Regulated Business, Continued Rate Base Growth Bode well for Growth: Hydro One Limited (TSX: H), is a leading electricity transmission and distribution company in Ontario with ~1.4 million valued customers. The company’s majority of the business is regulated, acting as a safety net amid economic doldrums. Hydro One caters to both retail customers and business houses and employs more than 8,800 people.

Business Model: The Business operates through two segments, i.e. Regulated Business and Unregulated Business. Within the regulated segment, the business conducts two operations, namely Transmission and Distribution. The transmission segment includes system transmits high-voltage electricity from nuclear, hydroelectric, natural gas, wind and solar sources to distribution companies and industrial customers across Ontario and accounts for 98% of Ontario’s transmission capacity with ~30,000 circuit kilometers of high-voltage transmission lines. The segment also provides cross border services to the United States and other neighboring provinces. Within the distribution segment, the business has 123,000 circuit kilometers of primary low-voltage power lines. Under the unrecognized part, the business deals with the telecommunications business and provides telecommunications support for the company’s transmission and distribution businesses.

Investment Rationale:

• Solid defensive play amid turbulent time: As broader markets take a hit from the increasing COVID-19 stats, accumulating defensive stocks seems to be a fair idea. Hydro One’s 99% business is regulated, which ensures stable cash flows, making it immune to economic cycles. The company’s defensive attributes act as a hedge and cap the downside in the stock amid large market swings. For instance, Hydro One stock remained resilient to recent stock market carnage and declined marginally as compared to more than 25% drop in the broader market. Also, being the pure-play electric Transmission and Distribution company, Hydro One is unaffected by the fluctuations in commodity prices and remains immune to output disruptions. The company’s rate base expansion, sustained demand for electricity and regulated business will continue to drive future cash flows and support the upside in its stock. The company plans to continue to invest in rate base assets (including core transmission and distribution business), leading to stable future cash flows. 

• Stable Income Flow through Healthy Dividend Payout: Hydro One has consistently boosted investors’ returns through higher dividends, thanks to its solid cash flow generating capabilities. Planned rate base growth and regulated cash flows will ensure higher dividend payout in the future, making it an attractive long-term bet for income seeking investors. The company targets a payout ratio of 70% - 80% and expects the dividend to increase by 5% in the future, which is in line with its rate base growth projection. Cash from operations rose to CAD 1,614 million, as compared to CAD 1,575 million in FY18. The company’s current dividend yield stands at 94%, which looks attractive, given the low interest rates prevalent in the economy. 

• Regulated Business Acts as a Long-term Tailwind: Hydro One is Ontario’s largest electricity transmission company and is accountable for Ontario’s 98% transmission capacity. The company’s 99% business is fully regulated and the demand for electricity continues to grow, which acts as a long-term tailwind. The Transmission segment generates steady cash flow with low volatility irrespective of the shape of the economy. The company expects that the future expansion of the transmission network is aided by higher demand from emerging industries and system requirements. These factors ensure sustainable cashflow in coming years, with improved business prospects which would lead to increasing shareholders’ return. 

• Electric Charging Stations to Enhance Product Offerings: The company has collaborated with Ontario Power Generation to launch Ivy Charging Network, a company offering electric vehicle fast-charger network. Part of the company’s unregulated business, the Ivy Charging Network will add an additional revenue stream for Hydro One. To start with, the company’s fast chargers will be available at 73 locations across Ontario.

• Cost-savings measures and Capital Allocation: The Company achieved additional productivity savings of CAD 202 million in FY19, compared to CAD 136 million in FY18. This increase was attributable to initiatives surrounding strategic sourcing, planning and execution, repatriation of the customer call center, and more efficient use of capital. Transmission OM&A costs reduced CAD 55 million, or 48.2% on y-o-y basis. The Company made capital investments of CAD 1,667 million during FY19 and placed CAD 1,703 million of new assets in-service.

