Stock Analysis

Red Electrica – A juicy dividend yield, but at what cost?

Red Electrica ($BME:REE) is a Spanish utility company which is mainly known for operating the Spanish electrical grid. The company is number 22 in the Noble 30 Index when measured by their dividend growth track record. Today I will share with you my quick analysis about Red Electrica and asses whether I find it an interesting stock to consider at the current share price.

Red Electrica Background

Red Electrica was created in 1985 and publicly listed in 1999 by the Spanish government which still holds 20% of the shares. The rest of the shares are publicly available on the stock market. This is unique, because many European utility companies have a stronger stake from the government or aren’t even publicly listed on the stock market.

source: https://www.ree.es/en/shareholders-and-investors/share/shareholders-structure

A good way to get a view on the company is to check their own promotion material on their investor relations website. Also Red Electrica created its own video which I found interesting as further background.

It nicely shows that it’s not only focused on the Spanish National Grid, but also in the communication sector via fiber optics and satellites. Besides that the company has a strong commitment to the 2015 Paris Climate Agreement.

This sounds nice and it is nice, but let’s also keep things in context about where they are today. Red Electrica still earned 82.5% of it’s revenue from the national power grid in Spain in the first 6 months of 2020.

It is noteworthy though that their dependency on this line of business dropped by ~8.5%. This has not been organic growth into the telecommunication sector, but rather the result of a 933 million Euro acquisition of Hispasat. Red Electrica now owns 89.68% in Hispasat. The majority of the other shares are still in position of the Spanish Government.

Red Electrica H1 Sales Results (H1 2020 financial report)

I find the acquisition of Hispasat very interesting. Most of my Spanish followers will recognize it for the satellite disks which offers them lots of access to television channels. But besides that I found it also to be a very innovative company. They are currently aiming to provide wifi and video access in Brazilian remote areas powered by Facebook Connectivity’s Express WiFi platform.

It’s in itself not a big thing from a Red Electrica’s revenue point of view, but it shows it commitment to the underserved and the innovation capability of their daughter company.

Having said that, they are effectively still a monopoly by being the operator of the Spanish grid. It made 1.992 million Euro in sales in the trailing twelve months. In the first half of this year their sales dropped by 1.5% year-over-year and 8.4% in net profit. The reason for such a relatively large drop was due to slightly lower revenues, higher operating expenses, increased amortization and higher cost of debt.

Being a monopoly has its downsides as well, because it is under increased scrutiny from the CNMC (Spanish Monopoly Watchdog). Tariffs collected from clients might see pressure and this is one of the major risks associated with its business model and the intelligent investor should be aware of this.

Having said that, Red Electrica is a typical European utility. It is relatively predictable, under strict governmental control and it’s business is by definition anti-cyclical.

However, lately they started to expand and diversify it’s portfolio. It also wants to be an essential player in the energy transition and I see that as their main catalyst for the next decade. Let’s see how that plays out. I’m slightly optimistic about it due to it’s geographical position so that it can act as a hub towards the mainland and colder parts of Europe.

Red Electrica Dividend Safety

Is Red Electrica’s dividend safe? That’s the main question that I want to answer as a dividend growth investor. Let me therefore explore several determining factors first and then get back to you with my answer.

Red Electrica Dividend history

The company has a pretty decent dividend growth track record. I have been able to track their dividend growth back until 1995, 4 years before they got publicly listed. This means that they currently spot a 25 year dividend growth track record without cuts.

It is a pure dividend growth track record, because it has neither ever maintained their dividend. This is actually unique from a European perspective, because many companies in the Noble 30 did froze their dividend from time-to-time.

Having said that, Red Electrica’s dividend growth statistics are the following:

  • a 7% dividend hike last year
  • an average annualized dividend growth of 7% over the last 5 years
  • an average annualized dividend growth of 8.42% from 2010 to 2019
  • an average annualized dividend growth of 13.54% from 2000 to 2009

As you can see, the average hikes are slightly decreasing from a 20 years timeframe perspective. The company was consistent in hiking the dividend exactly 7% every single year for the last 5 years.

Red Electrica 10 year dividend growth history

I like about its dividend growth that it’s slightly above my own requirement for early retirement. Red Electrica has been giving us this 7% salary increase over the last 5 years, while my own goal is an average of 6%. So if the company can keep giving us these increases then it will slightly compensate for the lower growing stocks in my portfolio (i.e. AT&T).

Last but not least, the company paid a dividend of 1.05 Euro over 2019, which is a dividend yield of 6.49% at a current share price of 16.19 Euro.

