Electrica SA (EL RO) is a recently privatized electricity distribution company in Romania with a predictable, regulated, and inflation-protected earnings stream trading at less than 10x forward earnings, a 7.5% dividend yield, and 65% of book value with 2/3 of its market cap in net cash. In addition to the attractive current multiple, a number of opportunities make Electrica an interesting investment:

- I believe earnings will double over the next 4 years through:

• Completion of planned investments in the regulated asset base (RAB), which will cause RAB to grow ~70% over the next 4 years
• A favorable regulatory environment that provides the opportunity for Electrica to earn a rate of return on its RAB in excess of the allowed return. The current regulatory framework sets a low bar for allowed costs since these costs are based on Electrica’s historical cost structure when the business was operated inefficiently under the Romanian State. The company should exceed its allowed cost targets.

- The opportunity to deploy the company’s excess capital in an accelerated fashion through buying out the minority shareholder in Electrica’s subsidiaries, acquiring other privatized distribution companies in Romania that are currently for sale, or potentially paying out a one-time special dividend.

• Applying management’s long term net debt to EBITDA target of 1.5x to Electrica’s trailing EBITDA shows that the company has debt capacity and excess cash equal to its entire market cap in a conservative scenario.
• The risk of earnings reinvestment is somewhat mitigated by the company’s plan to pay out 85% of its earnings in the form of an annual dividend.

- The fact that many Electrica employees bought shares in the IPO personally and the likely introduction of a stock based compensation plan for management further aligns management’s interests with those of shareholders.

For those who do not want to set up trading capabilities in Romania, EL RO also has a London listed GDR (ELSA LI) and many prime brokers will allow you to buy shares of Romanian listed companies on swap. The company has a ~920mm EUR market cap, of which 51% is float.

Business Background

Electrica owns majority stakes in three electricity distribution utilities in Romania. These regulated monopolies distribute 39% of all electricity consumed in Romania, while spanning 41% of the total land mass. Electrica also owns a majority stake in an electricity supply business and 100% of an unregulated subsidiary that provides construction, maintenance and repair services to the three utilities as well as to some of the other privatized utilities. Electrica owns 78% of the subsidiaries that are not wholly owned, with the other 22% owned by Fondul Proprietatea (Fondul).

Opportunity to Double Earnings over the Next 4 Years

As a result of the current regulatory framework in Romania and the company’s history of mismanagement under state ownership, Electrica’s recent privatization has created opportunities to significantly increase earnings:

Rate Base Growth

The company is regulated by ANRE. The current regulatory period started on January 1, 2014 and runs through December 31, 2018. The regulator is indifferent to capital structure, allowing companies to operate with virtually any capital structure they please within reason. Since rates are set based on an ROA calculation rather than ROE, there is a significant benefit to funding capex through debt. During the current regulatory period, Electrica is allowed to earn an 8.52% pre-tax return on its rate base, such that RAB * 8.52% = allowed EBIT. RAB at the end of 2013 was 4.1 bn RON. RAB has an inflation escalator built in, such that end of period RAB = beginning of period RAB + allowed capex – regulatory D&A + inflation. The inflation adjustment is based off of CPI. The National Bank of Romania has a long-term inflation goal of 2.5% +/- 1%. Current inflation is around 3%. This provides a tailwind to RAB growth. ANRE has approved Electrica’s capex plan through 2018, which calls for investments in the rate base of approximately 1 bn RON / yr (relative to depreciation of about 400 million RON).

From 2015-2018, Electrica will cumulatively spend capex in excess of its current RAB. Using IFRS D&A (which is conservative since regulatory D&A is actually a little bit lower) and my 2.5% long term inflation assumption, I have RAB growing from 4 bn RON today to over 7 bn RON by the end of 2018:

Opportunity to Outperform Controllable Cost Targets

ANRE sets tariffs in part based on an estimation of Electrica’s controllable costs (such as employee costs, maintenance costs, etc). Uncontrollable costs (taxes, etc) are fully passed through to customers. The regulator sets the amount of allowed controllable costs that a utility can recognize in tariffs at the start of each regulatory period. This calculation is mainly based on that utility’s historical performance. If the utility underperforms its allowed costs, they do not get compensated for these losses and end up earning a return on RAB less than their allowed return. If the utility outperforms these targets, the company gets to keep the entire outperformance for the remainder of the regulatory period. However, when the regulator sets rates for the next regulatory period, they give the customer 50% of the outperformance through lower tariffs. For example, if Electrica’s allowed controllable costs were 100 in 2018 but the company’s realized controllable costs were 50, Electrica gets to keep that extra 50 of outperformance but when the regulator resets controllable costs for the new regulatory period, allowed controllable costs would decrease to 75. During the current regulatory period, allowed controllable costs decline 1.5% per year on a nominal basis to encourage continued efficiency improvements.

