Thursday, 14 August 2014

The Water Utilities - Waiting for Ofwat

And Dee Valley Group PLC

Cathryn Ross, Chief Executive of Ofwat, courtesy
One of the first stops for the investor seeking income is the water utilities. Currently, they yield between 3.8% and 4.5%. But every five years British water companies must negotiate their terms of business with the regulator, Ofwat, and this can be a source of grief for investors. Both United Utilities and Severn Trent reduced their dividend payouts after the last 5-year review.  
However, the Gas & Water sector (in blue) has performed better than the FTSE All Share (in black) over the last five years and these indices do not take into account the higher income that shareholders have received from this sector:
Graph courtesy www.Interactive Investor, click to enlarge
The corollary is that the water utilities are highly valued. Income stocks have seen their prices bid high by investors looking for alternatives to the low yields available elsewhere in the financial markets.
Further, one way that the water companies have found to improve their performance is to borrow at low interest rates. They have relied heavily on loan financing to meet their capital requirements and to pay generous dividends. The result is that they are all heavily indebted.
PE Ratio
Market Cap pounds Mn
United Utilities
Severn Trent
Dee Valley Water
The water companies are now facing another 5-year review from Ofwat for the period 2015 to 2020. What is in store for them? The regulator has stated that it intends to reduce the regulatory weighted average cost of capital (WAAC) for the water companies from 5.1% to 3.85%. The WAAC is one of the inputs for the financial model Ofwat uses to set prices. If all other factors remain unchanged, this would imply a reduction of 24.6% in the companies' post-tax earnings. However, in part this reduction reflects the declining cost of debt. And Ofwat offers incentives to the water companies to meet certain performance targets.
But it comes as something of a shock to shareholders that Ofwat proposes that the cost of equity (post tax) should fall by 20%, from 7.1% to 5.65%, when using the model to calculate prices for the next five years.  
In broad terms, water company revenues can only grow by:
Ø  Ofwat-approved price increases. But Ofwat is looking for price increases below the rate of inflation.
Ø  Large projects that require new capital to, for instance, replace water mains or water treatment plants. Ofwat permits an increase in price to provide a return on new capital.
Ø  Growth in household and business use of water. The number of households is growing by 1% per annum.
In practice, average revenues of the four quoted water companies have risen by exactly the rate of retail price inflation in the past four years - 3.2% per annum. Meanwhile, earnings per share, once adjusted for extraordinary items, have stagnated.
Before investing in the water sector investors should consider:
1. Ofwat's final decisions will most likely be published in December 2014. The uncertainty running up to then will most likely be reflected in share prices.
2. The water sector is rated very highly by the market in historical terms. In part, this is the search for income and in part, the result of last year's bid for Severn Trent. Three institutional investors offered a 15% premium to the market price for that company.
3. The outlook for the next five years is determined largely by the regulator. And the indications are that Ofwat wants to keep prices low. There is political pressure on all regulators to restrict price increases at the cost of shareholders. This could mean that some of the companies would have to cut their dividends, just as United Utilities and Severn Trent did in FY 2011. Some might have to raise new capital from shareholders.

Dee Valley Group PLC (DVW)

The River Dee at Chester, courtesy Wikipedia
The Dee Valley Group (Dee) is by far the smallest of the four water companies quoted on the London Stock Exchange. This has, for the individual investor, some advantages. The company is so small - it has a market capitalization of 63 million pounds - that only one analyst bothers to cover it. As AXA S. A., the general insurance company, holds 35% of Dee's shares, the free float is further reduced. As a result, perhaps, Dee is on the lowest PE ratio and yields the highest dividend of any of the water companies and it has the lowest debt to equity ratio.
Dee provides a pure water service to 113,000 homes and 8,000 businesses in southern Cheshire and northern Wales. It does not offer a sewage service or run any other business than providing water to its market. Its small size enables the company to keep in close contact with the local authorities, agencies and its customers.
Financial Results
Ø  Earnings per share have increased by 3% pa over the 2007-14 period and dividends by 4%. This is slightly ahead of retail price inflation and indicates the bond-like nature of the regulated water business.
Ø  Return on equity is a healthy 15% reflecting in part the highly leveraged nature of the company's balance sheet.
Ø  Debt to equity ratio has remained fairly stable and it is currently 185%. Based on its regulatory asset value of 74 million pounds, debt financing is 68% compared to equity financing of 32%.
Ø  Net operating cash flow, including capital expenditure, was 12.4 million pounds over the period 2010 to 2014, just falling short of dividend payments of 13.5 million pounds. The company has not issued or bought back any of its shares in these five years.
Ø  The main risk to the business is probably the company's defined benefit pension scheme (DBPS). Although the scheme is currently in surplus, it could require substantial funding at some time. Because of the open-ended obligation of such schemes, nearly all companies with DBPS have closed them in favour of defined contribution schemes.
Dee's share price (in blue) has outperformed the FTSE All Share Index over the last five years, without counting its superior yield.

