MCY Mercury NZ ( MRP Mighty River Power)

[Snoopy]

This share should be valued over the long term on its ability to pay dividends only. The low ROE figure is not sufficient to be sure of growth given a ten year timeframe. The Warren Buffett style growth model won't fit as a result. Yet actually, there is something wrong with this analysis as I have presented it. It deserves a closer look.

The 'closer look' revealed that the ROE was actually spectacular. So that meant the Warren Buffett style growth model could be applied after all. Until the 2015 result came out and destroyed any recognisable eps and margin trends! This doesn't mean that MRP is not a good investment though. It just means I have to use a different valuation model to find out.

The valuation model I like to use in these circumstances is the average dividend over the business cycle method. In the case of MRP I am restricted to five years of data. Going back any further is IMO not useful because much of the geothermal power generation that makes MRP the company it is today was not in place before FY2011 (FY2010 was when the 140MW Nga Awa Purua station came on stream).

Nevertheless 'average value of dividends' does not allow for the company's ability to generate 'thin air capital'. If a company was never going to grow then this 'thin air capital' could be regarded as a bonus dividend stream. MRP has been able to commission two brand new significant geothermal power stations out of thin air capital since FY2010. And they have consent to build more (on the Taheke Geothermal Field, NE of Rotorua with local iwi co-ownership). Shareholders have the ability to fund MRP's growth without injecting any new cash capital into the company. I think that fact of the company has 'extra value' that is not reflected in the normalised 'earnings per share' figures.

SNOOPY

[Snoopy]

Nevertheless 'average value of dividends' does not allow for the company's ability to generate 'thin air capital'. If a company was never going to grow then this 'thin air capital' could be regarded as a bonus dividend stream. MRP has been able to commission two brand new significant geothermal power stations out of thin air capital since FY2010. And they have consent to build more. Shareholders have the ability to fund MRP's growth without injecting any new cash capital into the company. I think that facet of the company has 'extra value' that is not reflected in the normalised 'earnimngs per share' figures.

Slide 14 in the annual results presentation on "Tightening Supply with Thermal Rationalisation" is worthy of comment. It shows the 'Winter Energy Margin' (based on energy consumed) adjusted for thermal closures is expected to disappear by 2025. The margin will reduce below the 'System Operator Security Standard' as soon as 2019. So the construction of at least one major new power station may occur sooner than most people think. I think MRP are well positioned to build that new geothermal plant. And that bodes well for MRPs potential 'market share' in the medium term.

SNOOPY

[Aaron]

In general a 'special dividend' is not sustainable.
11.74/ (0.06 x 0.72) = $2.72
SNOOPY

Two years in a row for special dividends hopefully it is becoming the norm.
Using a capitalisation rate of 6% for Gentailers, what is your current cap rate for property trusts. (although I read somewhere you don't invest in them as your house is considered your property in your portfolio)
How do you establish a cap rate and does it just move up in line with interest rate rises so in theory if interest rates rise you write down the value of your investments. 6% is OK from savings but if I am borrowing to invest with a 7% interest rate my cap rate should be at least 10% I suppose. All guess work... I guess.

[Snoopy]

Two years in a row for special dividends hopefully it is becoming the norm.

By booking tax credits from an associated $500m asset revaluation, they certainly have the capacity to pay more special dividends in FY2016, whether or not they choose to do so.

Using a capitalisation rate of 6% for Gentailers, what is your current cap rate for property trusts. (although I read somewhere you don't invest in them as your house is considered your property in your portfolio)

It would depend on the property company. With AIA, I might still go for 6%. Something like Kiwi Income Property, with a lot of mall exposure. Maybe 7.5%. Something that was more office towers, maybe 9%. But as you noted, I don't own any listed property investments.

How do you establish a cap rate and does it just move up in line with interest rate rises so in theory if interest rates rise you write down the value of your investments.

All else remaining equal, yes a rise in interest rates would cause my fair value of my high yield income producing assets to head south. But for an income investment I have a lot of confidence in, I would still be looking for a gross yield around 2 percentage points more than if I had put that same money in the bank.

6% is OK from savings but if I am borrowing to invest with a 7% interest rate my cap rate should be at least 10% I suppose. All guess work... I guess.

You are playing quite a dangerous game borrowing to invest in these high yielding shares I think. The reason is that the directors already have a fiducary duty to shareholders to pay out excess capital. So by borrowing you are in effect saying that you know better than the directors and they should be paying out more to you. It's a big call to make.

SNOOPY

[Snoopy]

Nevertheless 'average value of dividends' does not allow for the company's ability to generate 'thin air capital'. If a company was never going to grow then this 'thin air capital' could be regarded as a bonus dividend stream. MRP has been able to commission two brand new significant geothermal power stations out of thin air capital since FY2010. And they have consent to build more (on the Taheke Geothermal Field, NE of Rotorua with local iwi co-ownership). Shareholders have the ability to fund MRP's growth without injecting any new cash capital into the company. I think that fact of the company has 'extra value' that is not reflected in the normalised 'earnings per share' figures.

