After a very strong rally in the first half of January, Russia’s stock markets have been hit by fears of a global coronavirus epidemic and collapsing oil prices which have led the market to give up all its gains made year to date. But not so the utilities sector, where share prices have surged by 16%. Currently the power sector is the only sector that is performing well and is set to lead the stock market for the rest of the year.
“The world is slowly but persistently moving toward electricity as the main source of final energy. We estimate that the share of electricity has more than doubled over the last 30 years to 19%. Russia has not ignored this process,” Vladimir Sklyar, an equity analyst with VTB Capital (VTBC), said in a note.
The emerging middle class has been a big source of new demand for electricity. In the Soviet era televisions famously either didn't work or they blew up when you turned them on. But modern Russia has embraced gizmos as its badge of membership of capitalist society.
At the same time the sheer size of the country means railways and telecom networks, their reform and development, are also driving up demand rapidly. The growing share of service industries (which are more dependent on electricity supply than other energy sources) in GDP have all led to an increase in electricity’s share of the fuel mix in Russia. Next up will be the advent of electric vehicles, the first of which are starting to make their appearance on Russian roads.
“At the start of this new year, we try to answer a simple question: are Russian utilities a Buy in 2020? A helicopter view on the metrics and sentiment gives a simple answer: yes. Russian utilities are profitable, growing, underleveraged, free cash flow-rich, cheap and generous names in the Russian equity universe with management teams that are already, or are soon to be, motivated by clear and transparent market mechanisms,” Sklyar said.
Russian utilities shares valuations are currently about 50% cheaper than the rest of the Russian market compared on both an EV/Ebitda and p/e basis. That means despite the rally of the last six months there is still more room for growth.
Finally, leading utilities operating in Russia have begun the process of shuffling their generation profile to reflect the rapidly growing concern with the climate crisis and reducing emissions. In one of the most notable deals of 2019 the Russian subsidiary of the Italian power generation company Enel sold off one its largest power stations as it is coal fired, but has been investing heavily in renewable energy sources to replace the missing capacity.
Investors have woken up to the growing potential of the power sector and the shares of listed utilities started to rally in the second half of 2019. After a strong first fortnight in 2020 Russian stocks have sold off heavily as investors become “risk on” again thanks to the outbreak of the coronavirus. Not utilities though. While the RTS index had given up all its gains as of the middle of February and most of the other sector had returned 4-5%, the utilities sector was up by a handsome 16% YTD as of the time of writing.
With earnings per share (EPS) in the utility sector expected to grow at a double digit rate over the course of this year compared with no growth at all for the benchmark MSCI Russia index, then utilities have already become the default choice for exposure to the Russian stock market, says VTBC. The firms Enel Russia, RusHydro, InterRAO, Unipro and OGK2 are all “pockets of growth” in a sector that is likely to put steady corporate profit growth.
Reform of the utilities sector started back in 2007 when the sector last rallied, but the 2008 crisis caused a pause. However, in the intervening years the reforms have continued backed by investment incentives that have led to an overhaul of the entire sector. Now that the investment phase is winding down that leaves utilities with most of their investment finished and improving profit and free cash flow positions.
And the reform programme has been updated and encompassed by the current so-called DPM2 programme to upgrade ageing generation capacity that is supposed to run to 2035 and will entail a total of $620bn of investment. Bank analysts are predicting that the rally will continue in 2020.
“Operationally, the outlook remains solid. The sector is fully deleveraged and is in our view capable of undertaking any investment it requires in the coming years. Companies enjoy robust profitability and cash flows (FY20F avg free cash flow yield of 16%),” said Sklyar.
“Each is using the low point of the capex cycle in a different manner: some are looking at M&A opportunities (InterRAO), others to raise dividend payments (Unipro), and yet others for horizontal expansion (renewable energy for Enel Russia) or vertical integration (gas turbine production for the GEH gencos),” Sklyar added.
The development of the power business is still being driven by profits and demand whereas only Enel has put reducing emissions, greening its portfolio and improving its environmental, social and governance (ESG) score as a top priority. As bne IntelliNews reported in “The cost of carbon in Russia”, power generation is by far the largest source of greenhouse gas emissions and accounts for 47% of the total, against the global average of 37% for the sector. However, Russia’s power sector carbon emissions are actually down by a third from the 70s, but that has more to do with investment in more efficient technology to improve profits than it does with any concern over global warming.
So what makes the utilities so attractive? Analysts say the sector has five key pluses.
Firstly Russian utilities are growth stocks at a time when most of the rest of the Russian economy is stuck in the quagmire of stagnation. VTBC predicts that the profits of utilities should grow by 16% this year year-on-year as a result of the rising demand.
Secondly because of the crisis most utilities have striven to pay off expensive debt early and the sector is now underleveraged. That leaves more of the revenue stream free for investment even with existing capex plans. VTBC estimates utilities have a 16% free cash flow (FCF) yield of which only half is being used to pay dividends.
Thirdly the companies are either already paying out almost all of their FCF as dividends or their share prices are well below market averages with price-to-earnings ratio (p/e) of as little as 1.6x.
Fourthly the management of Russia’s utilities are becoming increasingly professional. That has partly been driven by the growing use of management incentive and share option programmes that tie the motivations of management to the improved performance of the company.
And finally the sector is becoming increasingly predictable. Over two thirds (71%) of generating company revenues are locked in with multi-year tariff agreements, while the capex in most has also been set in stone through to 2025. Even the energy prices have converged with fuel prices to increase the productivity of the companies’ income.
However, analysts argue that interest in Russian utilities is still underweight despite the increasingly generous deals on offer as the “Russia risk” still overshadows the investment stories.
“Leading Russian utility Unipro can serve as a good example: despite announcing an 11.4% per annum three-year dividend commitment, investors have broadly ignored the stock,” says Skylar. “That would be unimaginable on the DM stock markets, where utilities, with their sustainable, predictable cash flows and rich dividends, are the sweethearts of pension funds.”
This spotty interest has been made worse by the slow catch up many utilities are playing to investors’ growing concern with ESG factors. While the “E” in ESG is still the most important, other factors like gender equality in the management or a commitment to developing renewables have not been prominent and so investors have lost interest as scrutiny of their portfolios for ESG compliancy increases.
Still, profits still count for most. While Scandinavian countries are now adopting strict rules for ESG compliance, elsewhere in Europe that is still minimal and there are no ESG restrictions on investors in London and New York.
The main risk to the sector is external shocks and currency fluctuations. However, here too the utilities are well protected. Thanks to their efforts to deleverage over the last few years most are cash rich and many even boast negative debt as they have net deposits of cash on their books for the first time ever.