01 Apr 2013, 03:58

Some thoughts on Mighty River Power

Note, this comes prior to the prospectus being delivered and before the loyalty scheme is announced. It’s also me sharing my thoughts – I’m not a financial advisor so this is as much a journal of some of my thoughts on the Mighty River Power sale.

As many New Zealanders know, Mighty River Power is about to be partially privatised. I’ve registered my interest in investing, along with over 440,000 other kiwis.

Estimates & percentage of profit paid out

Current estimates are that the shares will generate around a 4-4.5% dividend return (keep in mind, these are estimates from brokers). What’s concerning me with this is that the board of Mighty River have elected to pay out between 90-110% of profit. This is up from the previous dividend  payout of 75% of profit. That means that at the upper end Mighty River could be paying out previous retained earnings[1].

This is apparently a wise idea because the company currently has no major capital requirements as no new infrastructure is needed at present.

This is fairly standard thinking for when to issue dividends – if you don’t need to spend any money and you’re not investing in growth then you should pay the money out to shareholders. [2]

My thoughts on this policy

I take a rather conservative approach to business – keeping money for a rainy day always seems to work out well. I cannot see that paying out that highly is a wise idea. I’m not anti paying a dividend but common sense is telling me that 90%-110% is too high and is likely going to be used to temporarily boost the attractiveness of the shares which, in turn, drives up the price.

In my view, and generally speaking, investing in a power company is an investment in a stable business – you likely won’t get crazy capital gains but you should be able to obtain a reliable dividend yield and expect the company to not falter too badly in a tough economy (electricity supply is not something you’re likely to cancel in a hurry! _Whoops_, turns out there’s some very real risks to electricity demand – another concern I may blog about soon).

If the business is paying out ~100% of profits then that will be priced into the share price (higher price because it has a higher return). They’re also paying ~100% at a time when they have no need to invest capital in infrastructure.

What concerns me is that the moment Mighty River needs to invest in new infrastructure they will either need to:

Raise debt (which has associated servicing costs and lowers profits which, in turn, lowers dividend returns and therefore would harm the price since dividend return is likely the primary driver of their share price).[3] 

or

Dramatically lower their dividend to pay for the work in the medium turn to conserve profits. This would lead to a slide in the value of the shares since you’ve invested primarily because it’s a stable cash flow producing investment – not a growth share. [4]

Either way, it would likely result in the share price taking a reasonable hit. It’s a question of when not if they need to undertake significant capital works. It may not necessarily be a new power plant, it may be that an existing plant needs substantial work done to it.

I’m on the fence

Personally, I’m registered but waiting to see the details before making a final decision. I have several concerns like the one outlined here that I’d need to think about carefully before diving in.

Just to reiterate, these thoughts are prior to seeing any official documentation and based entirely on comments in the market and a quick skim of the 2012 annual report from Mighty River Power. I appreciate any feedback.

I’m also a long term investor typically – if you’re buying for a quick buck or are an active trader then your view of the business could be entirely different. Also, to reiterate, I’m not a financial advisor, just some guy with a website sharing his thoughts!

I appreciate that several people reviewed this blog post before publication. I didn’t get permission to name them so I won’t, but I very much appreciate their input. There’s no perfect answer to some of these points so their input helped in improving my own thinking prior to posting.

John-Daniel Trask

Additional notes and thoughts

[1] I’m told that this doesn’t necessarily mean that they would be spending savings. Utilities have big depreciation charges (non-cash) and when coupled with low capital expenditure then after-tax cash flow can be larger than net profit after tax. As mentioned, I’m not a financial expert by any stretch, but my general feeling of unease remains – they’re paying out more than I feel comfortable with.

[2] I learned a new term when working on this post: Agency Costs. Simplifying, as a shareholder you may not believe that the business would be spending the profits as efficiently as you might, or worse, just outright waste those profits on (perceived or real) stupid projects. In that situation you’d want the business to pay that profit out to you, the shareholder. Personally, I don’t think you should invest in a business that you believe is not well managed or where you don’t trust that the management would operate the business effectively.

[3] There is of course an advanced discussion on good debt and a business being able to leverage it effectively — that’s beyond the scope of this post but I’d still argue that Mighty River Power is not leaving much after their hefty dividend policy to service this without some impact on the dividend.

[4] They could also do other things like issue new shares but that’s beyond the scope of this chin-stroking-out-loud-pondering post.