Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.
The long anticipated Hydro One IPO is coming to market and we wanted to take a preliminary look at the company as well as what the valuation will look like.
Offering size: 81,100,000 common shares sold by the Province of Ontario. 89,250,000 with over-allotment or 15% of total shares.
Offer price: $19 - $21
Market-cap at IPO: $1.54 - $1.87 BLN
Use of proceeds: None, proceeds go directly to the provincial government.
Dividend Strategy: Plans to pay a dividend with a payout ratio of 70% to 80%, or $500 million annually. ~4% dividend initially.
The Company and Industry:
Hydro One is the largest electricity transmission and distribution company in Ontario. Hydro One essentially owns and operates Ontario's entire transmission network and is the largest distributor of electricity in Ontario by number of customers at 1.2 million vs the next largest distributor that holds 744,000 customers. The electricity industry consists of businesses that generate, transmit, distribute and sell electricity and Hydro One concentrates on the transmission and distribution portion of the chain. Specifically, transmission involves the delivery of electricity over high voltage line generating stations to local areas. Distribution entails the delivery of electricity over low voltage lines to homes and businesses within the local areas. The Hydro One transmission system accounts for 96% of Ontario's transmission network while the distribution system is estimated to have a 24% market share. There are 72 local distribution companies in Ontario and in total, 15 of them hold a 78% market share, offering an opportunity for consolidation.
The primary value drivers in the industry and for Hydro One are the returns on equity allowed by the regulator, ability to generate efficiencies and savings as well as the rate base. Hydro One expects to grow the rate base at a compound annual growth rate of 4.2% from 2014 to 2019. This can be compared to a growth rate of 7.1% from 2009 to 2014. So while there is some growth expected, it will likely be fairly modest especially as energy conservation efforts increase, leading to a reduction in actual energy consumption. Another key driver for growth would simply be economic growth in Ontario. As the population and economic activity grow (hopefully), one could safely assume energy consumption would grow as well. Finally, Hydro One has been a consolidator of electricity distributors in the past and access to the capital markets will likely allow the company to achieve further consolidation more aggressively. The only caveat to the acquisition growth story is due to the large deal of government involvement in all of the companies, which can make the process complicated. Hydro One has experienced annual growth in operating cash flows of 7.1% over the last five years.
While the growth is important for a company like Hydro One, the company also holds a significant amount of infrastructure assets that require maintenance and upgrading. Hydro One expects to spend $1.5 billion a year on capital expenditures, 60% of which Hydro One expects to be spent on the maintenance of current infrastructure.
The main competitive advantage we can see at Hydro One is simply the sheer size of the company and high barriers to entry for competition. Given the regulatory framework, it is difficult for new entrants to compete in any material way while the size and scale of Hydro One should allow for efficiencies as well as an ability to gobble up any smaller competitors it pleases. There are, however, two disadvantages that we can see in the short term. Given that Hydro One was a public entity in the past, it very well may be less efficient than the companies that are already operating on the capital markets and have been under close scrutiny. Additionally, ownership restrictions and continued involvement of the provincial government could lead to a discounted trading multiple going forward. At the current valuation range, this is less likely to be an issue.
Aside from the usual suspects you would see on the long list of company risks, the ones we think that are most worthwhile to point out is the regulatory environment and share ownership restrictions. A change in the rates by the National Energy Board or government or special interest groups limiting the operations of Hydro One is a very real possibility. It is worth noting that this is not unique to Hydro One alone, but to the whole utility sector. The share ownership restrictions could be the other big risk as it could lead to a discounted trading multiple relative to peers. There is potential that investors will not care as they simply want to get their hands on this issue in the beginning, but the restrictions essentially limit the options for the company and less options means less value for shareholders. While it may be a good thing from a provincial security point of view for residents of Ontario, it is less likely to be viewed as a positive aspect by the capital markets.
A rough estimate of the valuation of Hydro One can be seen in the table below, at a $19 IPO price and a $21 price. The table assumes the full over-allotment option is exercised and takes the rate base growth estimates of 4.2%, applied to revenue. To keep things simple nd for the sake of conservatism, we assumed that this growth trickles down to the earnings as well. In reality, given the management team, we would expect earnings growth to be even better as efficiencies and cost cutting occurs. The table applies growth to the 2014 pro-forma numbers. Looking at the estimated P/E, the valuation does look reasonable and comes in lower than the peer group that has a P/E multiple in the 18 times' range. In a market that is currently looking for stability we think there is some intriguing upside with Hydro One. Between a valuation that looks to be lower than peers, a dominant market position, support from the Province of Ontario (who is unlikely to want to see the IPO fail) and potential for efficiencies as they transition to a public company, investors who can get in at a reasonable price could be rewarded over the long-term, in addition to the ~4% yield.
|2015 revenue at 4.2% CAGR growth trend||$6,307,226,000|
|2014 Net Income||$708,000,000|
|2015 income with CAGR applied||$737,736,000|
|$19 IPO price||$21 IPO price|
|Per share metrics||2014||2015||2014||2015|
Unfortunately, the story is not completely rosy and the big question mark of government intervention remains. This factor (along with the 10% ownership restriction) could lead to a depressed valuation multiple relative to peers. So while a P/E in the 15-17 range sounds attractive, it may continually trade at this level due to some of the uncertainty that is added with the involvement of the Province. The final detractor is one that we think is getting overlooked. While the sale is arguably good for the province, as they are able to gain access to more capital to put to other uses, Hydro One actually does not get to utilize these funds. The general purpose of going public is to raise large amounts of capital that can be directed toward growth opportunities, a benefit that Hydro One does not actually get.
So while Hydro One offers investors a good dividend, stability and a strong market position at a fair price, there are other factors that could be a weight on the company over the longer-term. We would not expect these concerns to come to the fore in the short-term but it is an area that could hold investors back due to uncertainty. If investors can get access to this around the IPO price, we think there could be some potential but as usual, we would caution those who try to chase the shares if they end up spiking on the first day. We must admit, with a number of IPO's coming to market in Canada over the last few months being priced at aggressive multiples (Spin Master and exactEarth to name a few), it is nice to see one that appears to actually be leaving something on the table for retail investors.