The government’s advertising for the Meridian Share Offer is remarkable for its blandness:
Aside from the pictures and the words underlined in red, all of the advertising is selling a deal. Invest $1 a share now, pay a maximum of $0.60 later and make an ‘implied gross dividend yield of 13.4% in the first twelve months”.
However as Martin Hawes reinforces in his article today, when you buy a share you are buying a share of the future profits of the company. You are not making a short term deal.
The marketing emphasis on a short term deal for investors is perhaps a learning from the previous issue for Mighty River Power, which was a tough sell-in, and worse yet has still not made it back to the IPO price. And while financial literature is clear on the value of investing for the long term, many investors instead think in much shorter horizons.
Investing versus trading
A shorter investor horizon means that prospective investors may be indulging in trading, or speculation rather than long term investing. And while it’s possible to make good money out of speculation, and a vast amount of money is exchanged for this purpose, it’s a risky activity. It’s also expensive, as brokers collect 0.5-1% each time traders trade, and you are fighting full-time market professionals with very smart algorithms, better information and deep pockets.
The smart long term investor focusses very hard on assessing each investment up front, looking primarily at the risks of losing their money, as well as the potential for lasting returns from that investment. They, like Warren Buffet, periodically check that those initial assumptions are firm and they hold the investment for a long term.
Other, sometimes self-described long-term investors, are glued to Bloomberg screens or trading websites, and buy and sell shares frequently. This churn comes at brokerage and taxation costs that means traders have to earn tremendously higher returns from their efforts to match genuine long-term investors. The largest cost here is tax, as short term traders can have their investing gains classed as taxable income and long term investors do so tax-free. (See your accountant – I’m not one and I am not yours).
The above discussion on trading versus investing is there because the government’s headlines for the Meridian deal seem targeted at short term traders. Buy now, make a good yield for a year and worry about the rest of it later. As with Mighty River Power, the financial forecasts for Meridian are for only two years – less than that considering we are in the FY13 year already. All this, backed up by a strong sell-in campaign through brokers, is going to get a lot of short-term focussed investors on board. But it’s got a vicious sting in the tail.
That sting, and the real question with the Meridian and Mighty River Power businesses for me, is that there is no real long term growth story, and that there is significant potential for downside.
That’s not to take anything away from Meridian’s current business, which builds and operates a superb series of assets, as well as being the only player with any genuine innovation in the retail space, with Powershop. They also have, from my observations at Manapouri, a strong and improving safety culture, which always a strong indicator of business strength for me.
Growth is Limited
Any growth in Meridian’s future value, beyond that tied to population growth, will come from new asset builds and price increases.
New asset builds, by definition, are priced to sell electricity at the market price and make a reasonable, but not giant, return to investors. (If the returns were giant, then other players would build plants until the returns are normalised.) Meridian has executed on this well with recent solar plants. Most of the future demand may be focussed on renewables offshore, as we’ve seen reducing demand in four of the last five years (GFC, ChCh, Tiwai). However as I argue below, the long term demand for electricity from large power plants may be flat, or worse, softening. The offshore focus will be on commissioning plants based on renewable energy such as solar that can eventually substitute for high carbon emitting plants such as coal.
Any Price increases will be following on from years of price increases to NZ customers, and any increases in returns to shareholders will rely on the ability of the New Zealand public to absorb them. After years of increases that capacity is arguably near its maximum, and the Labour-Green opposition has clearly signalled its intention to work on the issue.
Medium to long term potential for downside is high
The risk section is alway worth a read in any Offer Document. Three of the short term risks are:
- Tiwai point: The Tiwai Point contract to me is not a substantial risk, as even if the Tiwai aluminium plant does close the average price that Meridian receives for the power previously allocated to Tiwai will be much higher than under the current contract.
- Regulation: Labour-Greens market regulation is a genuine risk in the short to medium term. A Labour-Green government will be far more affected by and likely to react to high electricity prices, especially for the lower quartile of the population by income. Their potential responses include regulation as discussed previously, including the imposition of some sort of price controls. This is how utilities are regulated in many other markets, and it limits the growth upside for investors. While I suspect that they are smart enough not to act to destroy shareholder value, investors should be aware that Labour and Greens have a lot of residual anger about the overall decision to start the asset sales and they may do something rash.