Relative to the other privatized distribution companies, Electrica is significantly over-staffed. Over the last few years, Electrica’s privatized peers have been pretty aggressive in cutting their headcount, allowing them to earn outsized returns in the last regulatory period. Contrarily, the headcount at Electrica’s utilities has stayed flat over the last 3 years. Electrica’s labor force is old: close to 30% of employees are 51-60 years of age and another 40% of employees are 41 to 50. This provides an opportunity to decrease the headcount through natural attrition in parallel with any potentially more aggressive measures.

I believe that employee costs today are roughly in-line with allowed costs. Management likes to measure labor productivity across its peers by looking at revenue per employee. The company sees no reason why it cannot get similar labor productivity to its Romanian peers over-time. If Electrica can right-size its labor force such that Electrica’s revenue per employee in 2018 is on par with where its Romanian comps were in 2013, there is a significant opportunity to outperform allowed costs:

My base case assumes Electrica matches the current headcount of its most inefficient competitor by 2018. To frame the incremental opportunity, assuming 2.5% inflation in Romania, RAB should be about 7 bn RON in 2018. If Electrica can operate in-line with the 2013 Romanian average headcount by 2018, I estimate the company would outperform allowed costs by 50mm RON. This would increase the 8.52% allowed rate of return ~70bps to a 9.2% realized rate of return on RAB.

Electrica’s maintenance costs are also inflated relative to peers. The company’s historically meager capex plan under State control has forced Electrica to “patch up” problem areas in the grid rather than replace them. The resulting increase in opex due to a lack of capex should reverse as Electrica implements its capex program. Peer companies have maintenance costs that are significantly below Electrica’s. Again, management sees no reason why their maintenance costs shouldn’t move more in line with peers over time. The company believes that they can cut their maintenance costs by more than half long term. Assuming they only cut 25% of maintenance costs by 2018, I estimate that Electrica would earn ~30mm RON in excess of the allowed return.

Opportunity to Outperform on Allowed Network Losses

The regulator also makes an assumption for allowed network losses at the beginning of every regulatory period. Network losses are the amount of electricity the distribution system loses en-route to a customer’s home. The mechanism for network losses is very similar – if Electrica underperforms its allowed network losses, the utility under-earns. If it outperforms its allowed network losses, Electrica gets to keep 50% of the outperformance in low voltage network losses and 25% of the outperformance in medium and high voltage losses.

Similar to the issue with maintenance costs, Electrica’s network losses are inflated due to the lack of investment in the grid. The company has many transformers that are 30+ years old and have 20% loss rates. A large chunk of Electrica’s capex budget will go towards replacing these transformers with ones that have ~1% loss rates. Further, ~35% of Electrica’s network losses are due to theft. In countries like Germany, this number is effectively zero. Investments in tamper-proof equipment on above ground infrastructure as well as moving overhead power lines underground, should help the company manage network losses down. Further, if investments in smart metering get approved by the regulator down the road, the company will be able to better attack the theft issue given the ability to identify precisely where power is being siphoned. ANRE has given the company a network loss target for the current regulatory period which calls for the company reducing network losses down to ~10.5% in 2018 (network losses in 2013 were around 12%). However, this target was set prior to the regulator’s approval of the new capex plan. Electrica will be meeting with the regulator over the next few months to discuss a variety of topics. In this meeting it is very possible that the regulator could lower the network loss target for the upcoming regulatory period given the increased investments. Due to the uncertainty associated with the outcome of this meeting, I am hesitant to put too much weight on potential network loss outperformance. However, management thinks they can get to 8.9% network losses by the end of the regulatory period. Assuming they get to 9.3% to discount for the regulatory uncertainties and the difficulty in pinpointing the likelihood of Electrica hitting their goals, the company would earn 45mm RON in excess of its allowed return in 2018. There seems to be a large opportunity to improve network losses countrywide. Network losses in Romania are some of the highest in all of Europe. Network losses in many Western European countries are around 4%.

