In this article I wanted to analyze a publicly traded company called Enagás. This firm operates the truncal natural gas pipelines in Spain. It is also a company that dividend investors have always taken into account due to its high remuneration. Its dividend has been increased at a 11,7% compound average growth rate since 2008 while the average dividend of the market has grown at a -18,3% CAGR for the same time frame. In the following chart, we can see the evolution of this metric:
Enagás management has stated that they have the intention of increasing the dividend at a 5% until 2020, much more than many companies. But is such growth sustainable in the long run?
In order to acquire a wider perspective than the mere Spanish natural gas market, I researched on the internet and found an extract of the World Energy Outlook (2017). There, I found an analysis about the role of natural gas in the global economy. The most relevant facts concerning Europe and Spain are the following.
Regarding supply, new exporting countries such as Australia, Angola, Papua New Guinea, Cameroon and Mozambique will enter the market while USA Will account for 40% of total exports increase. This fact means that there will be a force pushing down the natural gas prices. Furthermore, a better market organization and connected hubs will provide correlated spot prices and shorter supply contracts.
Regarding demand, the document mantains three possible scenarios. As a conservative investor, I will keep with the most restrictive one that can be seen in the following table:
Demand will grow at very difference rates depending on the regions, but we can see a pattern: developing countries will demand more gas due to their industrialization process, while developed ones will need less gas because of a faster adoption of renewable energies. In the following graph we can see it:
Regarding prices, we have witnessed a period of inusual low levels for natural gas. Such period has been the consequence of general overcapacity produced in the last years. Some authors think that prices will be kept low for the following twenty years. Nevertheless, in the long run, only prices that cover costs and allow reasonable profitability are sustainable. The WEO makes an estimation of future prices that can be seen in the following chart. Nonetheless, such evolution cannot be taken for granted since it depends on many factors that could or could not happend. Since overcapacity will eventually disappear, I think natural gas price will rise in the future and will allow better returns. For the studied company, Enagás, its competitive position will not improve accordingly because prices for its core business are regulated by law and transported volumes will not increase significantly, at least in Europe.
This information can be useful regarding valuation. On the one hand, prices seem to grow in the future. However, Enagás activity is regulated so this company will not likely be affected by that price rise. On the other hand, Enagás is a company that is investing in different countries where the role of natural gas is expanding and not contracting.
Since we do not know in which countries Enagás Will invest in the future, we can take a 2% as a growth component for valuation.
Another key factor for this industry is the legal environment. Since 1994, the European and Spanish legislative powers have adopted acts that regulates the different activities carried out in the gas sector. The main ones are the following:
- Ley 34/1998, de 7 de octubre,
- Real Decreto-Ley 13/2012, de 30 de marzo,
- Real Decreto 949/2001 and
- Real Decreto-Ley 13/201
They set a division between regulated and non-regulated activities. The first group are composed by regasification, storing, transporting and distribution activities. By the contrary, the rest of initiatives are subject to the forces of competition. Additionally, Spanish government stalled the development of new regasification plants and pipelines (due to overcapacity) and has introduced measures to correct the tariff deficit.
As we can see, the public sector has a strong influence over the natural gas industry, specially in terms of remuneration of regulated activities, investments and emissions policies.
A situation that I do not particularly like about the Spanish Gas & Electricity industry is the tariff deficit. Demand of natural gas in Spain witnessed an important rise between 2000 and 2008. For that reason, a number of investments were made to increase capacity, but contrary to this scenario, demand plummeted after 2009 and tariff deficit appeared. In the following graph we can see the deficit for 2014 and allocation among the different activities:
Nowadays the tariff déficit reached €363 million. With this scenario, government has announced that will take actions in order to correct this situation. Specifically, National Competition Comission has expressed its desire of modifying the remuneration scheme for Enagás. The proposed alternative would be based on cost of capital, which is currently at levels ranging from 4 to 4,5% for our company.
The intention with this change is to reduce Enagás income as it is low risk activity.
