Key theme for 2007, buy utility stocks (period.)

The key theme for 2007 is to overweight utility counters. I do believe that it is a matter of time before we see a re-rating of the sector. Currently, the sector trades at an average Price Earnings Ratio (PER) of 10x to 12/07 earnings and 1.3x Price to Book (PBV). Moving forward, my “gut feel” is that the sector will trade closer to 15x PER. This represents a 50% upside from where we are right now. Here’s the summary of how the utility stocks are currently trading and how it will trade assuming the re-rating does occur.

PER(x) P/BV(x) @15x

MERALCO B 7.1 1.0 P116.0
First Holdings 10.0 1.0 P94.5
First Gen 10.6 1.4 P82.5
Manila Water 9.7 1.4 P15.0
EDC 9.2 1.5 P7.8

In 2006, we saw the same phenomenon in the banking sector. Overall, the average valuation of banking stocks rose from 1.2x Price to Book Value (P/BV) to 1.8x P/BV. The re-rating was driven primarily by the improving asset quality of the banks. Thanks to the full impact of the SPAV law. It virtually eliminated all the systemic risk in the sector as banks get to clean up its balance sheet.

So for the utility sector, the key drivers are:

1.) “Pro-business” framework. The recent decision by the Supreme Court allowing MERALCO to keep the P0.0875 per kwh rate increase granted in 2003 shows that the government is willing to let utility companies make a reasonable economic return from their investment. This is also manifested in the recent rate hike granted to Manila Water and Maynilad.

2.) Big-ticket privatization. There are several deals that are coming up in the next few months. The Transco bidding and the NAPOCOR privatization will surely spice up the sector. The successful IPO of PNOC-EDC (EDC-P4.80) is a sign of things to come. Most likely, valuation will continue to improve based on the success of EDC.

3.) Tons of free cash. Fundamentally, most utility stocks are generating a lot of free cash. This allows them to pay dividend or buy-back their shares. MERALCO (MERB – P55.0) declared a P1.0 cash dividend for the first time in 5 years. Valuation wise, you would want to pay a premium on these companies.

Just like the banking sector, these drivers have virtually wiped out the systemic risk in the sector. So fast forward to 2007, there is every reason for utility stocks to take the spotlight.

What goes around comes around ….

The Philippine market was spooked by the move of Bank of Thailand (BOT) to impose investment control to prevent the appreciation of Thai Baht. Essentially what the BOT did is to prevent short-term funds flow from creating volatility in the currency. Based on the directive by BOT, all banks were required to hold in reserve for one year 30 percent of capital inflows that aren't trade or services-related, or repatriation of Thai residents' investments abroad. Also, foreign investors must pay a 10 percent penalty unless they keep funds in the country for a year. The Thai Baht has so far appreciated by 14% to Bt35.09 to US$1.0. On the other hand, the Philippine Peso has appreciated by 7.9%.

In 1997, Thailand was faced with a similar situation. However, instead of curbing dollar inflow into its financial system, BOT was forced to defend the Baht against depreciation. At its worst, the Baht traded as low as Bt58.00 to US$1.0. This triggered the ASEAN financial crisis. So as the saying goes, what goes around comes around.

So how will this affect the local market? In the short term, we should see volatility in the local market. We cannot deny the fact that Philippines and Thailand are lumped together in the same emerging market basket. Foreign funds will be selling the Philippine market until the situation in Thailand stabilizes. This might erase any hope of any yearend window dressing rally.

However, in the long term, I am still positive on the Philippine market. I do believe that the PSEi will reach 3,100. I guess it’s a matter of time before we reach those levels, for as long as it stays above 2,750.

For investors, the best way to play the market is to be defensive. We should take this opportunity to realign our portfolio and preserve the gains that we had for the year. As the saying goes: “Sell to your sleeping point.” Sit tight and keep a close eye on the market.

The MERALCO (MERB – P55.0) and PNOC-EDC (EDC – P4.55) Bonanza; PSEi at 3,000

The market has not fully digested the bonanza from two recent events. First, the Supreme Court (SC) ruling on MERALCO allowing it to keep the P0.0875 rate hike that was implemented in 2003. Second, the successful listing of EDC, which saw its share price, rose by 42% during its debut.

There are two implications in the MERALCO ruling.

First, it shows that the government is willing to take a “pro-business” stand in regulating the utility sectors. This is a 360-degree turnaround form the populist stand the government took earlier on. The move should see a re-rating of the utility sector at par with the market. Considering that most utility counters are trading 30% below market PER, the re-rating will thus bring the PSEi to 3,000 levels.

