Analysis: Hydro One

The following is my analysis on the company Hydro One, traded on the Toronto Stock Exchange (ticker, H.TO).

Disclosure: I do not hold any position in the company, nor do I intend to in the next 48 hours.

Quick Facts

  • Industry: Utilities – Regulated Electric
  • Segment: Utilities
  • Type of buy: Very Defensive
  • Dividends: $0.84 paid out annually (on a TTM basis)
  • Payout ratio: 73% (on a TTM basis)
  • Market Cap: approx. $14B, public float of $7B1
  • Payout ratio – Generally anything above 60% is unhealthy for the company. However, considering this is a heavily regulated business and has restrictions on its ROE, I believe I am okay to overlook this ratio. Essentially, giving out dividends is the way the company is paying its shareholders as the stock price increase would not be tremendous. Also, the fact that it enjoys a monopoly in Ontario makes me comfortable in owning this as the business is highly unlikely to shut down its operations in a blink of an eye due to this metric.

Why buy this at current price levels ($22.10, as of writing this article)

  • Price: I believe for a business which is valued at approximately $14B, with an EPS of $1.14, I believe it is fairly priced.
  • I also bought it because it enjoys a monopoly (more explained in the business model part of the post) as it is likely to stay around from 5-10 years from now and more.
  • Growth in electricity expenses in the province provides an opportunity to profit by investing in this company.
  • I would buy this more for dividends, as I find the growth opportunities to have dried up in the equity markets. Also, I am starting to get a bit concerned with the equity markets and their direction in 2-3 years from now.
    • Worst case scenario: If the stock heads down south in the near future, I am okay to hold on to it and earn a dividend. If it goes down when there is a general correction, I would either add to my position or consider other lucrative opportunities (should they exist or fit my criteria).
    • Considering it is in the utilities sector, in the event of a downturn this sector gets the most attention as people flock to buy a piece in this sector.

Business Model

  • Monopoly: It is the biggest energy player in the province of Ontario which is home to approximately 38% of Canada’s population. Moreover, it intends to buy out the remaining smaller players in the province.
    • Bought Great Lakes Power Transmission in 2016 which increased its coverage to approximately 98% of the province wide capacity.
  • As per the Q1 2017 Investor Overview1 the expected compounded rate increase in the customer end bill over a period of 10 year is approximately 8.2%. This is substantial and indicates the electricity is set to become expensive in the near future. While it would mean my hydro bills are going up, I want to profit from this opportunity by investing in this business.
  • Outstanding Acquisitions (subject to regulatory approvals):
    • Plans to buy Avista Corp for $5.3B USD ($53 USD per share in cash).
    • Orillia Power Distribution subject to approval from OEB.

Risks

  • Subject to regulations & changing political climate: The government appoints 40% of Board Members with veto rights over the CEO. This implies, the government will call the shots.
    • Considering, how this company is subject to political climate in the province, the business as a whole is stable and does not need much innovation. The drawback about the company being partly owned by the local government is it limits itself to a certain threshold when it comes to ROE.
    • Allowed ROE will reset annually after 2019 by a formula linked to long-term government bond yields and utility bond spreads1. The 2017 allowed ROE was 8.7%, which I would gladly take considering the conservative nature of the business and how this return is close to the long term S&P 500 return.
  • Anticipated secondary offerings: None until further notice2. The government released a statement on May 8, 2017 indicating it does not foresee selling their stakes any further. Obviously, if things go south in Ontario and the provincial government is finding hard to find revenues, this may change. This change might dilute the equity base as more additional shares are issued.
    • With this the province owns 49.9% of the company’s outstanding shares3.
    • The initial plan was to make 60% of Hydro One shares available on the public market. This means, there is still 10% worth of Hydro One stake the provincial government will look to divest in the near future.

Citations

  1. Hydro One Investors Relations pdf
  2. News Ontario
  3. Hydro One Investors Relations

Additional Readings

  1. Why does electricity cost so much in Ontario
  2. Motley Fool

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