Opportunities to Deploy Capital

One of the biggest concerns regarding an investment in Electrica is concern regarding the company’s capital structure and plans for the cash. As mentioned above, pro forma for the IPO, Electrica has over 2/3 of its market cap in net cash. The company has outlined a few uses of cash:

-          Buy out Fondul Proprietatea’s 22% minority stakes in Electrica’s subsidiaries

-          Fund capex plan

-          Acquisitions

-          Investments in smart metering

-          Maintaining a high payout ratio (85% of earnings), with the potential for a one-time special dividend

Fondul has been very public about its desire to sell its stakes in Electrica’s assets. Electrica is willing to purchase them as they view it as a good use of capital and it cleans up the structure. Applying Electrica’s pro forma enterprise value to Fondul’s proportional interest implies that these stakes are worth a total of ~400mm RON. Fondul has these assets marked in their NAV at ~780mm RON, which approximates their proportionate interest in the book value of these subsidiaries. Since both parties want to get a deal done, all of my earnings figures assume that Electrica buys out Fondul’s stakes. I assume a 550mm RON price (management believes they will be able to acquire it for less). No deal could have been completed until Electrica’s new board was elected (this just took place at the end of September).

Electrica does have a large capex plan to fund over the next few years. However, assuming Electrica buys out Fondul’s stakes for 550mm RON and pays out 85% of its earnings in the form of dividends to shareholders, I calculate that the company will still have net cash at the end of 2018. The company has a long term capital structure target of 1.5x net debt to EBITDA.

One of the other outlets for capital deployment could be acquisitions. Enel, which purchased majority stakes in three Romanian distribution companies from the State, has recently announced its intention to divest these stakes:

http://www.enel.com/en-GB/investors/press_releases/sale-of-enel-group-holdings-in-slovakia-and-romania-begins/r/1662134

Fondul, which is a minority shareholder in Enel’s distribution companies, has also expressed an interest to sell. Assuming that all parties are willing to sell their stakes in these businesses, I calculate that Electrica could buy all three distribution companies and still only have net debt / EBITDA of less than 1x based on 2015 numbers. This conservatively assumes that Electrica pays 80% of RAB for these assets, a large premium to the ~50% of RAB Electrica trades at. In this scenario, Electrica’s earnings would roughly double to ~2.40 RON / share.

Even if Electrica bought all three of these assets at this valuation, the company could still come close to funding its entire investment plan through 2018 without going above 1.5x net debt / EBITDA leverage. If they bought the assets for 70% of RAB, they would stay under their leverage target.

This is more of an illustrative example than anything because I think it is unlikely that Electrica buys all three of these utilities, but I wouldn’t be surprised if they acquired one or two. Enel is an active seller and there appear to be very few other natural buyers of these assets, further suggesting Electrica might get a bargain.

Electrica also points to smart metering as a potential use of capital. Currently there is very little smart metering in Electrica’s approved capex plan. However, in order to get in-line with EU targets, Electrica would have to spend ~400mm EUR by 2020 on smart metering. Electrica is waiting to have discussions with the regulator regarding how much capex ANRE would be willing to approve towards smart metering and how Electrica would be compensated for this investment before the company decides whether or not to invest in these projects. As the regulations stand today, smart metering capex earns an extra 50 bps allowed return in excess of the 8.52%.

Lastly, Electrica is committed to maintaining its high 85% payout ratio. However, unless the company executes on many of the issues highlighted above, management realizes that Electrica will remain significantly under-levered for a long time. Based on conversations with the management, I believe the company may consider proposing to payout a one-time special dividend if they are unable to deploy ample capital into the outlined growth opportunities.

Supply Business

In addition, Electrica owns an electricity supply business in which they effectively trade electricity and sell it to both household and industrial consumers. This business currently represents ~25% of EBIT. As of January 1, 2014 supply to wholesale customers has become fully liberalized, with household supply beginning its liberalization process in 2013, which should be complete by 2018. Electrica appears to generate most of its earnings in this segment from wholesale customers. The company believes that its purchasing scale in combination with a plan to provide more value added services to its customers should allow the company to maintain or grow its profitability in this segment. I conservatively assume supply earnings decline 10% per year due to competitive pressures. As Electrica continues its large investments in the distribution business, electricity supply will become a much smaller portion of total EBIT over time. On my 2018 numbers, this business will represent less than 10% of EBIT.