• Strong Balance Sheet to Aid Future Growth: Hydro One’s sustainable organic growth, focus on expanding rate base and strong cash flows, allow it to fund future growth opportunities. We believe the company remains well poised to pursue inorganic growth opportunities by levering its strong balance sheet.

Recent Updates: Hydro One, in order to support its customers amid COVID-19 outbreak, temporarily suspended late payment fees. Also, the company will return nearly CAD 5 million in security deposits to business customers.

FY19 Financial highlights: For the period ended 31^st December 2019, H announced its full-year results, wherein the company reported revenue of CAD 6,480 million, up 5.4% on y-o-y basis, driven by 8.3% y-o-y growth from distribution segment. Favorable distribution rates supported the solid growth in distribution revenues. The company posted adjusted net earnings of CAD 918 million, as compared to CAD 807 million in FY18. The company exited the period with total assets of CAD 27,061 million, which includes property, plant and equipment of CAD 21,501 million and regulatory assets of CAD 2,676 million as on 31^st December 2019. The group reported total equity of CAD 9,849 million in FY19.

Key FY19 Operational Highlights (Source: Company Reports)

Guidance: The group seeks to strengthen its business by enhancing the customer experience through innovative customer-centric practices. The group will continue to invest in the core transmission and distribution business and will utilize the regulated and unregulated business opportunities. The company will be relying on several growth factors, such as rate base expansion, productivity improvements and continued consolidation of other Local Distribution Company (LDC). The management is planning to launch Managed & Professional Telecommunications Services for the other telecommunication players. Furthermore, the business will add Cloud Service, Telecommunications Operations Services and Core Telecommunication Services in coming years. We believe this expansion is likely to drive additional income as most of the players are shifting towards cloud connectivity, managed services & security-based services with increasing bandwidth demand. The group expects 4% to 7% EPS growth in FY22, while the group is likely to invest CAD 10 billion of capital investment in order to renew and modernize grid.

Expected Capital Expenditure and Asset Base Growth (Source: Company Reports)

Top 10 Shareholders: The top 10 shareholders have been highlighted in the table, which together forms around 60.15% of the total shareholding. Ministry of Energyand Fidelity Investments Canada ULCholds the maximum interests in the company at 47.32% and 3.24%, respectively.

Top 10 Shareholders (Source: Thomson Reuters)

Key Metrics: The Company reported decent numbers in FY19, wherein H posted EBITDA margin at 33.8%, higher than FY18 of 33.1%. Debt to Equity stood at 1.35, improved from 1.36 of FY18. Net margin also improved drastically from -1.1% in FY18 to 12.4% in FY19. The business reported a higher ROE of 8.2%, as compared to -0.7% in FY18.

Key Ratios (Source: Company Reports)

Key Valuation Metrics (Source: Thomson Reuters)

Valuation Methodology: EV/Sales - Based Relative Valuation

Note: All forecasted figures and peers have been taken from Thomson Reuters

Stock Recommendation: The stock is quoting at CAD 24.49, with a market capitalization of CAD 14.6 billion. The stock has generated 7.22% and 18.99% in the last nine months and one year, respectively; and has outperformed the index by 32.5% in the last three months. The electric transmission and distribution industry being part of the utility sector remains immune to economic cycles. The COVID-19 outbreak took a toll on most of the frontline sectors and eroded a large chunk of investor’s wealth. Hydro One’s stable cash flows and rate base growth will provide a safety net to the investor’s portfolio. Considering the company’s stable cash flow generating capabilities, growing asset base, and operational efficiency, Hydro One’s valuation multiple is likely to expand. We have valued the company using EV/Sales based relative valuation method.  For this, we have taken peers like Emera Inc (TSX: EMA), Atco Ltd (TSX: ACO.X) and Canadian Utilities Ltd (TSX: CU) and arrived at a target price of double-digit upside (in% terms). Hence, we recommend a ‘BUY’ rating on the stock at the closing market price of CAD 24.49, down 3.0% as on 27^th March 2020.

H Daily Technical Chart (Source: Thomson Reuters)

Disclaimer

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