Graph courtesy Yahoo, click to enlarge.
Ofwat's review is influenced by the Customer Challenge Panels (CCP) that monitor the water utilities. Dee's CCP has supported the company's plans that it has lodged with the economic regulator Ofwat. The company proposes an increased capital spend for the next five-year period coupled with a small increase in prices above the rate of price inflation. Dee's customers are currently paying one of the lowest tariffs in the country. It has also argued that it should receive a small company premium for its cost of capital, on the grounds that smaller entities do not have the scale or credibility of larger entities. On the debt side, this is covered by Ofwat's intention to include the cost of 'embedded debt' - debt the company has already contracted.
However, Ofwat's decision on pricing will not be known until December 2014. The Company states, "Future dividends will be considered in the context of the results for the period and the outcome of the current price review process."
Assuming that Dee's business continues on its past trajectory, then my model values Dee's shares at around 1170p.* This is 16% below the current share price of 1385p. At 1385p the company's shares trade on a PE ratio of 15 and yield 4.5%.
*Assumptions: Eps growth of 2% p.a.; dividend payout of 66% of earnings; 15% return on equity; equity per share growth of 5% p.a.; average PE ratio of 13; discounted at 8.8% p.a. for the five years to 2019.
The cautious investor will:
1.       Wait until Ofwat's review is complete, which should be at the end of this year. The company is sure to make a statement on the impact on its business of the regulator's decisions.
2.       Note that Dee's share price reached a 12-month high of 1610p in April and a low of 1308p earlier this month.
3.       Consider that Dee's shares are close in nature to an index-linked bond with the risk of unfavourable quinquennial reviews by the regulator Ofwat.
4.       Keep an eye on the company's contribution to its DBPS.
Disclosure: I hold a long position in Dee Valley Group.

Saturday, 12 July 2014

Technical Analysis of the Stock Market

And The Sage Group PLC

Astrologer casting a horoscope, Robert Fludd (1617), courtesy Wikipedia
Astrology fascinated some of the most brilliant minds of the past. They included Galileo and Kepler. Today some lesser lights devote much effort and time to technical analysis of the Stock Market. In both cases, people are fascinated by the challenge of discovering meanings hidden in numerical sequences as observed in the sky or charts of the stock market. And they are lured by the promise of wealth and public recognition.
It must have come as something of a shock to readers of the Traders Column in the Investors Chronicle, that the trader, in his farewell article this week, should write, "I have come to believe that much of what passes for Technical Analysis is nothing more than faith-based nonsense. It would be laughable, but for the real money that it helps to lose. I include in this several of the dark arts in which I myself have dabbled in the past, including Fibonacci, the Elliott Wave Principle, and much of Gann Theory."
It is rather as if Benedict XVI had announced that he was retiring from the Papacy because he no longer believed in God.
As readers of this blog might recall, one method of judging where we are in the stock market cycle is to review a list of down to earth indicators, such as those used by Howard Marks of Oaktree Capital Management. See
But I cannot resist presenting a chart prepared by (Doug Short) that I came across recently (click to enlarge):

The chart tracks the flow of funds from individual investors in the New York Stock Exchange (NYSE). It is hardly a surprise that the S&P 500 rises on the back of inflows and recedes on the back of outflows. What is interesting is the magnitude of investor buying on margin since 1998 and the rapidity with which investors liquidated their positions in 2001 and 2008. American investors have become much more active with the result that markets are more volatile now than they were between 1945 and 1998.
Doug Short recognises that, as data for credit balances is available only six weeks after the event, it lacks any predictive power. But he comments ". . . the magnitude of the latest negative credit level is comparable to the maximum debt reached four months before the 2007 market peak. I see this as yet another caution light for investor expectations."
As the FTSE All Share Index closely follows the S&P 500, this observation is relevant for UK investors.

