The Investment Angle
In this uncertain environment of an ongoing recession + a global pandemic, it is prudent for investors to look for low-risk investments. There are few investments of a lower risk than Power Assets Holdings Limited (PAH), with a net cash position, 0.09 debt to asset ratio, and stable income from regulated utilities.
In addition to the low downside risk, Power Assets offers a 6.59% yield with a safe payout and is well-positioned to make acquisitions at depressed global asset prices. The company itself is also selling at a discount, due to a one-off charge expected in the first half of FY2020 and the market sell-off resulting from COVID-19.
Diversified, Regulated Business Means Security
Power Assets Holdings’ assets are diversified and deliver consistent income. PAH primarily invests in utility assets which are regulated in nature or transmission networks/renewables with long-term contracts or power purchase agreements.
The company receives the majority of its income from its associate businesses or joint ventures, which account for $698 million of their annual profit. Power Assets’ operating profit directly accounts for $227 million of the company’s earnings.
As shown above, the company’s assets are also geographically diversified, which spreads out regulatory risk and that of extraordinary events to their income. In a time when the potential for a local COVID flare-up remains one of the most present risks to economies on a local and national scale, international diversification in low-risk assets is a sound strategy for survival.
The company outlines its philosophy in purchasing companies as such:
The Group undertakes a rigorous due diligence and analysis process covering operational, financial, legal and risk parameters before undertaking any merger or acquisition activity. The Group seeks growth in its areas of expertise within stable, well-structured international markets that either yield stable revenues under government regulation or are safeguarded by long-term power purchase agreements. The Group joins the management of new associate/joint venture companies to guide and oversee performance and shares best practice to ensure synergies and maximum efficiencies.
Because the company values stable income from its investments and seeks to minimize risk doesn’t mean it has zero growth potential, in fact, core to PAH’s strategy is for its subsidiaries to show organic growth.
This goal of attaining organic growth is being realized, particularly in the gas networks segments. The company’s Husky Midstream subsidiary completed its first venture into natural gas in November 2019, with a pipeline and processing plant completed, and another on the way. The Wembley Gathering system, which already went into service, will deliver low-risk, long-term returns for PAH with a long-term transportation contract. The company’s EDL subsidiary through CK Williams in Australia recently opened a new renewable gas plant in Indiana.
PAH is also actively working to become more environmentally friendly. The company is investing in 3 more-climate-friendly gas-powered plants in HK Electric as well as similar moves in Canada. Along with this, they are ending their participation in coal-based generation in mainland China.
In parallel with these divestments, the company’s renewable subsidiaries have been expanding, with a new hybrid-renewable power plant in Australia, expanded plastic recycling capabilities in the Netherlands, and the focus on renewable gas and renewable hydrogen mixed with natural gas.
Superb Balance Sheet Adds Protection
Power Assets has a net cash position of $200.89 million and has held a net cash position for five years. The company carries minimal debt which has been simplified down to Australian-dollar-denominated bank debt at a fixed rate, costing the company approximately $15 million in interest annually. Their total debt is $428.33 million, none maturing in the next year, with a cash + bank deposit balance of $629.12 million.
The company’s debt level has fallen for the past seven years and the company’s current debt to asset ratio is 0.086 – extremely low. Given the company’s structural stability, the need to raise cash, other than for expansion purposes, seems unlikely, but with nearly all their assets unencumbered, doing so should not be difficult for the company.
An Opportunity in Crisis for Expansion
Due to the company’s strong balance sheet and cash position, and excellent credit rating, Power Assets is well-positioned to make acquisitions at these depressed asset levels resulting from the COVID pandemic.
This is clearly something that will have crossed the mind of its leadership, whose chairman, Fok Kin Ning, commented the following in their annual report:
With a sound net cash position and good liquidity, the Group is strongly positioned to pursue large strategic acquisitions despite geopolitical and economic uncertainties. Our strategy is to achieve organic growth among our underlying businesses, with opportunities to expand their operational scale through acquisitions. At the same time we join our strategic partner, CK Infrastructure Holdings Limited, to vigorously pursue acquisition targets that offer assured, long-term returns in well-regulated and mature markets with financial discipline.
Asset values are currently depressed, resulting from a broader market selloff over COVID fears. The S&P utilities ETF has fallen over 22% since its February peak and many companies are faring worse than that.
As I mentioned earlier, the company has a minute amount of debt and over $400 million in cash. Further, they have an A credit rating from S&P, which should ease their access to cheap credit. All in all, the company is well-positioned to make an acquisition in this environment, which would benefit its long-term profitability. PAH’s chairman’s expression of interest in making an acquisition and the history of the Li family, Li Ka-Shing in particular, in making acquisitions suggest that the odds for expansion in this environment are high.
The company since its inception has paid a stable or growing dividend, as well as several special dividends.