A couple of interesting statistics from FY2012, a year without an unusual river inflow. Mighty River Power had a 51.4% capacity utilisation from their hydro stations and a very impressive 94% capacity utilisation from their geothermal stations. This gives an idea of the relative importance of the two kinds of generation in relation to total energy generated by MRP. Since the commissioning of the latest geothermal station (Ngatamariki) in 2013/2014, MRP have enough revalued capital on the books to build yet another 'free' geothermal power station if they so choose. Let's say this potential new station could deliver 100MW. By how much would that increase the base generating capacity of MRPs portfolio?

1044MW Hydro (existing) x 0.514 = 537MW (effective)
463MW Geothermal (existing) x 0.940 = 435MW (effective)
100MW Geothermal (new) x 0.940 = 94MW (effective)

Hence the effective new capacity increase is:

94 / (537+435) = 10%

OK that new power station is not yet built, or even hinted that it will be started. But I would argue that MRP already has this new hidden value built into the company. The company is effectively 10% bigger than its current production capacity, and could up size by 10% seemlessly if management so chose to do it.

So I take my previous valuation based on eps flow alone:

11.74/ (0.06 x 0.72) = $2.72

and up it by 10% to take account of the power station on the books that could be built now:

$2.72 x 1.1 = $2.99

By my reckoning $2.99 is my best 'investment estimate' of where the value of MRP sits right now.

SNOOPY

[Aaron]

There is an alternative calculation using different data to work out the return on shareholders equity of MRP. If you look right at the end of note 10 in AR2014 you will see the carrying value of assets had they been recognised at cost. Just above that you will see the note referring to the increase in value of generation assets of $40m, in addition to the $80m booked in FY2013. With MRP there have been many prior year asset revaluations like this.

Go to the income statement (p6) and you will see that the total comprehensive income for the year of $258m includes revaluation of generation assets of $35m +$5m =$40m. None of this is included in the net profit of $212m (p5). Now go to the Statement of Changes in Equity (p8) and you will that there are entries for fair valuation of hydro and thermal assets ($4m) and other generation assets ($25m) net of taxation. The tax paid on these asset revaluations was therefore:

($40m - ($25m+$4m))/ $40m = 28%

This is the normal company income tax rate. This implies the company has chosen to revalue their generation assets and pay tax on that revaluation and therefore generate extra income tax imputation credits that will be available for shareholders. That policy strikes me as strange. I would have thought revaluation of capital assets like power stations was a non taxable item! Can any accountants out there explain why MRP have treated their asset revaluations in this way?
SNOOPY

Thanks for the reply Snoopy.

In regard to your question on asset revaluations post #663 (this may have already been answered) I would suggest the following but wouldn't put money on it.

I assume MRP claims depreciation on their dams and geothermal assets for tax purposes but they need to record a "fair value" for their assets for the presentation of the financial statements. Fair value is established using NPV and the assets are revalued up especially when interest rates are so low as interest rates form part of the capitalisation rate (low cap rate high asset value). There is no tax paid or imputation credits created by the revaluation but they recognise that if the assets were sold it would create an equivalent amount of income in the form of depreciation recovered so the revaluation is shown in equity after tax. That is my best guess but anyone can feel free to point out any errors in my theory.

Capital out of "thin air" watch it disappear again if interest rates start to rise and the capitalisation rate increases. You would have seen this with AIA with the return of capital. To me it looks like AIA borrowed real money to pay shareholders the asset revaluation increase(capital return). Also you see it all the time with property company revaluations. Interest rates fall, cap rates fall and assets increase in value. If interest rates rise it all heads the other way.
You shouldn’t see an allowance for tax (depreciation recovered) on property valuations anymore as they can no longer claim depreciation on buildings for tax purposes.
Large companies like these will have a tax fixed asset schedule and the one we see in the financial statements. Any tax deferred should be shown in the financial statements. In the case of MRP the tax deferral is indefinite as the assets are never likely to be sold.
The roughly $83mill tax paid on profits would be more than enough imputation credits for the dividends paid.
Property and asset revaluations would not incur any income tax. They are accounting journals based on subjective valuations that is one of the reasons we have a cashflow report.

[BlackCross]

MorningStar's latest recommendation report (31/8/15) has MRP as a hold.....

".....Our fair value estimate is unchanged at NZD 2.90 (AUD 2.70) per share. Mighty River Power is trading broadly in line with our fair value estimate. We maintain our narrow economic moat and high fair value uncertainty ratings. Mighty River Power is one of the four large electricity generator and retailers efficiently servicing the oligopolistic New Zealand Market. The company boasts the lowest cost structure in the industry, which is on track to decline even further as it moves to a fully renewable model...."

[Snoopy]

MorningStar's latest recommendation report (31/8/15) has MRP as a hold.....