The Sage Group PLC

Clay accounting tokens from Susa, Mesopotamia 3500 BC, courtesy Wikipedia
Successful long-term investors like to invest in companies with steady businesses that require little capital investment and are leaders in their chosen markets. Warren Buffett is said to look for specific qualities in a company. They are discussed at
The Sage Group PLC (Sage) is one such company that fits the bill. It specialises in providing accounting and related software packages for Small and Medium Enterprises (SMEs). Consider:
The market
Ø  Sage has built up a customer base of 6 million SMEs and recurring revenue is 71% of the business. 83% of subscribers renew their subscription annually. Both the proportion of recurring revenues and renewal rates are on the rise.
Ø  The company is heavily dependent on the mature markets in Europe (56% of revenues) and North America (28%). A move into Brazil and its large presence in South Africa coincide with weak fundamentals in both economies.
Ø  It claims to be market leader in six of its seven largest markets - the UK, France, Spain, South Africa, Canada and Brazil. And it claims to be the second largest supplier to mid-market SMEs in the USA.
Ø  The company has a good record of developing its products and adapting them to new technologies.
Ø  By offering a wide range of products for its three main market segments - companies with 1 to 20, 10 to 200 and 100-500 employees - Sage offers its clients products that fill their needs as they grow in size.
Sage has a myriad of competitors, ranging from large software companies such as SAP, Oracle and Microsoft, to new software companies that are offering cloud-hosted products. Its global market share has declined from 9% in 2008 to 6% in 2013. Its two biggest competitors, SAP and Oracle, have 25% and 13% respectively of the global market for Enterprise Resource Planning (ERP) software.
But recent reviews of its new cloud-hosted products suggest that the company has succeeded in developing good cloud-hosted products that can be integrated with its desktop software.
Further, Sage has embarked on a programme of selling off non-core assets to concentrate on what it does best. This is coupled with the objective of increasing 'organic revenue' by 6% a year. In the latest interim results for 2014, the company approached this objective by increasing 'organic revenue' by 5%.
Ø  Revenues, on average, have grown by 2% compared to a global industry average of 12% these past three years. In part, this is due to its concentration on developed markets, and in part to loss of market share. Earnings have also stagnated in 2011-13.
Ø  Cash generation is strong. In the last 5 years, Sage has generated net operating cash flow of 1.36 billion pounds that amply covers the 0.55 billion pounds normal dividend payout. The company uses little capital and pre-tax margins average over 20%.
Ø  Return on equity is now 26%, which has been elevated by some adroit financial management. Sage returned 1 billion pounds to shareholders last year by way of a special dividend and share buyback. It financed part of this with borrowings equivalent to one year's EBITA. In the process, the company reduced its average cost of debt from 4.6% to 3.8%.
Ø  The company has no significant exposure to defined benefit pension schemes. However, its balance sheet is top heavy with goodwill. Sage is a serial acquirer of businesses and, as its recent 188 million pound loss on disposal of businesses shows, these are often overvalued.
Sage's share price (in blue), until recently, has closely tracked the NASDAQ index (in green):

Graph courtesy Yahoo, click to enlarge
The drop off in Sage's share price in 2013 and 2014 reflects:
1.       The large special dividend payment, coinciding with a small inverted triangle in the chart.
2.       The market reaction to the September 2013 launch of a new cloud-hosted competitor in the UK called Xero. Xero is a New Zealand-based software company. With sales of 35 million pounds and a pre-tax loss of 18 million pounds, Xero has a market value of 1.6 billion pounds.
3.       The May 2014 announcement that Sage's CEO would be leaving the company.
At the current share price of 370p, Sage trades on a PE ratio of 16 and yields 3.1%. My valuation model values Sage at around 330p a share.
This valuation assumes that the present rate of organic revenue growth, which is 5% per annum, translates into a similar increase in earnings per share and net operating cash flow for the period 2014 to 2018.
The cautious investor will note:
v  Sage is vulnerable to new competitors, particularly in cloud-based products where the start-up costs are fairly small. The company states in its 2013 Annual Report that larger companies want desktop software and trained staff whom they can contact. This might well be true right now, but it does not follow that this will always be the case.
v  The loss of Sage's highly regarded CEO after only 4 years in office is a concern. He led the new strategy to concentrate on core products and generate 6% organic growth a year. Will a new CEO follow his lead, and if so, will the new CEO implement it successfully?
v  The shares have traded as low as 312p in the last 12 months and technology stocks in general are now out of favour.
Disclosure: I have a long position in Sage but will not trade these shares within the next 5 days.