Data from Company; Chart by Author
The dividend is the crux of the investment opportunity in Power Assets, due to the high yield, courtesy of the significant discount it is currently trading at. The current yield is 6.59%, which is well above the S&P 500 average of 1.96% and the utility sector yield of 2.98%.
Power Asset’s yield is an excellent investment for safe income in this turbulent time because – as I outlined earlier – they have a net cash position and well-diversified, regulated utility business, which all but guarantees the dividend’s safety. Though the payout has stagnated in the past two years, the company’s compound annual growth rate for the dividend remains consistent at 2.89% over a 5-year period, 2.87% over a ten-year period, and 3.12% over a twenty-year period.
With a growth rate outpacing inflation, investors can confidently lock in the 6.59% yield at these levels. The company’s payout ratio of 83.96% is high but should not be a source of concern. This comes down to the company’s stable earnings, cash position, and easy access to borrowing which can all sustain the dividend under whatever circumstances may come.
Shares Undervalued from One-Off Charge and COVID
Power Assets’ shares recently reached a ten-year low following a second selloff.
Note: The 2018 drop in share price was the result of a special dividend issued.
The company’s shares are depressed from two main causes: COVID-19 and the UK’s reversal of an expected decrease in the corporate tax rate. The impact of this is to be as follows:
“As a result of the re-measurement of the deferred tax balances in relation to the Group’s operations in the UK, the Group expects to have a one-off negative impact of approximately HK$800 million through sharing the results of joint ventures and associates in its consolidated financial statements for the six months ending 30 June 2020.
Taking into consideration the re-measurement of the deferred tax balances referred to above, the Company expects there to be a material reduction to the Group’s attributable profit for the six months ending 30 June 2020, as compared to the same period in 2019.”
The impact of this bill on the company’s stock price can be seen in this chart:
Following the company’s announcement on May 6 about the impact to H1 profit, the company’s stock began to decline again, falling 18.5% to $5.37. It has since recovered slightly $5.49 per share, which is still significantly undervalued, and only 6.4% off of its 52-week low.
Neither COVID nor the impact of the UK finance bill justifies the fall in share price. The finance bill impact, it should be noted, is a one-time impact as a result of accounting for the maintenance of a previous 19% tax rate. The country isn’t raising taxes in a way that would hurt long-term profitability, the company only has to account for the increased in its deferred taxes. Considering this, even though the interim 2020 results will take a profit hit, the share price hit is undue. An HK$800 million profit hit translates into a full-year decline of 11.28% to net income due to this item, less than the 18.5% shares have lost.
The impacts of COVID too are not particularly harmful to this company, given their strong balance sheet. The company’s diversification helps to minimize the risk of another large swell of cases in a specific geographic area. Overall, electricity demand hasn’t seen a huge collapse from the pandemic. In the US, in April – the time and place of one of the most intense, prolonged lockdowns – utilities saw electric load decline by 6.5%. This has since improved in most places globally, as things start to re-open. This also shows that even a worst-case COVID scenario isn’t detrimental for utilities.
The company can also take advantage of COVID to grow its assets by purchasing other utilities who might not be in such solid financial condition. Doing this will position them better for the long-term when the pandemic ends and businesses come back online.
Valuation and Upside
The company is evidently undervalued, but the question is: by how much? There are two main ways of assessing this, the first being comparing their current price to book value to their historical valuation. The company currently trades at 1.07 times book value. This compares to a five-year average P/B ratio of 1.328. Applying the current book value of $5.14 to this historical average gives us a share price of $6.83, and an upside of 24.4% from the current share price of $5.49.
The second method of valuation for this stock is its price to earnings ratio. With a consistent history of earnings – excluding the occasional divestments and IPO of businesses – the company deserves a valuation based on relatively stable earnings. Their current trailing P/E of 12.88, puts the company at the cheaper end of utilities, which have an average P/E of 21.11. The company, for the past 5 years, has averaged a P/E of 17.99.
The company’s long-term earnings prospects are unaffected by this one-off charge and the slight demand hit from COVID, so a return to the average P/E of 17.99 is not unwarranted. The consensus EPS for 2020 is only slightly depressed at $0.41 and earnings should be flat to 2021, at $0.43. At 17.99 X $0.41 we have a share value of $7.38, for an upside of 34.35%. For 2021, we get a share valuation of $7.74, for an upside of 40.98%.
For a conservative upside estimate, we will use the lower of the two valuations, $6.83, based on the company’s P/B ratio. Adding the $0.36 dividend gives us a 1-year return of 30.97%. In an environment of low-rates and high uncertainty in many sectors, a low-risk return of 30% is not a bad investment, even though it may not be an eye-popping high number.
How Do We Get There?