- The Deal: The risk of the government’s pay-later investment deal not working feels significant to me, as investors are in essence borrowing money at no cost and repaying it in 18 months time. It is the same as buying a stock on margin, which only investors who are experienced or have sufficient liquid resources should be able to do. Above all, this leverage increases the impact of share price volatility at the lower end, and if the market or share price collapses then investors may lose significantly.
Long Term Risks
All of the above is well understood, and priced into the offer. It’s a great business.
However I believe there are two major underlying risks that are not explicitly mentioned in the summary risks section – the risks from climate change and the risk from micro-generation. Each of these, and they are related a little, are risks that are vast in scale. True long-term investors would be wise to look at them in a lot more detail. It would not take much to produce more detail on the risks, but I would like to see an independent player produce them.
“Warming of the climate system is unequivocal, and since the 1950s, many of the observed changes are unprecedented over decades to millennia. The atmosphere and ocean have warmed, the amounts of snow and ice have diminished, sea level has risen, and the concentrations of greenhouse gases have increased”
The first report in particular is worth reading – but of most importance to Meridian investors is the research behind the following finding:
“Changes in the global water cycle in response to the warming over the 21st century will not be uniform. The contrast in precipitation between wet and dry regions and between wet and dry seasons will increase, although there may be regional exceptions.”
The text thereafter says that dry areas will become drier, and wet areas wetter. Looking out the window (or looking at our statistics) points to plenty of water in the dams, but I am sure that there is more rigorous research available in New Zealand than my window gazing. The map below is from the report, and has the northern part of NZ near a dry patch – but that’s as much as we can really see.
I would expect that companies as exposed to these climate changes as Meridian and Mighty River Power would dedicate significant resources to understanding and declaring climate change risks. It’s surprising to find only two references to “Climate Change” (or just “climate”) in this document, and those only in relation to the regulatory environment. It also surprised me, given their safety culture and renewable focus that they had not put this at the centre of their values.
In contract Z Energy is fully aware of their position with respect to climate change, and is actively working on mitigation and preparing for change. I even received from them some questions and a request for source data (which I fulfilled) after a blog post on the rise of electric cars. (And I also heard from them that there was a lot of internal discussion after this post on safety in the Z Energy Offer Document, again a very professional response by Z Energy.)
The IPCC report is a reminder that climate change is a core issue for one half of a Labour-Greens government, and that option is currently ahead in the polls. It’s now a lot clearer that the risk of regulation (perhaps overdue) in favour of climate change reducing activity looms large. The impact of climate change and resulting regulation is across the board:
- The biggest emitter of carbon in New Zealand is surely Tiwai Point, as the aluminium refining process is a major emitter. Any tax of carbon emissions will make it harder for the plant to stay competitive, and closure of the plant would reduce New Zealand’s emissions significantly.
- Use of resources like water is likely to become more regulated as the Greens lead the charge to clean up farming and preserve ecologies. This may reduce also the ability to operate power stations as efficiently as Meridian would perhaps prefer.
- Solar and Wind technology may be promoted, subsidised even, as the Greens lead efforts to reduce dependance on fossil fuels. This will accelerate the overall disruption of the electricity industry, discussed below.
- We are more likely to see the introduction of a carbon tax of some kind, which may increase the price of fuel to Meridian when lake levels are low, but also reduce overall demand for power. Given the increased likelihood of extreme weather events, including droughts, this could make dry years extremely expensive for Meridian as they may have to supply their major customers at well under cost. Meridian has hedged some of this risk away, but it remains to be seen how effective this is.
The Technology risk
For me the major medium term risk to the electricity industry is technology-based, and driven in part by governments’ promoting a shift to green energy. It’s the combination of affordable home and business solar generation (distributed-solar), electric cars and smarter devices.