Second, we should not underestimate the liquidity boost provided by the surging share price of MERALCO. To date, its share price has risen by almost 175%. MERALCO is a widely held stock. The wealth effect on MERALCO shareholders should spread to the market. Soon, this "liquidity" seek other undervalued stocks.

On the other hand, the successful listing of EDC will pave the way for other mega deals. In the pipeline are the privatization of National Power Corporation (NAPOCOR) and National Transmission Corporation (TransCo). The share price movement of EDC today is an indication that foreign funds have strong appetite for local equity issues. The offering of EDC is the biggest IPO since the listing of Petron Corp. (PCOR – P4.05) in 1995. Note that the liquidity boost from the Petron listing essentially propelled the PSEi to new highs in 1996. This is exactly where we are right now. To some extent, EDC is the new Petron.

So, I guess all the elements are in place to bring the market to 3,000 levels. As I mentioned before, we need to see “liquidity-flow” from local and foreign investors for the market to break out of the 2,800 levels. I think we are about to witness the move. The only wildcard in the equation is the political situation, which hopefully will be under control.

For investors, the key theme for the market is to overweight utility stocks. The writings are on the wall. My top picks are MERALCO (MERB – P55.0), PNOC EDC (EDC – P4.55) and Manila Water (MWC – P9.80).

The MERALCO effect, 2007 will be the year of utility stocks

The ruling on MERALCO implies a turnaround in government’s populist stand in regulating the power/energy sector. The ruling signifies a move towards a “pro-utility sector/pro-business” stand by the government.

Re-rating looms
For the past 5 years, utility counters continue to trade below market multiples. This shows that investors are putting significant amount of “regulatory risk” in valuing utility counters. Since 2003, the utility sector traded at an average of 30% discount to market. Moving forward, I expect this trend to change. Longer term, as the government continues to show its hands, the sector should be trading at par with the market.

Postive deal flow
Last week, the government successfully bided out Maynilad Water to a consortium led my DMCI Holdings (DMC – P6.10) and Metro Pacific – (MPC – P2.08). Next week, PNOC-Energy Dev’t. Corp. (PNOC-EDC) will list its shares in the stockmarket. Before the yearend, the government will be biding out the power generation assets of National Transmission Corp. (Transco). All these point to the fact that the government is opening up the sector.

Lower risk
So I do believe that we should go where the money is. Assuming all factors are in place, 2007 will indeed be a year for utility counters. The risk profile has changed and valuations cannot stay this low. The risks of holding utility counters have significantly gone down vis-à-vis its earnings profile. Thus, there is every reason to overweight utility stocks for 2007.

The scorecard on MERALCO (MERB – P50.50)

Last Wednesday, the Supreme Court (SC) reversed the earlier decision of Court of Appeals (CA) preventing MERALCO from implementing the rate “unbundling” scheme that was approved by the Energy Regulatory Commission (ERC) last June 2003. What the decision implies is that MERALCO can now keep the P.0865/kwh distribution charge that it has been charging its customer.

Beyond the ruling, here is the low-down on MERALCO.

1.) One-time gain of P12.82/share. MERALCO has provided around P19.72bn in provisions for probable losses in case the SC ruled against the company. Net of taxes, this should amount to P12.82/share in one-time gain. On the other hand, book value per share will increase significantly to P45.0.

2.) Annual recurring income of P7.0bn. Moving forward, MERALCO is expected to earn P7.0bn per year. On an EPS basis, this translates to P7.0/share. The last time MERALCO generated this much income was in early 2000.

Last Friday, share price of MERALCO rose as much 30% in reaction to this news. The “manna” from SC added close to P14.0bn to its market value. I vividly recall 4 years ago when MERALCO lost close to 80% of its market value when the SC ruled that it has to refund the P0.167/kwh that MERALCO has been charging its customer since February 1994. The ruling cost the company P30.0bn. I guess as the saying goes, what goes around comes around.

So how far, will the share price of MERALCO run? Currently, the utility sector trades at 10.0x PER. Assuming MERALCO approximates these values, MERALCO can potentially trade as high as P70.0/share.

However, there are two other “wildcards” that can potentially add more value to the company.

First, the pronouncement by the Lopez group that they are willing to sell their stake at the right price. So reading between the lines, it seems that a merger and acquisition (M&A) deal is brewing. Assuming, we factor in an acquisition premium, MERALCO can potentially be a P100 stock

Second, I do believe that there will be an overall re-rating of the sector. The decision on MERALCO is a big step in projecting a “pro-utility sector/pro-business” stands of the current administration. Assuming, the sector trades at par with the market; it should be trading at 14x PER and not at 10x PER.