Head South of the Border for Utilities With Growth, Yield, and Moats
We think Latin America holds better investment opportunities than its northern neighbor.
We are enthusiastic about the opportunities that Latin American utilities present to investors relative to their U.S. utilities peers. While we forecast U.S. utilities to experience anemic 1% annual electricity sales growth over the next few years, faster population growth and wealth creation in South America should drive premium demand growth rates. We think concerns tied to slowing economic growth in Brazil and other South American countries create an opportunity for longer-term investors to capture this growth at discounted levels.
The South American utilities we cover have the greatest exposure to the Brazilian and Chilean economies. Over the past three years, Brazil and Chile have grown at an average GDP of 3.6% and 3.4%, respectively. The U.S. Energy Information Administration's prediction that South American economies will grow 3.1% through 2035 syncs up well with our annual electricity demand growth expectation of 3%-4% across the continent. There may be some near-term risk that infrastructure projects are delayed or electricity demand growth falls short of our assumptions, given poor economic data as of late--Brazil's GDP grew just 2.8% in 2011 and industrial production fell 3.4% in January. However, we think this risk is immaterial to these companies' long-term fundamental outlook.
These utilities' low-cost, narrow-moat hydroelectric generation supports much of the continent's energy needs. Significant capital expenditures will be required to ensure that electricity generation, distribution, and transmission can keep up with consumer demand during the next decade. While Latin American regulatory regimes are in their infancy, most have constructive frameworks that allow the utilities to invest in projects that enhance reliability and ensure sufficient energy supply while providing adequate shareholder returns.
Dividend and Earnings Growth Potential Is Higher
Latin American utilities offer higher dividend and earnings growth than U.S. peers. Energy demand in Latin America is forecast to grow 4%-5% annually through the next decade. We believe Endesa Chile and Enersis are best-in-class Latin American utilities that offer investors an opportunity to partake in the continent's growing infrastructure needs. If dry La Nina weather conditions subside in 2012 as forecast, the utilities' hydro generation should return to more normal levels, providing significant margin growth. Parents Endesa Spain and, ultimately, Italian utility Enel provide growth capital and could extract more cash to support lagging European operations, benefiting minority shareholders through faster dividend growth.
Heightened political risk, foreign exchange volatility, complex ownership structures, and low financial transparency are additional risks with these emerging-market utilities. These risks require a higher margin of safety relative to U.S. peers, and we therefore characterize the firms' uncertainty as high.
Endesa Chile (EOC). Improving post-La Nina hydro conditions should jump-start growth. We forecast that hydrological conditions will begin to improve as unfavorable hydrological conditions in 2010-11 normalize in 2012-13. A return to 2009 normal hydro generation levels could produce $0.50 of additional earnings. The forecast 2012 dividend implies a 5% current yield. We estimate 7.5% dividend growth in 2012 as Endesa Chile maintains its 60-70% payout ratio, based on our 12% earnings growth estimate.
Endesa Chile's structural advantages give it a narrow economic moat. Its low-cost hydroelectric generation, economies of scale, and significant barriers to entry should help safeguard future cash flows and returns on capital. In its primary market, Chile, the firm wields about 2.5 times more capacity than either of its two largest competitors. It is also larger than its main competition in Argentina, is the primary electricity producer in Peru, and is comparable in size with its competitors in Colombia. Even though low water levels can force the company to buy expensive spot power to meet its contractual obligations, we assume in the long run, normal weather conditions will allow its hydroelectric fleet to maintain a cost edge over its thermal generation competitors.
We think strong growth, solid free cash flow, and low-cost generation make Endesa Chile worth consideration for investors seeking infrastructure exposure in emerging markets despite recent setbacks from low hydrological conditions caused by La Nina. With La Nina forecast to pass in early 2012, normalized weather conditions and expected robust market growth should drive earnings per share. A desire by Enel, Endesa Chile's majority shareholder, to extract more cash from its subsidiaries could see an increase in the firm's payout ratio, as European economic conditions may drive Enel's need for capital.
Enersis (ENI). As with Endesa Chile, we expect hydrological conditions to improve in 2012-13 in Chile, where Enersis has 38% of its generation capacity. This should allow the firm to rely less on expensive purchased power to meet demand. On a weather-normalized basis, we assume electricity demand grows 3%-4% annually in the five countries where Enersis operates.
