Thursday, 20 April 2017

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

So in part II of my analysis of EOCC I wanted to look at the specifics of the company. The most important issues are:

  • Company structure and history
  • Corporate governance
  • Alternatives
  • Debt and pensions
  • Assets and Moats
  • Earnings Outlook
  • Uses of cash
  • Valuation

Company structure and history

ENEL Generacion Chile (EOCC) used to be called Endesa Chile and it used to trade with the ADR (EOC). It is the former national electricity company of Chile which was privatized in 1989. The company contains a mix of hydro and thermal power generation facilities across Chile.

The ultimate parent in ENEL the Italian utility giant which in turn owns Endesa Chile and Enersis Chile as they then traded. Enersis Chile contains the distribution company Chilectra. In 2016 ENEL changed the company structure and Endesa Chile and Enersis Chile were split out with a number of assets moving within the convoluted organisation. 

The impact essentially is that prior to this point Endesa Chile contained the majority of generation assets of ENEL within Latam - so the stock was pan regional with generation assets in Peru, Colombia, Brazil and Argentina. Following the reorganization Endesa was rebranded ENEL Generacion Chile now contains only the Chilean assets with the other regional generation assets being consolidated within what is now called ENEL Americas (NYSE:ENIA). 

To further complicate things the immediate parent of Endesa Generacion Chile is ENEL Chile (NYSE: ENIC) which is an electricity distribution company which was formerly Enersis Chile (and which similarly has had the ex Chile distribution assets stripped out into ENEL Americas.) 

ENIA Company Presentation

So for comparative purposes the stocks have a limited earnings history as solely Chilean enterprises. Also this restructure was controversial which leads us onto:

Corporate Governance

ENEL do not have the best reputation for corporate governance. As part of the reorganization they overvalued assets that were transferred into the new ENEL Americas group and only changed the valuation after AFPs got involved and put pressure on ENEL with their own valuations. 

ENEL is ultimately controlled by the Italian government. Which is not great news. It is also indebted so again has an incentive to take cash out of these EM businesses. Although EM also offers it growth so the incentive to invest gives some balance.

Fortunately EOCC is as far down the chain as it is possible to be from ENEL. In my experience the local management are decent operators.

Share based payments are not an issue.

Debt and Pensions

Employee benefit liabilities of CLP 15,820m or $24m dollars this is only 3% of profits for 2016 and therefore not a material concern. The reason this is so low is the success of the 1980 pension reform undertaken by the military government which saw the formation of state mandated defined contribution schemes for all workers in the 'formal' economy - except funnily enough the military. This means that defined benefit pension schemes are generally non existent in Chilean companies. So we do not have to worry about a BT or Centrica sized pension black hole when looking at company fundamentals.

The debt level in EOCC is also low by industry standards at around 2x prior year profit gross (1.7x net debt). Debt in FY2016 was around 30% of capital , interest is 8x covered and net debt is 1.3x EBITDA. Debt is around 20% of the enterprise value. This is modest gearing and generally we expect a decent level of gearing in a utility to drive up returns on equity from a regulated assets base. I consider these debt levels vastly superior to the those offered in the UK.

These strong metrics mean EOCC has an international debt rating of BBB+ investment grade and AA within Chile (note Chilean government debt rating is high grade AA-).


It is all very well comparing EOCC to UK utilties but what about regional alternatives? Well I profess I am but one analyst so I start with my circle of competence. That excludes Brazil as I have less experience in that market so will put it aside for now. Still there is ENEL Americas (ENIA) and ENEL Chile (ENIC)?

I had a look at ENEL Americas but ultimately I feel it has a less appealing asset base, a slightly higher valuation and greater regulatory risk. The generation assets are less appealing as they are principally thermal and therefore replaceable (although the Colombian El Quimbo dam is a great asset). 

The distribution business is more highly regulated and therefore has more limited upside. The regulatory risk is greater especially in Brazil and Argentina where government are more interventionist. 

Note until recently the Argentine utility sector was totally depressed due to price freezes - it has had a substantial run in the past year or two though - have a look at Pampa Energia (NYSE:PAM) a stock I used to recommend in Latam as a free option on energy liberation.

ENIC on the other hand is basically EOCC + the Chilectra distribution utility. I prefer the pure play of generation in Chile rather than owning Chilectra too as Chile has a lower growth profile than the other countries in the region for electricity demand and hence the distribution assets are less appealing in the long run. 