Once the first half passes and the UK tax charge has been fully factored in, the company’s shares should be valued more accurately on long-term prospects. An additional catalyst for share price recovery is the potential for an acquisition in this environment, which would boost earnings. The timeframe for a recovery in share price is between 1-2 years, following each respective annual report, as the return to former valuation may require another year of reporting stable (then to be YOY improvement in) earnings, rather than the realization that these short-term impacts are minimal and the company’s EPS will remain largely intact for this fiscal year.
Though taking until 2022, when FY2021 is reported, would decrease the overall return from the share price recovery, the company’s safe 6.59% dividend is an equally important part of the investment calculus for Power Assets, serving as a stable source of income, which, unlike many other companies, is at a virtual 0% risk of being cut.
Minimal Downside Risk From Already Depressed Share Price and Book Value Support
For downside risk, we’ll apply the same two valuation measures to assess the potential loss. The downside risk for this company is minimal, given that it is trading near book value. The company’s 52-week of $5.16 is just above the company’s book value and shares should not fall further than that, which gives us a maximum downside of 6.4%, which would also present a better entry point for a dividend investor.
Applying a -6.5% impact assuming a worst-case, full-year lockdown-level COVID impact and a -11.28% impact from the UK tax adjustment to EPS gives us forward earnings of $0.354 per share. Giving the company a conservative forward P/E multiple to parallel this risk of a 22.8% hit to EPS, I would value the company at 14.65x forward earnings. Together, we get a share valuation of $5.186.
Currency and Regulatory Risks
One of the primary risks for PAH is fluctuating currency exchange rates, as the company is headquartered in Hong Kong, yet collects most of its income overseas. The company does its best to manage these risks through currency swaps and forward forex contracts, but the 2019 results were demonstrative of the potential impact that currency swings can have on earnings. Good news for buyers of the ADR is that the Hong Kong Dollar is pegged to the American Dollar, minimizing any further potential for currency risk in this investment.
The other main risk for Power Assets is the regulatory one. Though having regulated utility assets is excellent for a safe return, it can also have its downsides when regulators decide to decrease your allowed rate of return. According to concerns expressed in their annual report, the company may soon see lower allowed return on equity on its investments.
Some of this regulatory risk is hedged by the diversification in the company’s businesses, as the regulators in these different countries act independently. The negative impact from HK Electric’s rate of return on average fixed assets falling from 9.99% to 8% has already been felt, as the new agreement went into effect in 2019 and will last for 15 years. Australia is ongoing efforts to reform its network tariffs for electricity and PAH’s Australian gas distributor, Australian Gas Networks (“AGN”), is cutting prices by 8% under its new plan through 2025/26. Not that it’s a market where PAH has a presence, but even the US is revising their allowed ROE for utilities.
Despite how it may seem, these numbers aren’t all bad news. For one, if you dig deeper into AGN’s proposed rate plan for the next five years, you will find that the 8% is an initial cut followed by annual raises of 1.2% (before inflation) and plans for connecting 43,000 new customers to their network. In the UK, the company’s UK Power Networks subsidiary had the highest regulatory return on equity for the 2018-19 period of the UK transmission networks, under the country’s RIOO-ED1, which lasts until 2023. This significantly decreases the risk of lower allowed ROE to the company’s assets since 52% of their revenue comes from the UK, whose rate plan will remain stable for the next three years.
The company’s growth strategy is also working to manage the risk of lower allowed ROE by investing in renewables and assets not bound by ROE restrictions, yet still backed by long-term contracts. One of Power Assets’ most recent acquisitions was in 2017, in CK Williams, which operates gas transmission networks, produces gas from waste coal and landfills as well as operating renewable generation. They also invested in Husky Midstream, whose oil pipeline network is backed by long-term contracts, and Iberwind which is a Portuguese renewable generator, operating 15% of the company’s wind power capacity.
Power Assets has a diversified base of assets in extremely low-risk areas backed by long-term contracts or operating as regulated utilities which protect their income stream. The ten-year low pricing of shares offers investors an opportunity to lock in a safe 6.59% yield in these uncertain times, confident that it will still be paid in ten years from now. Something not so certain with many other high yielding companies.
Their superb balance sheet and eye for acquisitions position them well to take advantage of low equity prices worldwide to expand their business. Investors can also make a short term, low-risk, return by purchasing shares in a temporarily depressed state due to a one-off tax re-adjustment, which won’t affect long-term performance.
In short, Power Assets Holding Limited offers one of the best risk/reward opportunities for investors looking for a safe income stream and potential for share appreciation, with next to no downside risk, amidst a wave of uncertainty surrounding a reprise in coronavirus cases.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and should not be regarded as investment advice. This article should not be the sole basis for a financial decision, including the purchase of stock. Any personal financial decision should be made on the basis of your own research and consideration of your unique financial goals and investing ideals.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.