value and opportunity

In 2012, I sold my two utility stocks EVN and Fortum because I realised that I didn’t really understand the business model. I looked a little bit more general into utilities here, but with no real results. However,at least in Europe, the utility sector looks like one of the few remaining “cheap” sector.

If you don’t know a lot about a sector but need to start somewhere,it is always a good idea to look ifWarren Buffet has something to say about it

Although mostly his well-known consumer good investments like Coca Cola and Gilette are mentioned, Buffet runs a quite sizable utility operation called MidAmerican Energy.

Starting with the Berkshire 2011 annual report, let us look how the “sage” describes the business:

We have two very large businesses, BNSF and MidAmerican Energy, that have important common characteristics distinguishing them from our many other businesses. Consequently, we assign them their own sector in this letter and also split out their combined financial statistics in our GAAP balance sheet and income statement.
A key characteristic of both companies is the huge investment they have in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is not needed: Both businesses have earning power that even under terrible business conditions amply covers their interest requirements.

So let’s note here first: Buffet uses “large amounts” of debt for his utility company.

Just below we find the following statement:

At MidAmerican, meanwhile, two key factors ensure its ability to service debt under all circumstances: The stability of earnings that is inherent in our exclusively offering an essential service and a diversity of earnings streams, which shield it from the actions of any single regulatory body.

I would argue he second point is interesting: Diversification in utilities works across regulators, not necessarily geographic location.

What I found extremely interesting is that Buffet is allocating a lot of capital to the utility sector. Out of the 19 bn USD Capex in Berkies operating businesses from 2009-2011, MidAmerican Capex summed up to ~9 bn USD, so almost half of Berkies total Capex.

One can assume that Buffet is not making all share investment decisions nowadays, but I think capital allocation to operating companies will be still made by him personally.

Buffet seems also quite interested in renewable energy, as the following comment from the annual report shows:

MidAmerican will have 3,316 megawatts of wind generation in operation by the end of 2012, far more than any other regulated electric utility in the country. The total amount that we have invested or committed to wind is a staggering $6 billion. We can make this sort of investment because MidAmerican retains all of its earnings, unlike other utilities that generally pay out most of what they earn. In addition, late last year we took on two solar projects – one 100%-owned in California and the other 49%-owned in Arizona – that will cost about $3 billion to construct. Many more wind and solar projects will almost certainly follow.

Here, he also mentions that he doesn’t extract any dividends out of his utility group. He considers it a growth opportunity rather than a cash cow. I think this is also worth keeping in mind, as many investors would judge utility stocks mainly by dividend yield.

From the 2009 report we learn the following:

Our regulated electric utilities, offering monopoly service in most cases, operate in a symbiotic manner with the customers in their service areas, with those users depending on us to provide first-class service and invest for their future needs. Permitting and construction periods for generation and major transmission facilities stretch way out, so it is incumbent on us to be far-sighted. We, in turn, look to our utilities’ regulators (acting on behalf of our customers) to allow us an appropriate return on the huge amounts of capital we must deploy to meet future needs. We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.

This is as clear as it gets. Utilities are a “natural” monopoly. If you play by the rules (at least in the US), you are guaranteed a decent return.

In the same report Buffet once more explains why he is suddenly more interested in utilities:

In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite
willing to enter businesses that regularly require large capital expenditures.

From the 2008 report, this sentence is reinforcing Buffets strategy:

Indeed, MidAmerican has not paid a dividend since Berkshire bought into the company in early 2000. Its earnings have instead been reinvested to develop the utility systems our customers require and deserve. In exchange, we have been allowed to earn a fair return on the huge sums we have invested. It’s a great partnership for all concerned.

On acquisition of utilities, we can also find his thoughts in that report:

In the regulated utility field there are no large family owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business, including a willingness to commit adequate equity capital.

When MidAmerican proposed its purchase of PacifiCorp in 2005, regulators in the six new states we would be serving immediately checked our record in Iowa. They also carefully evaluated our financing plans and capabilities. We passed this examination, just as we expect to pass future ones.

So being nice and trustworthy to the regulator is what counts in this business.

Finally let’s look at some “hard numbers” from MidAmerican, in order to be able to compare this to other utilities. I will use the MidAmerican 2011 annual report for this.

		2011	2010	2009	2008
Total Assets		47.7	45.7	44.7	41.4
Shareholders Equity		14.1	13.2	12.6	10.2
total financial debt		17.8	18.2	19.3	18.2
Sales		11.2	11.1	11.2	12.7
EBIT		2.684	2.502	2.465	2.828
Net Income		1.331	1.238	1.157	1.85
Int. Exp		1.196	1.225	1.257	1.333
Op. CF		3.220	2.759	3.572	2.587
Capex		2.684	2.593	3.413	3.937
ROE		9.8%	9.6%	10.2%
NI margin		11.9%	11.2%	10.3%	14.6%
EBIT Margin		24.0%	22.5%	22.0%	22.3%
Debt/equity		126.2%	137.9%	153.5%	178.4%
EBIT/Int exp		2.24	2.04	1.96	2.12
ROA		2.9%	2.7%	2.7%

We can clearly see that this is low ROA business. Only the significant leverage allows Buffet to have ~10% ROE on average. Additionally, he seems to provide some “contingent” capital to MidAmercian, i.e. to promise a capital contribution of 2 bn USD if required. I think this keeps down the cost of debt without explicitly guaranteeing it. MidAmerican has a credit rating of “only” A- against Berkshire’s AA+. Also one can see that he reduced leverage over the last few years since taking over MidAmerican.

Nevertheless he seems to prefer this vs. returning cash to shareholders. Interesting.

So let’s quickly summarize Warren Buffet’s perspective on utilities as far as I understood it:

– he only started to invest into utilities relatively lately because he needs something where to invest his growing cashflows from the other operations
– he prefers regulated utility business, diversified over different regulators
– he invests a lot of money into renewable energy
– he uses significant leverage to achieve 10% ROE
– he is not looking at the busienss as a cash cow but a long term growth business and therefore does not extract any dividends