- Regulated utilities, despite their issues, are resistant to inflation due to in-built mechanisms for remuneration.
- In generation, Endesa has substantial nuclear assets, which explains its discount.
- In an inflationary environment, we like commodities, including electricity, and we think that nuclear will have to be appreciated as necessary eventually by the renewable crowd.
- With a substantial dividend yield also forming part of the appeal of this stock, we see only political risks, largely priced in, being the only ones facing Endesa.
- As such, we think it is a speculative buy to which we intend to have some small exposure.
We are positioning against inflation, and as such, we have begun to eschew stocks that don't have inflation hedges and are at risk of erosion of real value of their fixed contracts. Commodities tend to be the most suitable in an inflationary environment since their value is derived from some of the most liquid of markets. Last time we checked, electricity is a commodity, and thus we have started to give utilities a big look once again. Among them we have honed in on a specifically interesting opportunity, which although speculative will form part of our utility exposure due to its high optionality. This opportunity is Endesa (OTCPK:ELEZF), an Enel (OTCPK:ENLAY) subsidiary which has substantial nuclear exposure as well as resilient and rate-indexed remuneration schemes in its regulated utility business. Since it trades at a substantial discount and offers a high dividend yield, we see Endesa as an attractive income and price appreciation opportunity, although very binary in nature.
To look at the nuclear opportunity, we only have to look as far as the capacity factors and the low value on nuclear provisions provided by nuclear-heavy utilities like EDF (OTCPK:ECIFF). The capacity factors are unbelievable, and put any renewable energy source to shame. Moreover, the power of the atom doesn't require fickle environmental conditions to give us energy, although it does require robust protocol to help us avoid events more cataclysmic than natural disaster. As such, it is not very loved in the political sphere, because no one wants to risk an event like that, and the need to be politically correct as a politician will have you supporting the pipe dream of 100% renewable.
Meaningful renewable contribution to the grid is doable, like 30%, but not much more, again exemplified by the unreliability of renewable power sources, even hydro, in occasional extreme weather events. Thus, if oil dominance is out of the question for environmental reasons, the only other option is nuclear, which is probably the best option to begin with. Although it is not very politically tenable now, we do not believe any revolution greater than nuclear will occur in the next 10 years, and thus we believe that eventually, as oil becomes a more minor energy source paving way for renewables, we will need a source that is both low in carbon but very reliable to deal with the brunt of our energy demands.
Outside of Endesa's power generation are its regulated utility assets, which it operates on concession from the Spanish government's regulatory authority, the CNMC. It is not particularly investor friendly, but it does provide something of value: inflation hedges in its remuneration schemes for Endesa. Since remuneration schemes work off of regulatory WACC, which is related to the risk-free rate and an equity risk premium, in an inflationary environment where nominal rates will be rising, Endesa's compensation will grow at least partially in tandem. Moreover, periodic reviews of the remuneration schemes can open a window for Endesa to introduce more explicit inflationary clauses, if indeed profligate money printing eventually broils over from assets into consumer prices. Even if not a total inflation hedge, because there are moving parts, the regulated utility business is a good cash flow generator, and it is very predictable being earned on a straight-line basis.
Overall, valuation is on Endesa's side. We need to value the company's power-generating assets. The following are compiled primarily from available disclosures on renewable asset sales.
For Endesa's regulated utility assets, we'll be applying the multiple for Red Electrica's (OTCPK:RDEIY) business, which derives almost all of its income from regulated utility activities with the Spanish transmission grid. As for the power generation assets, we've weighted the above multiples by GWh technology split to get the appropriate valuation. Coal has been given a 0x multiple, and we use a conservative multiple for nuclear with EDF's nuclear provisions.
The valuation is as follows.
(Source: Valkyrie Research)
While the political risks are very clear, with lawmakers not in consensus at all about nuclear in the EU, we think that there is a chance that they come around. If they don't, the value of Endesa should fall quite meaningfully. If not, then our proposed appreciation opportunity is probably quite conservative. Regardless, a 7% dividend yield is here to compensate you in the meantime, while you watch as the political battle around renewables and nuclear develops. Overall, it is a worthy speculative buy.
This article was written by
Formerly Bocconi's Valkyrie Trading Society, seeks to provide a consistent and honest voice through this blog and our Marketplace Service, the Value Lab, with a focus on high conviction and obscure developed market ideas.
DISCLOSURE: All of our articles and communications, including on the Value Lab, are only opinions and should not be treated as investment advice. We are not investment advisors. Consult an investment professional and take care to do your own due diligence.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ELEZF over the next 72 hours. 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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