 years, despite the recent fall of 20%, which was in line with the overall Italian market.

National Grid (NYSEMKT:NG) - one of the largest private-sector utility groups in the world.

National Grid is also one of the most geographically diversified. NG owns and operates the electricity transmission network in England and Wales, the gas transmission network in Great Britain, and electricity transmission and gas distribution assets in the East Coast of the US. The near 50/50 split of operating profit between the UK and the US provides a strong hedge against headwinds in unfavorable changes in regulation, interest rate increases and currency risks.

NG is a stable utility business, with limited growth but with a high and stable dividend yield, currently around 5.2%. NG generated comfortable free cash flows in the past three years of between GBP 1 billion and GBP 6 billion per annum, allowing it to acquire treasury shares of around GBP 1.4 billion, and to increase dividends in line with inflation. Dividend payouts are less than 30% of operating cash flows, and have been almost fully covered by free cash flow in the past three years. In the last financial year, net financial debt to free cash flow reached 3.5x, and interest coverage was a comfortable 4.4x, earning NG a comfortable credit ratings between of BBB+. The margin of operating cash flow to sales was at 30%, one of the highest in the sector, and net profit to sales reached a comfortable 15%, an enviable level for a listed corporate. Some of NG’s current valuation parameters are among the lowest in the wider utility sector, especially for a company wish such strong financial metrics; market capitalization to operating cash flow is 5.4x while market cap to book value is at 1.6x, and P/E is 8.4x. Return on equity has been a stable 11-12% over the past three years.

Red Eléctrica de España (OTCPK:RDEIY) - the sole owner and operator of Spain's high voltage electricity transmission grid.

Over the past 5 years, RDEIY increased revenues by 20%, net income by 36%, while net debt remained impressively unmoved - a rarity in utility company, especially ones with that healthy growth rate. Net financial debt to operating cash flow reached 4.4x, well below the sector average, and earning RDEIY impressive credit ratings between A- and A, which is again a rarity for utility companies. The margin of EBITDA to sales was an outstanding 77% in 2017, and net profit to sales reached an enviable 35%.

The relatively low leverage and strong cash metrics ensure RDEIY is in a strong position for the near term to continue growing dividends per share, which have doubled in the past 7 years. A current ‘guaranteed’ dividend yield of 5.35%, and growing, is an attractive investment proposition for income equity investors. Dividend payout ratio is less than 70% - comfortable relative to the sector. The share price grew by 70% over the past 5 years, and currently market capitalization to operating cash flow is 8x and return on equity is 22%, making an investment in RDEIY attractive for both capital growth and income investors.

Political risks should be monitored

Political risks are the main risks for all those companies, since they depend on government regulation, rather than market forces, to determine their income. But in those companies’ respective countries, there is no current indication that government are planning any severe deterioration in the regulation and compensation regimes. And in the three countries - Italy, Spain and the UK - there are currently minority coalition governments that have limited breadth for focusing on major regulation change that could damage their well-functioning energy system. As always, investors should assess favorable investment opportunities while looking out for any future change in outlook.

Disclosure: I am/we are long TEZNY, SNMRY, NGG, RDEIY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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