We estimate 11% dividend growth in 2012 at Enersis partly thanks to management's recent boost in its target payout ratio to 55%. The forecast 2012 dividend implies a 4.5% current yield. The dividend could grow even faster than earnings if management increases the payout ratio to its long-term 60% target. Enersis' parent and majority shareholder, Enel, could also demand higher payouts if conditions in Europe weaken.
We assign Enersis a narrow moat. Its concentration of hydroelectric generation assets, which represent 59% of its total generation capacity, makes the company a low-cost electricity producer. With the exception of Argentina, regulators in each of the company's five countries allow the firm to earn a fair rate of return from service area distribution monopolies. Through its stake in Endesa Chile, it benefits from Chilean regulators' 10% allowed real returns on assets, a particularly generous level with critical protection from inflation.
Enersis owns 60% of Endesa Chile and therefore has its results consolidated in its financial statements. Enersis also owns 54% of Endesa Brazil, where the firm has generation, transmission, and distribution assets in Brazil. In addition, Enersis owns stakes of distribution assets across Chile, Argentina, Colombia, and Peru. Whereas Endesa Chile gets all earnings before interest, taxes, depreciation, and amortization from generation assets, Enersis has a roughly 50/50 split between generation and distribution. And whereas Endesa Chile generates nearly all its EBITDA from its namesake country, Enersis generates about half in Chile, nearly a third from Brazil, and about 10% each from Colombia and Peru. Argentina has been a regulatory trouble spot, leading Enersis to write off its entire investment there during the fourth quarter.
Similar to Endesa Chile, we think strong growth, solid free cash flow, and low-cost generation make Enersis worth consideration for investors seeking infrastructure exposure in emerging markets despite setbacks from low hydrological conditions caused by La Nina. Enersis also gives investors a source of more stable earnings, owing to the firm's collection of adequately earning distribution assets in Chile, Brazil, Peru and Colombia. With higher assumed rainfalls this summer during Chile's rainy season, we expect Enersis' earnings to grow 11% in 2012. Dividends should follow suit from a 55% payout ratio, and could go even higher if Enel's need for capital presses the company to pay out more cash.
CPFL Energia (CPL). To arrive at our fair value estimate, we assume 8% average annual earnings growth through 2015 driven by strong customer growth, long-term economic expansion in the firm's service territories, and regular tariff adjustments for inflation. We forecast a 9% dividend yield for 2012 based on management's recent practice of distributing 95% of earnings. We assign CPFL Energia a narrow moat from the competitive advantage the Brazilian regulatory framework allows and its low-cost hydro generation fleet.
We think Brazil's largest private power distributor offers an attractive means for risk-tolerant investors to benefit from the country's economic stabilization and growth. Scale and natural monopoly status not only provide CPFL Energia a sustainable competitive advantage but also position the company well to benefit from increased demand during the next decade. The utility, which has a customer base accounting for 13% of the national market, is Brazil's largest private power distributor. These difficult-to-replicate assets represent a sizable barrier to entry. Brazil's young regulatory environment allows CPFL Energia an additional competitive advantage, with about three fourths of operating income derived from regulated electricity sales providing a steady and predictable cash flow stream.
Copel (ELP). To arrive at our fair value estimate, we assume 8% average annual earnings growth through 2016 driven by 3.5% annual demand growth and regular tariff adjustments for inflation in the industrial state of Parana in Brazil where it operates. A continued industrial slowdown in Brazil could affect Copel more than its Latin American peers given that 36% of sales derive from the industrial sector versus about 12% for Enersis and 8% for Endesa Chile. At current prices, we forecast a 4.4% dividend yield for 2012, as we assume the company continues to distribute about 45% of earnings.
Unlike CPFL, we don't think Copel has a moat, given the state government's value-destroying influence. The state of Parana owns 59% of voting shares in the company, giving the government ultimate power to veto management plans and even regulators' rate allowances. In recent years, the state of Parana has disallowed regulator-approved tariff increases so that customers' bills did not increase in times of economic difficulty or excessive inflation. This has led to subpar distribution returns and ongoing uncertainty whether the firm will be able to earn above its cost of capital.
That said, Copel has some great assets. More than 99% of its generation comes from low-cost hydro. Copel also has received concessions for ownership interests in more hydro power plants across Brazil, including Maua, Colider, Cavernoso, and Sao Jeronimo. With the exception of Sao Jeronimo, these projects will probably come on line in 2012-14. Brazil's secular economic growth, especially in the industrial-heavy state of Parana, will support ongoing investments in new generation capacity.
Andrew Bischof does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.