Monday, 23 June 2014

Vodafone PLC after the sale of Wireless


Vittorio Colao, CEO of Vodafone, courtesy Wikipedia
In May last year I argued that the main value of Vodafone lay in its 45% ownership of Verizon Wireless. My model then valued the remainder of Vodafone's business at 67p a share (see As Vodafone consolidated its shares in February 2014, issuing 6 new shares for every 11 old shares, this would equal 123p a share today.
Verizon Wireless was a great investment and Vodafone has passed on 51 billion pounds from the sale to shareholders.
Vodafone retained 26 billion pounds (after paying US taxes) of the proceeds of the sale of Wireless. These proceeds amount to 98p a share. Adding 98p to the 123p a share that I valued the company's non-Wireless business in May 2013 would give a notional current valuation of 221p to Vodafone. Vodafone shares currently trade at 192p.
What is the financial state of Vodafone post Wireless?
1.       In its 2014 Annual Report, Vodafone provides us with three years of trading results excluding Wireless. It does not make for pretty reading. If one excludes the contribution from Wireless, Vodafone's results for 2012-14 would be as follows:         
Pounds billions to 31 March
Profit/(Loss) before tax
Revenues are flat and the company is deeply in loss.
2.       Net operating cash flows for the three years total 5 billion pounds, which falls far short of the 16.5 billion pounds paid in dividends. The figures by years are:
Pounds billions to 31 March
Net operating cash flow*
Normal dividends paid
               *Defined as operating cash flow less capital expenditure and interest payments
The 11.2 billion pound shortfall was paid out from the dividends received from associates, nearly all of which came from Wireless. Vodafone is expected to pay a dividend of 11p a share in 2015, costing 2.9 billion pounds. But will the company generate sufficient cash to pay it, or will it have to borrow? It is troubling that management say they will increase the dividend and yet that a huge investment programme will put pressure on cash flow. A dividend paid out of borrowings is not sustainable.
3.       The asset side of the balance sheet has taken a turn for the worse. While the 46 billion pound investment in Wireless has disappeared from this account, the company has suddenly added 16.6 billion pounds in deferred tax to non-current assets. €18.3 billion (15 bn. pounds) arises in Luxembourg, where Vodafone has a company that it uses to avoid paying tax in other jurisdictions.
 Vodafone expects to generate sufficient profits in Luxembourg to absorb tax losses of €63 billion*. Vodafone will have a great time transferring profits to Luxembourg. The huge losses apparently derive from past impairment charges to goodwill and intangible assets.
*The average tax rate in Luxembourg is assumed to be 29%. Hence the deferred tax asset of 18.3 billion requires 63 billion euros of prior years' losses to be compensated with future earnings. Source: 2014 Annual Report.
Goodwill and intangible assets are valued at 46.7 billion pounds. Given that Vodafone regularly takes impairments for goodwill and intangibles, it is not a wonder that the market discounts Vodafone's net asset value by 27%. 
4.       With the receipt of cash from its sale of Wireless, Vodafone's debt to equity ratio is quite improved: net debt to equity falls from 44% in 2013 to 27% in 2014. And Moody's maintains the company's A3 credit rating for long-term unsecured debt.
However, there are two caveats.
Ø  The quality of the assets has declined significantly with the loss of Wireless, which paid Vodafone 15 billion pounds in dividends over the last three years.
Ø  Averaging the last three years' net operating cash flow, it would take over 11 years to pay off Vodafone's net debt.
In May 2013 I wrote about truth in financial reporting. I used Vodafone as an example of management presenting its results in such a favourable light that they badly distort the company's true performance. This misreporting is tied to executive remuneration. It is a bad business.
Essentially, management presents results to shareholders that greatly overstates the company's performance, both in terms of profitability and operating cash flow. In particular, management excludes the very large capital costs of maintaining Vodafone's business and the interest cost of financing its operations.
Capital costs include:
v  Buying spectrum band width and licenses
v  Software development
v  Buying and maintaining property, plant and equipment
These three items average 7.6 billion pounds a year over the last six years, equivalent to 20% of Vodafone's revenues.
Recent Trading
Vodafone has acknowledged that trading in Europe has been difficult. Adjusted operating profits there fell by half between 2012 and 2014. The decline has been across all major markets - Germany, UK, Italy and Spain.
Vodacom, which includes South Africa and five other African markets, reported a 10% decline in adjusted operating profits, in part depressed by the fall in the value of the rand.
India - which moved from a loss of 8 million pounds in 2012 to a profit of 326 million in 2014 - and other AMAP* - which improved its profit from 218 million pounds to 393 million - are both moving in the right direction. But these businesses are still quite small.
*Africa, Middle East and Asia Pacific region.
Vodafone encounters the same difficult market conditions everywhere:
v  In most markets there are four or more competitors.
v  It is difficult to distinguish one company's offering from another, except by price.
v  Prices are under constant pressure, from both competition and the regulators.
v  'Bundling', by expanding into new technologies and products, increases costs and competition. Fixed line and cable operators are moving into each other's markets and Vodafone's mobile market.
v  In 2014, the company lost market share in 10 of its markets (including all the large European markets) and gained market share in seven (including India, South Africa and Turkey).
v  Companies must invest large amounts in spectrum, software and plant just to stay competitive.
Meanwhile, the growth in the global market for telecoms, in real terms, has come to a halt:

Mobile (bright red), fixed voice (light red) and fixed broadband (pink), courtesy Vodafone's 2014 AR.
Recent Acquisitions
Vodafone has often paid a full price for its acquisitions. The trend continues.
*      In September 2013, the company bought Kabel Deutschland, in a bidding war with Liberty Global, the US based cable company, for €7.7 billion. Applying a standard 33% tax rate to Kabel's pre-tax earnings means that Vodafone paid a whopping 50 times earnings. Kabel is the largest cable company in Germany. It gives Vodafone a big lift in its German market. And Vodafone promises big cost savings and revenue synergies.
*      Also in September 2013, Vodafone paid Verizon $3.5 billion for its 23% stake in their Italian venture. Applying an Italian federal tax rate of 27.5% to adjusted operating profits suggests that Vodafone paid 26 times earnings for the remaining stake in the joint venture.
*      In March 2014, Vodafone bought ONO, Spain's second largest cable company, from a private equity group for €7.2 billion. Given that ONO made a profit of just €52 million the previous year, the company paid around 130 times earnings and close to five times sales. Vodafone promises revenue synergies of €1 billion.
Project Spring
Vittorio Colao has been Vodafone's CEO since 2008. He has launched a new strategy with the hopeful title of Project Spring. The main elements are:
v  Total investments of around 19 billion pounds in the next two years.
v  Aim to reach 91% of the population in Europe with 4G.
v  Lay fibre-optic cable "deep into residential areas across Europe" and into selected emerging market urban areas.
v  Developing products for enterprises (commercial) and extending machine-to-machine wireless transmission to 75 countries.
v  Modernising 8,000 stores.
There is no mention of the expected return on investment or the possible implications for earnings per share.
The CEO's outlook, from the 2014 Annual Report, is for short-term pain followed by medium-term gain:
"In the short term, we continue to face competitive, macroeconomic and regulatory pressures, particularly in Europe, and still need to secure our recovery in some key markets. . . We anticipate that our investments will begin to translate into clearly improved network performance and customer satisfaction in the coming year.
"In the medium term, this will become more evident in key operational metrics such as churn and average revenue per user (‘ARPU’); and subsequently into revenue, profitability and cash flow. I am confident about the future of the business given the growth prospects in data, emerging markets, enterprise and unified communications. . . While cash flow will be depressed during this investment phase, our intention to continue to grow dividends per share annually demonstrates our confidence in strong future cash flow generation."
The company has already warned that its margins will be lower and its cash outflow higher in 2015 than this year. The promise is that heavy capital spending will bring about an improvement in profitability in the medium term.
At the current price of 192p Vodafone is yielding 5.7%. But it is not making profits nor is it generating sufficient cash to pay that dividend. Under these circumstances, my standard valuation model is of no use in valuing the company's shares.
Vodafone's share price has been steadily falling since the date that shareholders no longer had the right to the payout from the sale of Wireless (this is marked on the graph with a small black triangle in late February 2014).
Graph courtesy Yahoo, Vodafone share price in blue compared to FTSE 100 in green, click to enlarge
Given the parlous state of Vodafone's future as a stand-alone concern, the only factor supporting the shares is a possible bid. Vodafone has break-up value. A bid could come from AT&T, although it has said it is currently not interested in Vodafone, or another, very large telecommunications company. Or it could come from a well-endowed private equity firm. In either case, a potential bidder can afford to wait until Vodafone's shares fall to a more attractive level.
Investors in Vodafone should consider:
1.       The attractive dividend yield is not, in the present trading conditions, sustainable.
2.       Without the share of Wirelesses net income Vodafone is no longer profitable.
3.       Like-for-like revenues have declined by 6% in the past two years. Vodafone has spent 14 billion pounds in the last 12 months on acquisitions, which should help to reverse this decline in revenues. But the company continues to pay a high price that, on prior experience, may not prove to be justified.
4.        The CEO's plan is short on concrete objectives that will benefit the shareholder.
5.       The company will increase its debt, as it is both committed to a dividend payout that exceeds its capacity to generate cash and by the 19 billion pound capital spend set out in Project Spring.
6.       The share price is likely to fluctuate in relation to bid rumours rather than trading results. The share price is inherently unstable.
Disclosure: I do not hold any long or short positions in Vodafone and I will not do so for at least 15 days from today.