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Hydro One an opportunity with less risk

January 14, 2017

By Gulshan Malhotra

2016.Q3 results

Earning: Hydro One’s (Grey Market: HRNNF, TSX: H) diluted earning per share (EPS) excluding extraordinary items increased by 56% in Q3.2016 compared to Q2.2016; it was the same as Q3.2015. Also, basic earnings per share for the year-to-date (September 2016) was $0.99 compared to $1.14 for the same period in 2015. In Q3.2016, Hydro One lagged behind in earnings by $0.15 in comparison to Q3.2015.

Table 1: Earning per share

table-1

In Q4.2016, the earnings should be $0.30, in order to achieve the results similar to 2015; this is 100% higher than the earning for the period Q4.2015 and 23% lower than the earning for the period Q3.2016.

Capital Expenditure: Capital investment was $1,220 million during a 9-month period (ending in September 2016) as compared to $1,212 million during a 9-month period (ending September 2015); this is 1% higher than in 2015. This means the capital expenditure was more or less similar to 2015.

Table 2: Capital Expenditure

table-2

Acquisition of Great Lakes Power Transmission and Orillia Power Distribution: Acquisition of Great Lakes Power Transmission was completed in Q4.2016. At the same time, Hydro One reached an agreement to acquire Ontario based Orillia Power Distribution. These are strategic acquisitions, which place Hydro One in a strong position as an electricity distributor and transmitter of electricity in Ontario. This also will help to increase net income in the long run through an increase in rate base and synergies.

Change in senior management: These changes are considered favourable since the organization made these changes to achieve a higher target, increase integration between different departments, and become more profitable.

Revenue is higher than last year by 6% primarily due to changes in the distribution rates and higher peak transmission demand on account of warmer weather in 2016; this was partially offset by the divestiture in Hydro One Brampton.

Regulatory Environment

Hydro One is regulated by the Ontario Energy Board (OEB), which is a regulator for Ontario gas and electricity distribution and transmission services. Hydro One’s approved return on equity (ROE) in 2016 was 9.19% for both transmission and distribution segments. It’s approved rate base for 2016 was $16.90 billion ($10.04 billion for transmission and $6.86 for distribution). The deemed capital structure included 60% of debt and 40% of equity for both of its businesses. Hydro One’s ROE was either the same or greater than its allowed ROE on a consolidated basis over the past five years.

Analysis

Acquisition and Merger: In 2013, ex- banker, Ed Clark, recommended to the Ontario Government to promote consolidation in the Ontario electricity distribution sector. Furthermore, he recommended that Hydro One be privatised in order to promote the consolidation. These recommendations were based on the opinion that consolidation would reduce costs and result in synergy. Consequently, customers will receive value for money.

Hydro One is taking advantage of Clark’s recommendations; they are taking a very aggressive position on merger and acquisition. In recent years, Hydro One has acquired four distribution companies and one transmission company which includes Norfolk Power (August 2014), Haldimand Hydro (June 2015), Woodstock Hydro (September 2015), and Great Lake Transmission and Orillia Power (October 2015).

Cash Position: Hydro One’s capital structure is 51% debt and 49% equity, compared to the deemed capital structure of 60% debt and 40% equity. The capital structure is favorably off by 9% (or $1.8 billion). This also means that Hydro One’s capital structure is not optimised and there is room for improvement.

Table 3: Capital Structure

Amount in million YTD
Sep-2016
Capital Structure Deemed C. Structure Variance
Short-term debt 1,118 5% 4% 1%
Long-term debt 9,552 46% 56% -10%
Total debt 10,670 51% 60% -9%
Equity 10,058 49% 40% 9%
Total debt + equity 20,728 100% 100% 0%

 

With reference to fixed assets, funding to Hydro One in rates is for depreciation which is annually in the range of $700-$800 million while capital expenditures are in the range $1,600-$1,700 million. The remaining unfunded portion of $900 will be funded by 60% financing through debt and 40% through equity. The cash flow is sufficient to fund their capital program, acquisition and merger.

Rate Base: Rate base can be defined as a value of the assets of a utility company. The rate base helps the local government in determining the price that the utility company is allowed to charge its customers. The rate base determines prices because it helps to ensure a reasonable profit for the utility company while keeping utilities affordable for the customers.

Figure 1: Rate base

figure-1

Hydro One’s rate base is consistently growing. The primary reason for the growth is increase in plant properties and equipment (PP&E) as a result of increased annual capital spending compared to depreciation expenses for the year. As per their forecast, this increase in rate base is also projected in future years. I do not see any funding risk and regulatory risk since they have continuously proved to the regulator about their capital expenditure’s need successfully.

Dividend Paying: Up to September 2016, the dividend was $0.76 compared to the EPS of $0.99 which was 77% of the net income. The dividend was almost 3.2% of the average stock price during 2016. I considered it favorable to the investor. Since the customer is getting a steady income at the same time it also shows that the company is generating cash.

Conclusion

In recent years, Hydro One has acquired electricity distribution and transmission companies to grow their business. This will help them to grow their net income and dominate the utility sector in the province of Ontario. Their rate base has increased in recent years, and growth is also forecasted for the future. This will further help them to increase their net income. In addition, their balance sheet and cash position is strong enough to fund their strategy. The company also showed their capability to maintain operational efficiency and generate net income more than regulated approved return on equity. So, I opine that it is worthwhile to invest in Hydro One stock due to their efforts to increase the net income which consequently will result in an increase in market capitalisation.

 

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