Tuesday, 18 April 2017

Can we find a truly Defensive utility? ENEL Generacion Chile (NYSE:EOCC): Part I

My fruitless search for a truly defensive utility in the UK took to me to foreign shores and back into the arms of an old acquaintance. 

ENEL Generacion Chile (NYSE:EOCC) is a Chilean electricity generation company. I used to cover this company and was very familiar with it having visited management many times. In the last couple of years they have had something of a reorganisation but the fundamentals remain the same.

Let us do a quick surface appraisal. EOCC pays a 3% dividend yield rising to 5%+ in the medium term (as the pay-out is scheduled to increase), it trades on 10x 2016 PE, it has gross debt of only 2x the last net profit and it has negligible pension liabilities. This makes it immediately more appealing than the likes of Centrica and SSE. EOCC is a former state company too but unlike the UK entities the pension liabilities of EOCC are tiny because Chile established a private national defined contribution pension system decades ago.

Let us look at the macro in this part I and valuation in a separate part II. 

Chile is the Norway of Latin America. The comparison is pertinent as both nations have huge coastlines, small populations, strong governments and a cash cow export – (they also both do a lot of salmon farming). Chile has the best institutional integrity in the region, the kind of strong institutions that Argentina used to have and were totally eroded under the Kirchner government. That means regulators, the central banks, companies and investors in the country are among the least corrupt in the region. 

The Chilean economy is driven by copper. Chile is the world’s largest producer of copper and it has both private and public (Codelco) investment in the copper industry. This means Chile is an export oriented mining economy. Chile also has a very open import system with low barriers to trade. 

Generally Latam is split between larger nations which have attempted to build their own industrial base (Brazil and Argentina) and smaller nations that have accepted their export oriented position and have more open economies (Colombia, Chile and Peru). 

In between are nations like Venezuela which have neither an industrial base (just oil) nor an open economy – and countries like Bolivia and Paraguay which are generally populist and underdeveloped. Uruguay is an oddity – being a bit like Switzerland – Uruguay has agriculture and banks where Argentines hide their dollars.

So Chile’s economy is generally vulnerable to global shocks and follows the global industrial cycle as copper (and other minerals) follow closely the industrial cycle. Investment has been strong in recent decades due to Chinese industrial growth and global demand for copper. Interestingly the stock market does not reflect the mining base of the economy being principally banks, retailers, pulp, utilities and an airline.

Now because the Chilean government are sensible people they recognise they are vulnerable to copper. Therefore the government budget is cyclically adjusted to reflect the variance of revenues from the mining sector to produce neither a net deficit nor a net surplus over the cycle. 

Government Budget (Trading Economics)

Not only that, the government also has very low debt levels. 

Debt to GDP (Trading Economics)

Debt to GDP is just 17%. A few years ago it was approximately zero. The government issues bonds primarily to create a market of liquidity for local and international banks. Furthermore the pensions of this relatively young nation are invested in defined contribution funds called AFPs. By law all workers contribute ~10% of their salary to these funds. These funds are heavily invested historically in the local equity market. This tends to keep valuations elevated and means Chile is off the radar for a lot of stock screeners.

So here we have a highly cyclical and open trading nation with a prudent policy of economic management and decent quality institutions. Chile is really quite close to being a developed nation. If you go to Santiago it feels like any modern city in the west. But outside of Santiago the nation is still relatively poor by western standards. However these growth trends toward development and relatively young demographics mean Chile has greater potential for growth.

Chile has a younger population than say the United Kingdom. However the pyramid is less impressive for demand growth than another regional economy like Peru:


This brings me onto EOCC. EOCC is the largest generator of electricity in Chile. It has a 35% market share with 6,350MW of installed capacity being principally Hydro (55%), Gas (34%) and Coal (10%) with some limited wind assets (1%). The primary competitors are Colbun, AES Gener and E.CL none of which you can buy as an investor without local market access. So I will focus on EOCC as it has an ADR.

The Chilean system works with a mixture of contracted energy and uncontracted supply. The generators will contract a large proportion of their production ahead in contracts with suppliers. The price of electricity is controlled via the regulator through the distribution system. The distribution system is separate from the generation side and is also private. This pricing takes into account some pass through for generation fuel costs and hydrology. The generators then bid to contract energy to the distributors at competitive prices. That contracted base will be an estimate made by EOCC of how much energy it can produce via Hydro in combination with Coal thermal base load and some gas base load and peaking. ~80% of sales are via the regulated system with the residual being unregulated (which means commercial sales to industry usually mining) and spot sales (meaning energy sold into the system at marginal cost during times of supply shortage.)

Now this is all a bit complicated but essentially what it means is if hydrology is better than expected EOCC can produce more energy via hydro and therefore reduce its cost of generation even whilst its contracted sales price remains relatively firm. Essentially EOCC are long rainfall - or rather snowfall -as most of the water in the reservoirs is derived from snowmelt in the Andes – hence hydro production peaks in the spring and summer. 

Now this is a crucial point – EOCC has a driver for better margins and earnings that is totally uncorrelated with global capital markets which are in a time of massive risk on/risk off trading.

The Fed can make it rain dollars, but they can’t make it rain.

In recent years it hasn’t been raining. Rainfall in Chile is driven by the ENSO cycle:

ENSO Cycle - note the last very strong El Nino 1998 and  moderate one in 2009 (Met Office)

During El Nino years Chile experiences bumper precipitation – during La Nina Chile experiences drought. A La Nina cycle followed by several neutral years has depleted reservoir levels driving down margins and driving up power costs in Chile. A new El Nino cycle would drive up rainfall – given the havoc El Nino causes in crops etc this makes EOCC quite an interesting hedge. We are currently overdue an El Nino cycle but present conditions are uncertain.