So let’s see if it has enough wiggle room to keep increasing the dividends at a rate of 7%. Let’s find out!

Red Electrica Earnings and Free Cash Flow

The earnings numbers and especially the free cash flow numbers from Red Electrica are not the most easy to grasp. Just have a look at the below chart.

Red Electrica Earnings Per Share and Cash Flow Per share including the dividend payouts

We can see in the chart that the Earnings have been steadily growing until 2015 and then briefly declined to slowly get back to 2014 numbers again. The Free Cash Flow numbers are another story though, because they were pretty volatile, especially up to 2016.

As an example, the 2014 numbers were heavily impacted due to an increase in investments in Property, Plant and Equipment (PPE). The reason for it is something that I’ve seen more often throughout their annual reports, because Red Electrica is typically investing a lot in ensuring to be the the southern hub for Electrical Transmission towards the countries north of Spain.

Source: 2014 annual report

These volatile numbers make it a bit harder to say something meaningful about the payout ratios, so we depend quite a bit on our insights regarding their balance sheet in the next section. Having said that, the EPS payout ratio seems to be the most stable and it currently pays out 79% based on earnings.

It has been steadily increasing since 2016, because until 2016 the payout ratio was health around the 60%. 79% is already at the high-end for me and I’m not too happy that the dividend wasn’t covered by Free Cash Flow in their latest 2019 annual report.

Honestly, I would have expected this to be a bit more stable due to the nature of their business. The company is just very active on the investment front and time will tell us how it will impact their future earnings potential.


PS: I didn’t use Funds from Operations (FFO) for this section, because Red Electrica is clearly diversifying into other industries. Hence it’s not a pure-play in this regard.

Debt

The debt numbers from Red Electrica actually look so so. Half of their balance sheet is made up of long term debt. I am a bit surprised though about the slow increase in debt.

I would’ve expected a steeper rise in debt after those acquisitions, but it seems to have quite stabilized since 2014. Equity has been improving in the meanwhile, hence why the debt/equity ratio has been slowly decreasing. I also double checked the Interest Coverage ratio and this looks actually pretty good with 7.04 (meaning that the company earns 7 times more in EBIT than their interest obligations).

It is a low interest environment, but I’m happy to see that the company is keeping it’s debt in control. This is not a company that can easily dispose of highly leveraged assets in case interest rates would suddenly increase. There would simply be no buyer.

Red Electrica: Long Term debt and debt/equity ratio

It’s also worth noting that Fitch gave Red Electrica an A- credit rating, with a stable outlook back in April. Not everything looks rosy though and I would really like to bring attention to the following quote from Fitch’s analysis:

Long-Term Risk for Domestic Revenue: We foresee a material loss of remuneration for Red Electrica’s pre-1998 assets (estimated at about 40% of its total regulated asset base in Spain) with a fall in revenues of about EUR 240 million from 2024, according the regulator’s estimations. The revenue fall will increase the weight of non-regulated revenue and will place leverage metrics materially above the guideline of the current rating. The revenue cliff is already captured in the approved regulatory framework to 2025.

Limited visibility from 2023: Red Electrica’s update of its business plan, including the financial policy, will be relevant to assess how the company intends to mitigate the impact of the sharp revenue decline in 2024 on the credit profile. An additional key milestone is the approval of the National Transmission Grid Development Plan for 2021-2026, which is not expected before end-2020, as it might incorporate additional regulated revenue for the period.

This is the second major risk that I see for this company.

I’m not too confident yet in Management’s capabilities, hence why I don’t intent to change my thoughts about Red Electrica until I see a clear vision and business plan for the years after 2024 (it’s currently a Tier-4 company in my allocation strategy).

Dividend Safety Conclusion

All in all I rate their dividend safety as so so.

Their payout ratio is trending in the wrong direction and price pressure from the regulator might cap their earnings growth potential. At the same time there’s a revenue cliff upcoming, hence why Red Electrica will probably take a more prudent approach towards its dividend in the upcoming few years.

I consider the the dividend safe until 2023, but at risk from 2024 onwards if the board of directors fails in further diversifying its business in high margin businesses.

Red Electrica Fair Value Estimation

So far I’m fairly OK with Red Electrica as a company. The company currently trades by a Price to Earnings of 12.7. This is a pretty good number compared to many other companies.

I’m not too big of a fan of just looking at the P/E, but I do consider it to be a nice litmus test.

