South American Utilities (PAM and ELP) Stock Research Report
May 26th, 2021
Pampa Energia (PAM) & Companhia Paranaense de Energia (ELP)
Common background for both PAM and ELP
For the prudent investor, utilities have long been a safe haven from the volatility of the stock market. This is especially true for electric companies.
A Sector Full of Moats
Irrespective of the individual companies’ decisions and situations, utilities tends to benefit from a series of moats due to the structure of their business sector.
The first one is economy of scale. Electricity production is a very capital-intensive sector, and new dams, power plants or electric grid networks require billions to be build. They are also very durable assets, lasting decades. This means that any company able to gather a critical mass of assets will be able to save on maintenance, corporate overhead, regulatory costs, etc.… thus reducing the cost per kW produced.
The second one is operational capacities. Being extremely technical and sensitive operations, utilities need specialized personnel who are experts in their trade, and very familiar with the infrastructures in place. Running the electric supply of a whole region or country smoothly and efficiently is no small feat, one which would be hard to replicate for a newcomer in the industry.
Lastly, utilities, due to their vital importance to the country, are heavily regulated. Prices are often decided jointly in negations between the company, the government, and other stakeholders, to guarantee that sufficient investment can be made to maintain a stable and safe supply. Employees will need specific certifications. The company’s assets will regularly be audited and controlled by the regulatory agencies.
Regularly, a company will be granted a monopoly over an entire region, or even sometimes the whole country, reducing vastly the sales & marketing costs.
All together, these moats mean that utilities tend to work as monopolies or oligopolies, with very limited competition.
Pricing power is somewhat limited by political constraints to not completely gauge the consumer, but profits per kW produced are almost guaranteed to stay above a certain threshold. Otherwise, under-investment and corner cutting could endanger the country’s electric supply.
A Value Investing Approach to Utilities
For a value investor, utilities can seem like a perfect company to own.
It has large and almost indestructible moats.
Its business is highly predictable, and it is not uncommon to be able to be reasonably sure of the company’s prospects 20 or 30 years in the future.
It is asset-rich and usually can borrow at low cost (instead of needing to constantly raise capital and dilute existing shareholders).
It is always able to price its production to guarantee a profit and a healthy margin. Actually, the government itself has an interest in making sure that the company has enough cash flow and profit to reinvest into its assets.
It is likely to keep growing at the speed of the broader economy.
So, in terms of company quality, utilities have a lot to go for them. But of course, one last important question is the matter of price. Due to their safer nature, utilities tend to often be pricey. Cautious investors like utilities, and sometimes buy them at any price as an alternative to bonds. In an era where safe bonds have often zero or even negative interest rates, this makes sense.
But this is a big problem for any other type of investor, as these companies are unlikely to grow quickly, improve dramatically their margins, or launch a new bestseller product like other companies. If bought at an expensive price, they are unlikely to lose you much money, but will also not bring much in the form of returns.
In a nutshell, utilities are great stocks to invest into, as they have very strong intrinsic margin of safety built-in their business model. But low growth and stability means these returns will only be good if the stock is bought at a discount.