Now on page 96 the Meridian offer document does refer to this risk, stating:
“Demand can be affected by a number of factors, including level of activity in the industrial sector, competitor behaviour, regulatory changes, population growth, economic conditions, technological advances in the more efficient use and generation of electricity (including by customers, potentially as a consequence of regulatory subsidisation of competing technologies)“
Those competing technologies are, in the main, distributed solar panels, and prices are steadily falling so that it is now often viable to invest in a system for the home. Return on investment is 5-10% says MySolarQuotes, and Meridian amusingly has a program that apparently delivers a much higher ROI of around 10%. (That’s higher than the after tax return on their shares, begging a question.) To be fair I know nothing about what’s behind those calculations, but I am starting to hear stories from people who are making the numbers work for themselves.
The key metric to watch is the cost of installing a home solar system per unit versus the cost of adding a new power station. The cost of a new large power station sets the overall price for electricity, and when homes can generate at a lower cost than this then power companies are unlikely to want to build. Finance companies will become very active in offering to install solar units and receiving monthly payments based on monthly solar generated electricity. That price per unit will be set significantly lower than the price of retail electricity, making it easy for householders to invest, and to pass on the system to the next home owner.
Solar will reduce the demand from the lower parts of the day, but do little to affect peak power requirements in the evenings, and that means the industry will still need to build plants, and set prices, to cope with that.
A very large number of companies are working hard on reducing the price of solar energy, so it’s just a matter of when this happens, not if. The so-called Swanson Law stipulates that the price of photovoltaic cells falls by 20% with each doubling of global manufacturing capacity, and capacity is expanding quickly. The chart below from The Economist in 2012 shows the plummet in prices of cells, in dollars per watt. The article also acknowledges that technology developments yet to emerge from labs will drive further cost reductions. It’s just a matter of time.
The cost of energy is only part of the electricity cost that households and businesses pay. A significant amount is spent on line fees, to companies that have a very cosy monopoly in each region and another one nationally. Thus there are two prices for the distributed solar systems to beat. The first is to substitute for householder demand at full retail prices, which include line fees. The second is to be able to sell excess electricity back to the grid, excluding the cost of line fees. That second option becomes very interesting in peak hours, when electricity prices are high.
Meridian, and other power companies, will find themselves doing financial models that include the impact of buying distributed solar power back from customers (excluding lines costs) during the day. That’s going to make it increasingly hard to justify new plants, as they can use less hydro during the day. However solar power is generated during the day, while peak demand is dinner and bath time at night, so that tilts the balance towards the generator-retailers who can buy cheap solar during the day and use hydro at night.
The energy that distributed-solar generation supplies to the grid will also require the lines companies to significantly upgrade their own networks (lines and, especially, meters) to cope. This will be expensive, and that expense will drive their lines fees higher, and in turn the prices of our retail electricity will go higher, and in turn this will further promote the switch to micro-generation.
Finally, as hinted in the prospectus and investment statement, to accelerate the adoption of solar and wind power in the home a new Labour-Green dominated government could introduce legislation that required power retailers to buy back electricity generated by homes at a particular price. The higher the price, the faster the adoption will be, and the lower the future profits of the large electricity generator-retailers.
It’s a real issue for Meridian. This Yale Environment 360 article is a recommended read. It includes a quick survey of the US market, where prices are falling underneath retail in some states, and some utilities are fighting using government, while others are joining the rush to support distributed-solar. No prizes for guessing which ones will win in the long run.
Enter Electric Cars and Big Batteries
I’ve written before about the rise of electric cars, starting with plug-in hybrids, but as the Tesla S is proving electric cars will be superior than internal combustion cars for many use cases. The relevant impact here is that they can be plugged in at work or home, and used to store that electricity generated from solar panels during the day, and to return the electricity to the house or grid at night during peak times. The electricity storage economics will help accelerate the switch to electric cars, and the end game is that many homes and offices will reduce their overall demand from the grid dramatically.
Meanwhile smart devices will increasingly be able to switch their own electricity use on or off based on the market price at the time, or signal to households to do the same. This all will help to smooth out peak demand, which means our ecosystem capacity is used more effectively and there is less need to build more plants.
If lines companies won’t provide reasonable access to sell back to the grid, then the distribution of electricity could be to neighbouring cars in an office park, or to households in an apartment block or similar – a building, street, suburb or industrial area. As battery prices fall, the installed solar systems will come with enough battery power to smooth demand over the day, with or without the car.