".....Our fair value estimate is unchanged at NZD 2.90 (AUD 2.70) per share. Mighty River Power is trading broadly in line with our fair value estimate. We maintain our narrow economic moat and high fair value uncertainty ratings. Mighty River Power is one of the four large electricity generator and retailers efficiently servicing the oligopolistic New Zealand Market. The company boasts the lowest cost structure in the industry, which is on track to decline even further as it moves to a fully renewable model...."

Thanks for this update 'from the pros' Blackcross. I am pleased that my own valuation of $2.99 is within the ballpark. All these NZX top ten companies are analysed to death. So it would be a real surprise if there were big disagreements. Nevertheless different analysts looking at a company can have different perspectives. It would be interesting to know more about how Morningstar set up their assumptions as well as their final $2.90 result.

My '6% gross yield' benchmark is lower than most analysts would use (resulting in a higher MRP valuation). But generally I assume less growth than other analysts, which is a balancing factor. I am a little surprised that Morningstar think that MRP has the lowest cost structure though. I thought Meridian's cost structure would be lower.

I tend to look longer term than most analysts, because I hold shares right through the business cycles. I never try to guess exactly where the power market will be in a years time, for instance. I prefer to remain safe in the knowledge that weather does not always go to a plan. I also heavily favour actual recent result scenarios, rather than dreaming up what I think might happen. In stable markets, I find history tends to repeat!

'Stable markets'! Well nothing is ever truly stable. Some of you may have noticed an inconsistency in my valuation.

1/ I am assuming a stable power market going forwards.
2/ I am building in an allowance for an increase in 'thin air capital'. 'Thin air capital' can only arise long term because the valuation of generation assets goes up because the overall market is growing!

In truth I do believe the electricity market will continue to grow in the medium term (except if Tiwai closes). But I think it will grow less than in the pre-GFC days. Probably about 1% per annum on average, down from 2% per annum pre-GFC. I could fiddle around adding a 1% growth factor to my 'stable' energy revenue projections. But I don't believe it would change my valuation result much, and it is easier not to do it. So in keeping with my new investment analysis philosophy (keep everything as simple as you can to be effective, but no simpler) I chose not to do it. Not doing it will introduce an extra small element of conservatisim in my investments valuation. And I think that is a good thing.

SNOOPY

[Snoopy]

Thanks for the reply Snoopy.

In regard to your question on asset revaluations post #663 (this may have already been answered)

It hasn't!

I would suggest the following but wouldn't put money on it.

I assume MRP claims depreciation on their dams and geothermal assets for tax purposes but they need to record a "fair value" for their assets for the presentation of the financial statements. Fair value is established using NPV and the assets are revalued up especially when interest rates are so low as interest rates form part of the capitalisation rate (low cap rate high asset value).

I agree with all you have written above. If you go to page 14 of AR2014 you will see that an increase in discount rate of just 0.5% will reduce the value of the power stations by $489m! That is very significant when on the same page it would take a 'future wholesale electricity price path' (I think that means the result of a discounted cash flow calculation reflecting future prospects), shows that prices would have to fall some 7% to have a similar effect.

There is no tax paid or imputation credits created by the revaluation but they recognise that if the assets were sold it would create an equivalent amount of income in the form of depreciation recovered so the revaluation is shown in equity after tax. That is my best guess but anyone can feel free to point out any errors in my theory.

Property and asset revaluations would not incur any income tax. They are accounting journals based on subjective valuations that is one of the reasons we have a cashflow report.

Sounds plausable. This helps solve a problem with my own suggestion of just taking the asset revaluation straight to the bottom line, and so incurring an immediate tax bill. Say the assets needed to increase by $500m to reflect the NPV of the discounted cashflow. The company does this but in so doing so creates a tax bill of $500m x 0.28 = $140m. This in turn means the net assets gained as a result of the revaluation is only $500m-$140m = $360m. So the revaluation falls short and we have to do another revaluation of $140m, which also incurs tax. And that leaves the valuation short again, so we carry on in a kind of endless revaluation loop!

You shouldn’t see an allowance for tax (depreciation recovered) on property valuations anymore as they can no longer claim depreciation on buildings for tax purposes.
Large companies like these will have a tax fixed asset schedule and the one we see in the financial statements. Any tax deferred should be shown in the financial statements. In the case of MRP the tax deferral is indefinite as the assets are never likely to be sold.
The roughly $83mill tax paid on profits would be more than enough imputation credits for the dividends paid.

In FY2014 normalised earnings of 11.1cps were rather less than the 16.9cps declared in dividends. Obviously that situation is possible because of accumulated tax credits from previous years.

SNOOPY

[Aaron]

In FY2014 normalised earnings of 11.1cps were rather less than the 16.9cps declared in dividends. Obviously that situation is possible because of accumulated tax credits from previous years.

SNOOPY

This is from Note 6 2014 accounts. "Imputation credits available to shareholders in the future amount to $45.8 million (2013: $32.5 million)." Accumulated $13.3mil additional Imp Crs in 2014. Paid more in tax than attached to dividends. I guess you could compare dividends to earnings to estimate it all but I haven't tried.