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Fools Eye View: Putting Some Power Into Our Portfolios

At the press of a button we expect our lights to come on and our air cons to start delivering a stream of cool air to make our lives a bit brighter and our living conditions a bit more pleasant. But all of us are a little guilty of taking those essential services for granted.

We won’t tolerate power outages. We can’t cope when our water supplies are interrupted. But at the same time, we expect those services to be delivered at the lowest possible price.

In some countries, such as Singapore, we are even able to drive down the cost of our utility bills by switching providers at the stroke of a pen. But we seem to forget that utility companies are very capital-intensive businesses. They require a continuous inflow of funds to finance the purchase of new assets and to upgrade existing ones as they age. So, where do those funds come from?

Lots of cash

If utilities are owned by the state, then the money will come from the pockets of taxpayers. That sounds reasonable enough. That’s a great way to keep down utility bills because the cost of capital is almost zero.

Unfortunately, every tax dollar that is used to finance utility companies is a buck that can’t be used somewhere else. The same dollar can’t be ploughed into operating a gas-fired electricity generator and provide social services at the same time….

…. Something must give, which is why many utility companies are in the private sector, rather than government owned.

But there is no getting away from basic economics. These companies still need oodles of cash that will have to come from investors, lenders or retained profits.

Lenders and bondholders will expect their pound of flesh in the form of interest, while investors will want their dividends. Consequently, these businesses need to produce enough profits to cover their obligations to both lenders and shareholders. In the main, they can.

On average, utility companies generate more than three times as much in operating profits than they need to pay in interest. Operating profit at Singapore’s Sembcorp Industries  (SGX: U96) is eight times more than its interest obligations, while Malaysia’s Tenaga Nasional (KLSE: 5347)  produces four times more operating profit than interest costs.

In Hong Kong, CLP Holdings, better known as China Light & Power, can cover interest payments three times over from operating profits.

Apart from lenders, shareholders will want their rewards too. And utility companies don’t often disappoint. The average dividend yield across 19 utility companies examined is an appealing 4.2%. What’s more, the payout to shareholders is adequately covered. The payout ratio, which is measure of the amount of profit that is paid out as dividends, is an undemanding 60%.

There is another group of important stakeholders apart from lenders and shareholders. These are the consumers, who don’t want a heart attack every time they receive their utility bills. It is probably fair to say that utility companies don’t make excessive profits from their customers. If anything, they could probably do with making a bit more.

On average, the profits that they make as a percentage of revenue is around 7%. So, they can’t exactly be accused of profiteering, even though many of them are monopolies. That is because most utilities are regulated.

This regulatory oversight makes it harder for them to raise prices to increase revenues. Consequently, they need to generate profits in other ways, which is primarily through being more efficient.

On average, utility companies have generated around 11% of bottom-line profits on shareholder funds. YTL Power, which owns PowerSeraya in Singapore, has generated $11 of net profit on every $100 of shareholder equity, while the UK’s SSE has generated a return on equity of around 16%.

The relatively high return on equity has come from a combination of an acceptable net income margin, a hefty chunk of borrowings and an adequate net asset turnover.

We need to remember that these are capital intensive businesses. So, it is unlikely that they are going to be outstandingly efficient in their use of assets. Nevertheless, they are still capable of generating, on average, $40 of revenue on every $100 of asset employed in the business. That is commendable for an asset-heavy industry.

Thanks to their respectable return on equity of around 11%, and retaining around 40% of profits for internal use, utility companies should be able to grow their dividends at a modest rate of around 4% a year.

They aren’t going to shoot the lights out with dividend growth. But they should offer stable, long-term dividends for income investors. They should also be able to ride out economic downturns. But they are vulnerable to high interest rates, given their heavy reliance on loans. However, in a low interest-rate environment, they could continue to deliver.

A version of this article first appeared in The Business Times.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo owns shares in Tenaga Nasional.