As the number and scale of the distributed-solar installations increase, the retail price of electricity will fall, until it is equal to the marginal cost per unit of the latest solar and battery kit. Meridian, as an all-renewable producer of electricity with superb dams and windmills, will almost always be the low cost generator-retailer and the last generator standing, and I expect them to win in this future scenario. However they will also have to work through a lot of disruption, and for example have to deal with the ever-increasing lines companies fees.
But surely this switch to distributed generation of electricity is far into the future? Well, as I’ve tried to explain above, the switch is already happening, and several companies in NZ are offering the service to homes. The number of installations is absolutely tiny, but the number to watch is the annual, or even monthly, growth rate for new solar installations. It’s going to be a classic disruptor growth curve.
None of this takes away from the fact that Meridian is very good at what it does – building and operating generating assets, and retailing to consumers. It’s a very solid business. (And a nice hedge against rotten weather, as more rainfall means greater profits.)
However the issue for valuation, as this analyst report from FNZC states, is that “The long life of electricity assets mean that most of the DCF value comes from years after 2017”, which in English means that the majority of the value of the company is ascribed to rising streams of profits into the future, driven in part by an assumed price rise.
Brian Gaynor, sees little growth story, stating that
“Analysts may argue that Meridian’s 21.8 prospective P/E fails to reflect the company’s higher “normal” earnings and strong cash flow but the fact of the matter is that an official prospective P/E in excess of 20 in the prospectus is extremely high for a company with low growth and significant political risk.”
I agree. P/E is the price/earnings, often stated per share. A forward P/E of 20 means that the share price is 20 times what the projected net profit after tax will be in a year’s time. It’s the same as giving the bank $20, and expecting (maybe) only $1 in interest after tax in a year’s time. The only reason you would do that is if you also expect the income from the $20 investment to sharply rise in the following years.
But this is not a growth stock per se. When Trade Me sold to Fairfax they had a prospective P/EBITDA of 15.6 times, which is an estimated P/E of about 20 after tax. Trade Me currently has a P/E of 23.5. So is Meridian really going to deliver the similar returns to shareholders as Trade Me did from 2006, or going forward? Given that Trade Me delivered to investors a 22% return per annum since 2006 I highly doubt it.
This means that the price seems very high versus the stated returns. But there is more:
The risk of complete loss – the disruptors are coming.
As discussed the impact of distributed-solar will be disruptive for the industry, and disruptive technologies can reinvent entire industries. Like essentially all disruptive technologies, the well-informed smart observer can see them coming from some way off, even if they at first appear like toys to the incumbents. And just like essentially all disruptive technologies, most of the incumbent players are culturally and structurally incapable of responding, and are knocked off their profitable perches as newer players take over. This can happen quickly, and even the 18 months between share instalments could be enough to show the emergence (but nothing like dominance) of disruptors.
Just as many of us saw the impact that the web was going to have on traditional media, many of us can also see the rising challenge for big power. The disruption will certainly mean a drop in profitability for the industry, but the real question is which companies are paralysed by the thought of reacting, and which ones will take advantage. And the other question is when will this happen?
I back Meridian to respond well, as we see with their diversifying foothold into Australia with two new solar energy plants, and with Powershop, which is an asset that could take advantage of a fast moving retail field. But overall we should not downplay the medium to long term risks when investing in any traditional power company.
So the disrupters are here, but they are very very small and likely based on marginal economics. As an investor you’d likely look askance at a solar installer player. But then again many perhaps investing in early stage distributed-solar companies is the safer long-term play to go alongside an investment in big electricity generator-retailers? One thing is for sure, having a truly diversified portfolio never goes out of fashion.
Perhaps we will look back at this electricity asset sale process with the same attitude that we now look at Telecom’s huge deal to sell Yellow Pages. Is the government actually prescient in selling down electricity generator stocks? Only time will tell.
I’m not a financial advisor, and not your financial advisor, and not making a recommendation either way for any stock. Seek your own advice.
I am the majority shareholder for Powerkiwi, a company that was until recently a large supplier to Powershop, a Meridian subsidiary. This commercial relationship has now concluded.