In the previous chart, we can see the downside potential of a new, and more restrictive remuneration scheme. I have represented both return over invested capital and weighted average cost of capital. Taking into account that difference between these two metric for a competitive industry ranges between 0-2%, the loss of profitability is about 6% (assuming that cost of capital never changes).
Once that we have reviewed economic and law environment of natural gas industry, we can review Enagás performance over the past 11 years. To start with, I have calculated return over equity and its decomposition. It can be observed in the following chart:
In the graph we can see how both operational profitability and return over equity have remained almost constant over the considered period, the difference between return over assets and cost of debt has lowered slowly and net financial leverage has been increased (being the component that boosted ROE).
I also wanted to compare Enagás to the industry it belongs (Electricity and Gas). Enagás ROE has been systematically over its peers and this has been possible thanks to its higher financial leverage (blue bars).
According to Enagás management, the key points of its strategy are the following:
- Deploy the TSO business model in countries with high potential.
- Take part in the development of key european infraestructures.
- Generate more cash flow.
- Increase operational efficiency.
- Increase the dividend paid to shareholders.
Regarding last point, we have already seen in the first section that Enagás dividend growth has been much larger than average market.
With respect to cash flow generation, I have measured it by dividing free cash flow over sales to check its evolution:
As showed in the above chart, free cash flow from operations over sales has grown at a compounded average rate of 8,2%, while FCF/sales has grown at a faster pace (28,5%). Due to the abrupt increasing in the last year, I also repeated the exercise taking into account only the years 2007-2016 the growth rates are 2,2% and 22,5%, respectively.
Regarding geographic expansion, it needs to be said that Enagás has exported its expertise to countries such Mexico, Perú, Chile, Sweden and has participated in international projects such as TAP. Measuring economic performance of each of Enagás investments is a very difficult task due to the fact that some of them are consolidated and not reported separately. Anyway, I have measured the economic return of investments that are valued using the equity method in the balance sheet. Such investments are registered following the NIC 28. According to this method, investments are firstly recognized at cost. In subsequent years, dividends received have been subtracted while incomes received have been added back. I have calculated the internal rate of return and the result obtained was a 8,2%, which equivalent to a PE of 12,5x. This shows the good but not great acquisition policy.
At the beginning of the post we wondered if the dividend paid by Enagás is sustainable or not. In order to measure the sustainability, I decided to work with the Cash Flow Statement. In the following table we can see the main items of the past 11 years:
If we take free cash flow to the firm line and subtract interest paid and debt repayment, we get a negative result. It means that the company is borrowing money in order to pay dividends. In case Enagás wants to keep increasing its dividend, it will need to increase profitability by improving its operating efficiency and / or decrease financial leverage.
Besides analysing dividend sustainability, I also wanted to reach a conservative entry price. Due to low future natural gas demand, I have normalized Enagás Balance sheet and Cash flow statement over the past 11 years. After that, I have corrected both assets (equity investments) and liabilities (interest paying debt) accounts to better represents the firm reality.
Moreover, I have also revised Enagás Cash flow statement, that has also been normalized over the same period, resulting a free cash flow to the firm of 0,7€ per share.
Taking everything into account, I have reached an entry price of 18 – 21 € per share. Enagás is currently trading at 26,90€, which is above our reference valuation.
Enagás is a company that has expanded geographically in the last 10 years. This expansion has been financed basically with debt and this is the main reason debt burden and interest payments have grown rapidly, even with low interest rates.
Regarding the legal environment, I would like to highlight the threat of goverment consisting in a reduction of the price paid for regulated activities.
I would like to see Enagás improving its operational efficiency, reducing its debt burden and the dividend growth. If so, a good entry price would provide us with a good candidate for a conservative portfolio. If Enagás improves its operating efficiency and reduces its debt, it can be a good candidate that can add some dividends to our portfolio. However, as value investors, a good entry price is paramount. And for this case, I would not trust dividend discount model.