Corporate Governance and Aligned Management

EBRD (European Bank for Reconstruction and Development) made a 75mm EUR investment in the Electrica IPO, making it the largest shareholder outside of the Romanian State. I believe that EBRD’s involvement has contributed to Electrica’s decision to create a corporate governance structure that is friendly to private investors. The Romanian State was only allowed to nominate two board members, with the other 3 board members entirely independent and nominated by the other shareholders. Shareholders must approve through vote any investment in excess of 30mm EUR, with approval of at least 55% of total shares outstanding. Shareholders must also approve the company’s capex plan, any M&A transactions contemplated, any amendment to the Constitutive Act, and any major donations made by the company with the same 55% of shares outstanding.

One of the new board’s first jobs will be to approve a compensation plan for the management team. Given EBRD’s push for equity-linked compensation at their other Romanian investments (Romgaz for example), it seems likely that Electrica’s board will also push to enact a compensation structure that is performance-based and tied to both earnings and share price. This alignment of incentives should support continued value creation.

Illustrative IRR Scenarios

Since the precise method of capital deployment is uncertain, I believe it is instructive to look at a few different return scenarios. In all of these scenarios below, I assume Electrica buys out Fondul’s stake for 550mm RON and that they complete their outlined capex plan. I also assume what I believe is a conservative amount of allowed cost outperformance, such that 2018 realized return on RAB is 9.5%, relative to the 8.5% allowed rate of return. This 9.6% assumes that Electrica performs in-line with allowed employee costs (matches the most inefficient peer’s current revenue/employee in 2018), cuts maintenance costs by 25% (even though comps are 50%-65% lower than Electrica), and outperforms network losses slightly.

Scenario 1 assumes Electrica invests its excess capital in the rate base and earns 8.52% on the incremental investment. If the company is valued at a 10x multiple of 2018 earnings by July of 2017, an investment in Electrica would yield an IRR of ~28% over 3 years:

If you assume no outperformance of allowed costs, the IRR is ~24%.

In the second scenario, I assume Electrica pays out all the capital the company does not need to fund the future capex plan in July of 2017. In this scenario, the IRR is ~32% over 3 years:

If you assume no outperformance of allowed costs, the IRR is ~28%.

In the third scenario, I assume the company pays out all the capital the company does not need to fund the future capex plan today. This scenario yields a 52% IRR on one’s investment net of the special dividend:

Assuming no outperformance in allowed costs, this IRR would be ~44%.

What Some Investors May Miss

While I have only seen a few sell-side reports, it seems that many analysts do not model Electrica’s future earnings correctly in addition to applying unrealistically low multiples. I believe this is due to a few wrinkles they fail to recognize including:

-          Electrica received payment for ~220mm RON overdue receivable in May of 2014 - this should be added to pro forma cash. Q2 ’14 has since been reported and this number is now reflected on the balance sheet.

-          Many analysts don’t seem to give the company proper credit for the interest income Electrica should earn on its net cash. This could be a meaningful number since 2 year government bonds trade at ~2.6% in Romania.

-          Electrica is in the process of liquidating / putting through insolvency its loss making external electricity network maintenance subsidiaries. These subsidiaries lose over 50mm RON/year which should be backed out of pro forma earnings.

-          Electrica Serv, the unregulated distribution service company that provides services to Electrica’s three distribution utilities is allowed to earn a 3% return on the capex it deploys for Electrica’s utilities. Historically this number was pretty small since Electrica underinvested in its infrastructure, but in the future this should grow to ~30mm RON / year of EBIT

Overall, my earnings estimates are approximately 30% higher than sell-side projections.

Other Potential Risks

-          Change in regulatory environment. While I have met with the regulators and they generally seem reasonable, there is always a risk that the future regulatory environment is less favorable than the current one. I am somewhat comforted by the fact that the current regulatory period doesn’t end until December 31, 2018, so the likelihood of any near term unfavorable change is remote. Long term there may be some potential downward pressures on allowed return.

-          Company doesn’t deploy the cash as expected and remains under-levered for a long time. This would cut into the IRR of the investment but downside is protected by the low multiple of current earnings and support from the dividend yield.

-          The Romanian State still owns ~49% of Electrica. It could use its muscle to try to force them to make bad investments, be less aggressive on cost cutting, or veto decisions that are in the best interests of shareholders