Assets and Moats

EOCC has some excellent irreplaceable assets that give it something of a moat. Thermal power plants are generally not great assets as they have limited lifespans and are quite readily replaceable with newer, more efficient thermal plants. Therefore the capital intensity of thermal energy companies is high, not quite as expensive as Nuclear (have a look at KEPCO in Korea) but still high. These assets of EOCC are therefore not that exciting.

The hydro assets though are excellent. Hydro assets are irreplaceable in that their unique geographical advantages cannot be readily replicated with an alternative. Chile has already exhausted most of the best locations for these assets and EOCC own several of them. Furthermore international water rights are not an issue as Chile captures all the water flows which drain west of the Andes within its borders. These assets give EOCC a small but significant moat. Barriers to entry in the hydro sector are huge due to the scale required for projects and the scarcity of new potential development sites. 

Earnings Outlook

I am assuming a moderate normalization in rainfall with some increased hydro resource available. If we consider relatively low revenue growth of 3% a year but operating margin improvements from 26% in 2016 to 30% in 2017 and 33% by 2021 then I foresee decent earnings growth for the future of 7% a year (with a dip in 2017 comparison from 2016 due to a one time comparative gain from 2016 in non operating income). 

Amiable Minotaur Model: Margins Forecast

Margins should improve slightly from a structural perspective aside from hydrology because the Los Condores plant will be completed in the next 2 years offering additional low cost hydro to the mix.

Uses of Cash

With no further significant projects currently in the pipeline and good cash generation EOCC are guiding for an incremental increase in the dividend payout ratio from 50% in 2016 to 70% by 2020. That would see the yield increase from 3% this year to 7.5% by 2020 which would be a robust return for those seeking income.

Amiable Minotaur Model: EPS and DPS forecast

Even with this raised payout in my model and assuming decent profitability as disclosed above the company will be running net cash by 2020 on my numbers. It is likely of course that within the next three years a new major project will be initiated but it is noteworthy that they would not necessarily need to cut that dividend to fund it.

Taxation is an issue. Chile has a withholding tax of 35% but there are credits to this for corporation tax paid and DTT treatises which Chile has with the US and the UK. I believe the effective rate of WHT is between 8% and 15%.

Therefore the yield I have demonstrated gross will be slightly reduced by the WHT. But this is not a substantial reduction. Still another reason why investors often prefer onshore dividend income, depending on your own tax code. 


The company trades on 10x FY16 earnings and whilst there is no long term average for EOCC the former Endesa Chile long term average was 11.6x. So valuation on that metric at least seems fair.

On the DCF I get a valuation of $35 per ADR. This assumes a 2% end period growth rate and a WACC of 8% (Ke 10%, post tax Kd 4.2% and 35% debt ratio). This DCF value is quite high and in part driven by low capex in the medium term due to no foreseeable projects. 

On the DDM model I get a value around $21 due to the still low payout ratio expected in 2017 and using a 5% dividend growth rate long term (below the growth from payout increases but more inline with long run earnings growth potential). If I assume a 70% payout next year the DDM rises to $26. Still a bit low but the Ke is quite high for this company due to the foreign risk vs say a US or UK Risk free rate.

Using a forward multiple I might pay 14x earnings for the stock. That is a bit arbitrary but not out of line with the forward multiples of the UK sector. Here again I see a value of $28 per ADR. 

So taking a stock that has a floor value in the dividend of $21 and is potentially worth as much as $35 and trades today at $23-24 seems like a fair risk reward given the potential for a decent dividend in the meantime. This means a 30-50% upside to my fair value range. The currency will also of course play a part so softness in copper could cause weakness in the meantime.

I think EOCC shares are worth around $30-35. 
(assumptions are USD = 650CLP - April 2017)

The utilities in the UK all seem to offer a decent return today in yield but I worry even on a 5 year view about the pension and/or debt levels. I think that EOCC offers something better and currently this is a good entry point to purchase EOCC as it trades relatively cheaply and offers decent long term prospects with low specific risk due to a strong balance sheet: Exactly what I want in my long term value portfolio. I would happily buy this stock for the long haul and - subject to no significant changes in its structure or governance - keep it.

Reasons I like EOCC:

  • It trades at a fair price with a good and likely improving yield
  • It has some high quality irreplaceable hydro assets
  • It has a strong balance sheet
  • It has upside risk to earnings from better hydrology and the aforementioned ENSO
  • It diversifies my portfolio risk profile away from developed stocks
Reasons I worry about EOCC:
  • The ultimate owners are unsavory
  • The currency situation / Chilean macro could deteriorate due to copper/global trade
  • The growth profile from new projects is limited at this point
  • A La Nina cycle would likely squeeze margins again
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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