Note some modest correlation between EOCC results over the last 10 years and the El Nino pickup in the 2009/10 period:
Endesa Chile 10 year earnings - Note the 2009 brief El Nino impact vs La Nina from 2010/11

Interestingly during periods of extremely good hydrology the whole system can take advantage as thermal based companies like AES Gener can simply buy hydro on the spot market and sell it under their contracts at prices well below the marginal cost of thermal production so they just shut down plants.

Now Chile has another interesting quirk. It has four electricity grids. The country is several thousand kilometres long which makes transmission of electricity challenging. The main grids are the SIC (central) and SING (northern). The SIC grid serves principally residential and industrial customers around the populous Santiago area. This grid draws a lot of energy from Hydro sources south of Santiago. The other grid of note the SING is almost entirely thermal being situation in the arid Atacama desert and primarily provides energy to the mining industry. EOCC operate in both but the primary exposure for the company is the central grid.

EOCC is indirectly and directly exposed to the copper price and copper mining industry. 

It is indirectly exposed via the currency. As EOCC is a domestic producer it generates sales in CLP but purchases a lot of fuels in USD. Therefore higher copper prices mean the CLP appreciates and thus reduces fuel costs increasing margins. It also drives up the value of the CLP cashflows and dividends that EOCC generates. (Much of this is however hedged)

The company is also directly exposed via demand – increased mining activity means increased sales and generation both from miners and from general business activity. Copper ore grades have been falling for years as the best assets are mined first meaning the industry is becoming more energy intensive which should drive future growth in the SING grid at least.

So EOCC is, like most EM stocks, a play on a weaker dollar or at least a higher copper price. 

Now EM stocks are about growth. Chile has some growth. The demand CAGR over 10 years for electricity is 3.4% - if we add to this some price inflation a revenue growth rate of 5-6% seems reasonable. This is decent but unexceptional. However Chile is much closer to being a developed market. Energy consumption is around 3,000 kwh/per capita compared to ~5,000 in the UK or ~7,000 in Germany. Now Chile has far greater consumption than Peru or Colombia (~1,000) – so there is less potential for growth as the country is higher up the development curve. The underlying economic growth rate is decent but slowing compared to history:

Annual GDP Growth Rate (Trading Economics)

The real barrier to growth in Chile is environmental opposition. There is opposition to new hydro projects due to the flooding of land and environmental concerns. This saw the HydroAysen mega project shelved by the government. Aysen was a proposed project with 2,750MW of capacity jointly owned by EOCC and Colbun. This would have given a huge boost to Chilean hydro resources but it was technically difficult being in the deep south of the country the transmission line was a major environmental sticking point. Aysen may come back in a revised form – which would boost the stock. 

Now the issue is there is also environmental opposition to thermal energy, especially coal, due to pollution. Chile however imports all its natural gas and much of it via LNG due to disputes historically with Argentina so gas production is expensive. And there is opposition to expensive energy!

This leaves renewables. In Chile they call them ‘non conventional renewables’ (NCRE) due to the fact that they already have renewables in the form of hydro. EOCC do therefore have a small amount of wind based renewables and the energy companies have a legal commitment to increase their NCRE production in the coming years. 

Most likely solar power will pick up the slack as Chile has a lot of sunshine. But the difficulty is the best sun is in the northern area and solar only runs during the day so is unsuitable for mining projects with crushers running 24 hours. There is currently no interconnection between the two grids so harnessing the power is a bit more difficult. ENEL Chile has no solar power because ENEL Green Power consolidates the solar assets of ENEL in Chile (more on the group structure later.) Solar development has been rapid in Chile but this causes problems for pricing depressing prices periodically and within the daily cycle discouraging new alternative base load projects.

What about nuclear? Nuclear energy in Chile theoretically would be a good idea. The country has a huge coastline and lots of depopulated areas especially in the north of the country. Much like Japan they import all their fuels so it could also improve the trade balance. However much like Japan Chile has massive earthquakes and tsunamis. After Fukushima we can assume nuclear will never happen in Chile.

So the Chilean generation capacity is not really growing as new projects can’t get approval and this is reducing the potential growth of the sector. EOCC has one project currently underway which is a 150MW hydro project called ‘Los Condores.’ This is a run of river plant rather than reservoir based so should have an estimated 46% load factor or 600Gwh which is around 2.5% of current generation sales. The capex for that is $660m and to date it is 45% finished. After 2018 capex should drop substantially upon completion. 

What this means is EOCC has limited growth beyond 2018 with earnings growth driven by (a) higher sales prices (b) lower cost production. What is likely to happen is revenues growth is limited whilst margins expand due to improving hydrology. Without a substantial growth in the asset base EOCC cannot grow their market share and therefore cannot grow top line much beyond the market level. 

The good thing for shareholders is a lack of available projects means the dividend should rise. The company is guiding for an increase in the pay-out ratio from 50% today to 70% by 2020 raising my estimated yield from 3% trailing to 7% by 2020. (Note by law Chilean companies must pay out a minimum of 30% of earnings as dividends.)

Therefore somewhat unusually you have an EM stock where really the value proposition is greater than the growth proposition – or at least the defensive quality of low debt and low variability in earnings is stronger than the potential for greater capital reinvestment and appreciation. 

Things that are good about Chile:

  • A sensible and macro prudent government with low debt
  • Good hydrology conditions and conditions for renewable energy
  • Decent economic growth and population growth rates
  • Reasonably low corruption

Things that not great about Chile:

  • The country and currency are heavily exposed to copper and the global industrial cycle
  • Limited capacity growth opportunities and significant environmental opposition
  • The demographics/growth profile are not as favourable as other regional economies

In Part II we will look at the company specifics and valuation case.

Disclaimer: I have no interest in stocks mentioned in this article at present although I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

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