Having said that, you’ve just read my opinion on the dividend safety, so in this case I will be looking at an minimal margin of safety of 20% from the fair value. I believe that this justifies the risk associated to the company.

Let’s estimate the fair value using the Dividend Discount Model and the Discounted Cash Flow methodology.

Dividend Discount Model

I am using a Discount Rate / WACC of 7%. Cost of capital is relatively low for Red Electrica, because growth expectations are low and the beta as well (part of the underlying math required to calculate the discount rate/WACC).

I also believe that the dividend growth rate at 7% isn’t sustainable, hence I’m using 4% instead. Using these numbers, the DDM gives me a fair value of 35 Euro. This is way-off from the current share price of 16.19 Euro.

Dividend Discount Model – Fair value estimate Red Electrica

Such a difference usually means that it makes no sense to use it. So let’s have a look at the Discounted Cash Flow calculation instead.

Discounted Cash Flow Model

The fair value of the company based on the DCF model is 10.02 Euro

Discounted Cash Flow model – Red Electrica Fair Value

Well, it ain’t getting any better with my calculations! In this case the company seems heavily overvalued.

So which numbers are providing this sensitivity in the calculation?

  1. The Terminal Value of the entire company (8.4 Bln Euro) is actually pretty good, but I always deduct it with the amount of net debt and in this case Red Electrica has a lot of debt on the balance sheet compared to its cash.
  2. The terminal growth rate is 2%, somewhere around the Spanish inflation rate and the Spanish GDP numbers.

I’ve run the numbers several times and this seems to be correct. I’m not going to fiddle with the numbers to get it closer to the current price, because that would just result in confirmation bias and wishful thinking.

Fair Value

It’s hard to give you a real fair value for this company, because both the calculations are to much off from where it trades today. At the fair value price from the DCF calculation the company would trade at about a P/E of 8. Hey, why not?

It is a company with a high level of debt and hardly any pricing power due to strict government control. To me it’s a bit of a troubled company and this is how I exactly feel about Red Electrica.

Hence, I can’t give you a reliable fair value estimation. You can see my calculations above and you’ve read about my dividend safety before. The only thing I can say it that I’m treating this stock with caution.

Final Thoughts and Considerations

Honestly, I was expecting that I was going to cover an undervalued stock and that doing a deep dive into the company and their numbers would proof my feeling.

Well, I was wrong!

There’s not too much that I’m liking when looking into their numbers. In my opinion the only way I can treat this company is as a dividend yield play.

This is not good enough for me and it has hurt me in the past.

I currently own a 50% position as part of a Tier-4 classification.

I’m not intending to add anything anymore in the foreseeable future. It’s a small position in my portfolio, so for now I’m just holding onto it. In the meanwhile I will keep an eye on how they will perform over the upcoming few years.

Quick Recap

Pro

✅ Business is diversifying (i.e Telecom)
✅ Strong dividend growth history
✅ Interest on debt is covered well by EBIT

Con

🛑 Earnings / Free Cash Flow growth last 5 years
🛑 Payout Ratio ~80%
🛑 Lot’s of Long Term Debt
🛑 Price pressure Spanish regulator
🛑 Potential 2024 revenue fall
🛑 Overvalued according to DCF calculation


What do you think about Red Electrica? Do you share my opinion or are you more optimistic?

Let me know what you think about it in the comment section below 👇

Yours Truly

European Dividend Growth Investor

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Michael
Michael
29 days ago

Nice review. I am not that familIar with them. Back in July, M* gave them a FV of 17 Euros. Some backtesting seems to show When DRIP is on it kept pace quite well with the S&P until about 2016 or so then tailed off. I am guessing the dividend withholding tax must be fairly significant?

Tiago
Tiago
29 days ago

Really great. Thank you for the analysis. I really fear that dependence on government regulation. Agree with you. Ok, as a small position in the portfolio

Mario Gauci
Mario Gauci
29 days ago

I have a very small position as well. I mainly invest when there is a market dip. I intend to hold for now due to the dividend paid. Thanks for the review

Andrea Kirkby
Andrea Kirkby
26 days ago

I totally agree with your conclusions. In the low interest rate environment a lot of investors have joined the dash for yield, pushing up the valuations of yield assets such as utilities. In the UK, renewables and utilities investment trusts are trading at high premiums to the value of the assets, which to me is a clear steer to stay clear of the sector. It’s worth noting that a monopoly is not the same as a moat. Monopolies usually have no pricing power, and can always be exposed to competition by government regulations changing. To me, having read this analysis,… Read more »

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