Tuesday, 9 April 2013

Ruminations On "MRP"

How "Mighty" is Mighty River Power?

In New Zealand the government is selling down 49 percent of some Crown owned businesses.  The objective is to reduce government borrowing and debt service.  It is all part of the drive to get the country back into fiscal surplus within a couple of years or so.  This objective is laudable and to be strongly commended.

The first of the businesses to be floated is Mighty River Power ("MRP"), a state owned electricity generator and retailer. The float looking like being wildly popular.  We are not so sure. 

All investments have positives and negatives. MRP is no exception. It can be assessed on a long term basis versus a short term basis.  Probably on a short-term basis the share price will appreciate.  Share demand hangover will likely contribute to post-float demand. Who knows?  But on a longer term basis more serious questions about the company emerge.

Here are some longer term positives (to our mind):

-Strong renewables power generation (hydro and geothermal)

-Based in the North Island where the majority of electricity demand is centred.

-Strong dividend policy: the company intends to pay out 75% of net profits after tax.

-Government ownership of 50% will likely ensure that the company will continue to pay dividends: the government is cash hungry and will keep pressure on the company to keep paying dividends, even if it is imprudent to do so.

But there are also longer term risks.  (A quick reading of the "official" statement of risks addresses none of these, apart from a short statement: "Insufficient access to future capital" .  To our mind, this is one of the biggies, as we argue below.)

-Political risks. Will a future incoming government want to re-nationalise MRP and compulsorily purchase shares at a price to be determined by the government of the day?  Unlikely?  Eventually Labour will get voted back into government and the Greens will probably have a substantial say.  Re-nationalisation is a distinct possibility.  Whilst some have argued that privatising 49 percent of the company will increase the quality of governance, since company actions will be publicly announced and scrutinised, the brute reality is that the government of the day retains control--51 percent to be exact.  That ought never to be forgotten.  Is such a controlling shareholding a positive or a negative?  To our mind, it is a long term negative. We believe the Crown would have preferred to sell a controlling stake in MRP; selling only 49 percent was an attempt to make the sale more palatable to the electorate.  The outcome is that the risks to investors are increased, not decreased.

-Government ownership can constrain the way the company can access capital going forward. Governments these days do not want to put more capital (taxpayer funds) into State Owned Enterprises (“SOEs”). This means that the only way for an SOE  to get more capital is to borrow more, which increases the risks of the company. With respect to Mighty River Power, the company cannot go to the market to raise more capital, without the government being willing to stump up with more capital to match additional private investment.  If the government refuses to participate, the company is stymied, since the Crown must retain 51 percent of the shares.  

This places MRP in an invidious position.  It cannot raise more equity capital.  The only options are retaining more profits (which will affect the dividends) or raise more debt.  

Current government policy is to demand higher and higher returns from SOE's which means more dividends, not less. 

These factors will likely reduce the ability of the company to reinvest profits in the business and will increase the risk of paying out too much in dividends. When companies do this they usually try to “cover it over” by borrowing more. Thus, there is a substantial risk that MRP will have to take on more and more debt going forward.

-These risks are not academic.  The government over recent years has not been a long term passive shareholder of the businesses it owns. It has a history of demanding increasing returns from SOE's.  We suspect MRP has already faced some of this pressure.  It has sought to expand its business--offshore.  It has put up  US$250m investment offshore in high-risk, speculative geothermal development. It is now starting to write off some of that investment.  This has increased the risk profile of MRP.  How much this has rolled out as a benighted response to government pressure to increase earnings and pay more dividends in the future is unknown.  But . . .

-The company has a BBB credit rating, which is not high. This also confirms that it is a higher risk company and that its balance sheet is not particularly strong.  Its debt is very close to being rated as "junk". 

-It has a 50 percent gearing ratio, which means that it has borrowed up to 50% of the value of its total asset base. This is not considered a high gearing rate, but it is certainly not a conservative one.

-Most of the assets of the company are in property, plant and equipment—largely hydro dams, powerstations, and the like. The problem with this is that over time these assets get revalued upwards on paper, so on paper the company is worth more. But these assets are large, chunky and illiquid.  They are hard to sell and realise the value should the company ever need to.  Were the company to suffer a credit downgrade or be forced to realise assets to fund borrowing costs it would be in a potentially difficult position.  Meanwhile the company is likely to continue to borrow more against the (higher valued) assets, whilst keeping its borrowing ratio at 50 percent of total assets. The risks will be rising without the appearance thereof. 

-A good question to ask is whether the company can sustain a significant business downturn or reversal. At present the level of free funds from operations (the amount of cash MRP generates from its business once all existing commitments and costs are paid for) is only 4.2 time the annual interest expense on current borrowings. This is pretty low: 10 times would be much better. What this means is that if interest rates were to rise significantly (due to a ratings downgrade, for example) there is not much free board to whether the storm: the company might come under financial strain.

-Finally, the amount of shares a small investor will be able to buy is likely to be pretty small. Problems arise should a small investor want to sell, since small parcels of shares usually attract higher brokerage to sell (between 2 and 3 percent).

In the short term things may well look rosy for a time. The market may possibly appreciate the share price quite strongly, at least initially. Smaller investors and overseas institutions may want to purchase larger holdings. But the risks of this company are medium to longer term.  The capital structures and access to capital going forward are not positive.  The risks are all longer term, in our view. 

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