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Analyst report - sectors
M&A activity likely in the utility sector
November 12, 2007
Brendon Lau, ShareAnalysis

Interest rates rose by 0.25% as expected, and more hikes could be only months away. Some may be worried that these hikes would keep utility stocks out of favour for the foreseeable future. Despite the threat of higher interest rates, we believe a number of utility stocks could outperform over the next few months.

Utilities are believed to be sensitive to interest rates because investors often compare these stocks to bonds, as utilities pay relatively stable distributions and own assets with relatively long asset lives. Furthermore, high gearing levels of these companies make them sensitive to interest rates. This means as interest rates go up, share prices of utilities (and bonds) should go down. Also sapping confidence is the relative under-performance of the Utilities sector. Since the market bounced from the sub-prime-induced sell-off in the middle of August, the S&P/ASX 200 has jumped about 19% but the Utilities sector has dipped around 1%.

This is partly thanks to the hammering Australia's largest energy retailer, AGL Energy (AGK), got after it issued a shocking profit downgrade due to margin pressure and higher costs. The main issue facing AGK is the high spot gas price it has to pay during peak times to make up for supply shortfalls. AGK is unable to pass on the higher cost to customers due to price regulations. While surging energy prices impact all energy retailers, AGK appears to be more exposed to this issue.

Another challenge facing energy retailers is customer churn. With deregulation, retail customers have more choice of energy retailers. This has led to a high number of customers switching retailers quite frequently to chase better deals.

However, looking at the past reporting season and considering the M&A potential for the industry, we remain upbeat on the outlook for the sector as a whole. Our preference though is biased towards utilities that own energy generation and transmission assets and towards utility funds.

We have identified three key revenue drivers for the sector. The first is the organic growth in energy consumption within the existing client base. The second relates to economic growth, which bolsters demand for energy from businesses. Looking at the string of recent economic reports, Australia's economy looks set to power along robustly for the foreseeable future. The third driver is population growth, which also appears to be growing strongly. The Australian Bureau of Statistics (ABS) is projecting our population to increase to between 24.9M and 33.4M by 2051.

While these drivers are unlikely to jump-start the shares of utilities in the near term, we believe industry consolidation could well do the trick. Late last week, AGK jumped 5% on speculation it may be a takeover target. It was reported that a Hong Kong power company is interested in assets in New South Wales.

Furthermore, the sector remains awash with liquidity and it would appear that most companies are either targets or acquirers. Over the last financial year, we saw a wave of acquisitions and disposals, including a string of gas transmission and distribution asset acquisitions by APA Group (APA) and the acquisition of Alinta by the Babcock & Brown/Singapore Power consortium.

Meanwhile, a swag of other asset transactions have yet to be fully reflected in Utilities' financials. We would not be surprised to see more M&A activity and corporate restructuring over the next year, and we highlight some beneficiaries of this development in our stock picks this week.

Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.

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