I. Sector landscape and outlook
In general, utility sector comprises companies that provide basic services such as electricity, natural gas, sewage services, water services and waste services to common households and commercial and federal places as a public service. As the services are public in nature, the sector is heavily regulated and limits the opportunity of charging high rates, thus diminishing the scope of earning colossal profits. These companies require heavy infrastructure that is expensive and requires periodic updating and maintenance. The companies finance these infrastructures by floating debts. Thus, their balance sheet often showcases debt loads to be paid with interests. The 24/7 criticality of the industry makes it kind of safe investment for investors, holding stocks for long-term to infuse stable income into their portfolio.
The utility sector takes care of the essential items and services required, and thus, the COVID-19 pandemic had less impact on the sector. During the time when all the businesses were closing amid the countrywide lockdown; utility sector remained operational to cater to the essential need of the consumers. However, social distancing and lockdown have created supply chain disruption as many key materials and equipment are shipped from abroad.
On that note, let us understand the various factors that can create and demystify the performance of the companies operating within the industry.
Fig 1: Factors affecting the Utility sector
Source: Kalkine
Higher Debt Levels
The utility companies require a considerable level of costly setup, and thus their balance sheets demonstrate a hefty debt load. Changes in the market interest rate make the utility debt cost more susceptible to risk. The Utility sector is also capital-intensive in nature and thus requires constant availability of liquidity to fund infrastructure purchases and maintenance. Higher debt load also leads to higher debt to Equity ratio, impacting credit ratings of the company. A negative or inferior rating crates hurdle in securing funds from borrowers or investors.
Customer Churn
With multiple retailers in the market, consumers can easily switch from one retailer to another based on choosing a more cost-effective plan for their household.
Power Purchase Agreement
A Long-term agreement regarding power purchase between operators and their consumers leads to decreased profits as the cost of the company keeps changing. While costs generally increase with time, the long-term contracts have contract prices fixed at the current rate.
Now that we know about factors affecting the Utility sector, let us ponder on the demand and supply dynamics in the Utility sector.
The sectors provide Australians with electricity, water, gas, as well as waste removal services. With a rising population, urbanization, climate change and depleting resources, the demand for cost-effective utility services is at zenith.
Electricity
In 2019, total electricity generation has been estimated to be 265,117 Gigawatt hours (GWh) in Australia with fossil fuels contributing to most of the electricity generation and consumption. Total electricity generation from Fossil fuel sources stood at 209,636 GWh in 2019, representing 79% of total electricity with coal accounting for the majority of electricity generation at 56% of total electricity generation in 2019. Total electricity generation from renewable sources stood at 55,481 GWh, representing a rise of 12% over 2018. Renewable sources contributed to 21% of the total electricity generation in 2019. In the renewable segment, wind and solar were the primary contributors, each representing 7% of total electricity generated, followed by hydro at 5%.
Electricity consumption has increased nominally over the years. Because of COVID-19 impact, demand for commercial electricity has decreased, and residential requirement for electricity has risen. The commercial requirement has gone down because of shuttering down of various businesses.
Fig 4: Annual wholesale consumption of electricity
Source: Australian Energy Regulator
Wholesale electricity prices also plummeted and are currently trading at five years low because of decreased demand driven by COVID-19 lockdown measurement, which resulted in crippling business across Australia. According to National Electricity Market, average spot wholesale prices went down by 48% to 68% over the previous corresponding period to ~$32 to $43 per megawatt-hour in Q2 2020 while demand was only 2% less than Q2 2019.
Natural Gas
According to CEIC Data, Australia’s Natural Gas Consumption has been recorded at 5.200 Cub ft/Day billion in Dec 2019, a 30% increase from 4.008 Cub ft/Day billion recorded in for Dec 2018.
Fig 5: Natural gas consumption in Cub ft/day
Source: CEIC
Future Consumption Expectation
Rising population, urbanization, climate change and depleting resources are expected to boost demand for fuels in the future considerably. According to EIA, the estimated fuel consumption is set to increase by one quadrillion Btu from 2019 to 2030.
Fig 6: Estimated fuel consumption in quadrillion Btu
Source: EIA
Having understood the demand conditions, let us have a look at the current risk factors ailing the Utility sector.
- As the services are public in nature, the sector is heavily regulated and limits the opportunity of charging high rates, thus diminishing the scope of earning colossal profits. The competition also limits difficulty in increasing prices to increase revenue.
- The industry is extremely capital-intensive. The infrastructures are expensive and require continuous upgrades maintenance. Most of the time, the company have to buyout infrastructure by floating debts in the market and giving higher yields to investors, thus increasing the costs of the infrastructure further.
- When the economy is booming, market interest rates generally go high, thus increasing the overall costs of the company.
Outlook
The utility sector is immune to the economic cycles as it provides basic services such as electricity, natural gas, water services, creating a constant demand for its services. Utility stocks are considered defensive as they offer long term investment options for investors and provide stable and consistent dividends. As the services fall under essential services, the demand never dies, making the companies’ revenues less volatile. This creates a stable business operation which is reflected in the market trajectory of utility stocks. Given, the economy is expected to remain uncertain in the near term; utility stocks are likely to be in the limelight.
II. Investment theme and stocks under discussion (AGL, CEN, IFT and APA)
After understanding the sector, let us now look at four companies listed on the ASX. The price potential of the companies under discussion has been analysed based on ‘Discounted Cash Flow’ method.
- ASX: AGL (AGL ENERGY LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap: A$ 10.62 Billion)
AGL Energy Limited is engaged in the operation of energy businesses and investments, including electricity generation, gas storage and the sale of electricity and gas to residential, business and wholesale customers.
Valuation
Our illustrative valuation model suggests that stock has a potential upside of ~15% on 5 August 2020 closing price. At the same price, the stock is offering a dividend yield of ~8.85%.
- ASX: CEN (CONTACT ENERGY LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap: A$ 3.94 Billion)
Contact Energy Limited is a New Zealand-based energy company with a diverse mix of assets which helps it to maintain a reliable, affordable, and environmentally sustainable electricity supply in the country.
Valuation
Our illustrative valuation model suggests that stock has a potential upside of ~21% on 5 August 2020 closing price. At the same price, the stock is offering a dividend yield of ~8.73%.
- ASX: IFT (INFRATIL LIMITED)
(Recommendation: Hold, Potential Upside: High Single Digit, Mcap: A$ 3.22 Billion)
A New Zealand based company, Infratil Limited is operating in the energy, transport, data infrastructure and social infrastructure sectors.
Valuation
Our illustrative valuation model suggests that stock has a potential upside of ~9% on 5 August 2020 closing price. At the same price, the stock is offering a dividend yield of ~4.4%.
- ASX: APA (APA GROUP)
(Recommendation: Hold, Potential Upside: High Single Digit, Mcap: A$ 13.25 Billion)
APA Group is engaged in owning and operating energy infrastructure assets and businesses.
Valuation
Our illustrative valuation model suggests that stock has a potential upside of ~7% on 5 August 2020 closing price. At the same price, the stock is offering a dividend yield of ~4.8%.
Note: All the recommendations and the calculations are based on the closing price of 5 August 2020. The financial information has been retrieved from the respective company’s website and Refinitiv (Thomson Reuters). Recommendations are valid at 6 August 2020 price as well.
*Please be aware that dividends are variable and not guaranteed.
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