Homework: Electrica SA update
Electrica is the only remaining “Emerging Market” stock in my portfolio. I bought the stock in December 2014 and now after 3 year and some months it maybe time to assess how the situation looks against my initial expectations.
Including dividends, the stock is up ~18% in total since then, in my portfolio however the stock is flat because I bought more of Electrica at higher prices. Compared to a +53% performance of the portfolio in the same period, the stock is clearly a underperformer and the question is clearly if I should keep the stock.
My initial thesis relied on the following assumptions:
- the stock was cheap for a grid company with guaranteed returns on invested capital
- Romania was supposed to grow significantly and Electrica as well
- As a former Government owned company, I expected significant cost savings potential
- I had expected After Tax / After minority Earnings of around 442 mn RON in 2017
What happened ?
In the beginning, everything looked great, especially 2015 was a knock-out year. But as this table shows, already 2016 profit was stagnating but still in line with my expectations, before 2017 profits then fell significantly short of expectations, despite having purchased the minority stakes from Fondul at a reasonable price:
|Exp. Profit a.M.||252.6||311||376.9||441|
|Act. Profit a.M.||296.8||362.4||356.6||192|
The result presentation from 2 weeks ago now tries to explain this very unfavourable outcome.
One factor is an incentive programs for people to leave the workforce. As a prior Government entity, it is pretty clear that the company was quite overstaffed and adjusting the workforce makes clearly a lot of sense in the long-term. For 2019, this was supposed to be a 59 mn RON (pretax) expense which explains a little bit less than 50 mn RON after tax. The mention around 37 mn RON (pre tax) for other one-offs, which leaves a lot more to explain.
The bigger problem seems to be the unexpected strong growth of the country and as a consequence sky rocketing electricity prices. For some reason, electricity production in Romania did shrink, while Elctricity consumption increased due to the current economic boom. Already in the initial assessment I pointed out that the legacy electricity supply business could be vulnerable:
– business is partly electricity distribution, no pure “grid” play (no guarantees for distribution)
As prior Government entity, Electrica has to carry old retail contracts where former clients can get electricity at guaranteed prices. This means that Electrica could not pass through the significantly rising wholesale prices to most of its customers.
Instead of a ~174 mn RON pre-tax profit for the supply division that I had projected for 2017, the segment only made a profit of 1 (!) mn RON, leaving a gap of 173 mn RON pre tax to my estimates. It looks like that the situation is improving a little bit but I guess my initial estimates for the supply segment were clearly to optimistic,
In the distribution segment, investments are ramping up a little bit slower than I thought. However, unexpected for me, the distribution part has also hit by the rapidly increasing electricity prices.
The problem ist that Electrica has around 11,3% “network losses”, i.e. electricity that gets into their grid but does not reach the customer. It looks like that Electrica is responsible for buying the electricity on the market to compensate these losses and it seems that they didn’t hedge their purchases. Overall this seems to have been a negative effect of around 94 mn RON pre tax. Without this effect and the personnel reduction program, distribution profits would have been higher in 2017 than in 2016.
Looking at the stock chart, one can easily see how this has impacted the stock price negatively, especially in comparison to the overall index and my other previous stock Romgaz:
Electrica has been a outperformer until electricity prices rose in 2017. Since then, especially Romgaz who is an (accidental) electricity producer gained strongly whereas Electrica had to give up most of its gains. Looking back I should have kept Romgaz as a kind of “Hedge”.
Summary & what to do now ?
One of the lessons learned in the Electrica case is clearly that high GDP growth is not always good for businesses, especially if prices increases for inputs cannot be passed fully to customers.
Operationally I think Electrica is on track but I think I have underestimated the vulnerability towards volatile electricity prices.
Including the services business, I think the distribution business currently should produce ~350 mn RON in annual profit when electricity prices normalize which translates into a P/E of around 11,5. Assuming that the can grow this by 5-10% over the next years I do think that the stock ist still attractive, even if the supply segment is valued at zero.
So for me the stock is clearly a “hold”. The case might take longer as I thought, but compared to any other alternative I still think the stock is attractive at the current share price.