Red Electrica REE SM
May 16, 2008 - 7:03pm EST by
2008 2009
Price: 42.53 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 8,800 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Warning:  If your portfolio looks like a "who's who" of activist hedge fund names, you may want to turn back now.  But if you understand the importance of downside conviction and risk-reward asymmetry, please continue forth.
Thesis Snapshot:  REE is a regulated electricity transmission utility with big upside that offers long-term growth, value, and visibility in today's uncertain capital markets and should generate at least a 20% annual return (including dividends) for the next 3-5 years.  REE is trading at 9x 2009 FCF (on maintenance capex (MCX)) notwithstanding 15% EPS growth, 10% FCF growth, a 3% dividend growing 15%, a defensive business model with no volume risk, excellent visibility into long-term targets, and two near-term catalysts.  REE is in the beginning stages of a spending boom on Spain's transmission grid that will drive solid and predictable growth for the next decade.  REE has potential upside to €67/shr (+60%) at year-end 2008, based on both DCF analysis and comparable FCF multiples (15x €4.50/shr FCF), and excellent downside protection from both cash flow and fixed asset values.  Even if REE does not pop to €67/shr by year-end, it seems a good bet to accrete ~20% annually for the next 3-5 years with FCF/earnings growth, dividends, and modest multiple expansion as regulatory visibility crystallizes.  The big upside potential and asymmetrical risk-reward are unusual for a defensive, regulated business model, and justify REE as a core position in any portfolio.
The opportunity exists primarily because 1) the market is overly pessimistic regarding future regulatory risk and currently values REE close to its downside valuation; and 2) REE does not screen well on EPS and EBITDA multiples as its regulatory framework dictates the expensing of all maintenance expenditures once an asset is put in place.  I believe REE has plateaued recently for several other factors, including 1) early-2008 regulatory delays and weak European markets have exhausted some event-driven investors; 2) recent utility investor focus is dominated by M&A speculation surrounding other Spanish and European utilities; 3) REE has outperformed the utility universe over the last nine months, making its chart seem more vulnerable and less interesting; and 4) REE is a modestly complicated situation in a market that has been selling complexity and risk.
Company Description:  Red Electrica de Espana (REE) is the owner / operator of a majority of Spain's regulated electricity transmission grid and has recently been designated sole TSO (transmission system operator) for Spain after consolidating the industry over the past five years.  The grid is regulated by the Commission Nacional de Energia (CNE) with ultimate policy in the hands of Spain's Ministry of Industry.  REE is 20% owned by the Spanish government.  Capitalization >> €42/shr, 135mm shares, 5.7b mkt cap, €2.9b net debt.  €50mm average daily volume.
Secular Story:  The Spanish government has drafted a National Energy Plan (NEP) 2007-2016 that calls for €8.7b of investment spending on electricity transmission to guarantee security of supply.  REE has already guided to €600mm average annual growth CX over the 2007-2011 period and, based on the plan extension through 2016, will likely see similar growth for an additional five years.  A new regulatory framework targets IRRs on this investment spending of at least 7.7% versus REE's WACC of ~6.0%, providing significant accretive growth potential.  The long-term visibility provided by this investment program has enabled REE to give 2007-2011 guidance of >15% EPS CAGR and >15% dividend CAGR.  Additionally, as part of the law designating REE as TSO, the remaining third-party-owned transmission assets must be sold to REE by July 2010.  Such acquisitions could total ~€1.0b and REE has indicated it would likely finance these acquisitions with debt to further optimize its balance sheet.  Regulated growth stories are hard to find and typically support very attractive multiples.
Attractive Business Model:  Transmission utilities globally benefit from both superior predictability of earnings and significant accretive growth spending; and, as a result, trade at attractive multiples supported by low WACCs.  Italian comparable TRN.IM trades at 18x P/E and U.S. comparable ITC trades at 28x P/E, with EPS for both being a good proxy for maintenance FCF.  The predictability of earnings is driven by both regulated returns and high margins.  Transmission utilities generate EBITDA margins of ~70%, versus ~25-30% for traditional electric utilities, because they do not purchase and pass-through substantial and volatile fuel and energy costs.  Transmission utilities benefit from superior growth because more capacity is a solution to both line loss inefficiencies and ballooning regional electricity prices that represent the majority of a consumer's bill.  When also considering that transmission is only <5% of a consumer's electricity bill in Spain, it is understandable that regulators are more focused on promoting robust networks than squeezing transmission rates.  Based on Spain's National Energy Plan, REE will enjoy robust growth with attractive returns and excellent visibility for at least the next decade.
Regulatory Framework:  As regulatory risk is a key factor for REE, I will provide some background in the next few sections to clarify the situation. REE's network is governed by two regulatory frameworks.  Royal Decree 2819 / 1998 (RD-1998) was finalized in December 1997 to establish a modern regulatory framework for all assets that were existing at the time and any future assets put in place.  RD-1998 was intended to create regulatory consensus and visibility ahead of REE's IPO in 1999, during which the Spanish government sold a majority of its stake.  Prior to RD-1998, remuneration for transmission assets was more loosely regulated as the Spanish government owned a majority of the grid.  Forming an investor-owned utility facilitated the government's plan to consolidate Spain's electricity transmission grid in order to improve operations, achieve efficiencies, and finance growth.  Royal Decree 325 / 2008 (RD-2008) was finalized in February 2008 to establish a new framework for assets put in place from January 2008, with assets put in place prior to January 2008 still governed by RD-1998.  RD-2008 was initiated to improve regulatory consensus and visibility at the onset of the current investment spending boom dictated by Spain's NEP.
RD-2008 is also intended to converge the regulatory framework in Spain with those in force throughout the European Union.  Both RD-1998 and RD-2008 target post-tax, unlevered IRRs in the 7.5 - 8.0% range, which is in-line with other attractive European and US frameworks.  The important takeaway here is that the Spanish government is motivated to promote stability, visibility, and attractive returns to help finance a robust electricity transmission network that is critical to maintaining the secure supply of electricity.
Regulatory Hiccup:  In December 2006, Spain's regulators made a modest change to the remuneration framework for "sister company" ENG.SM, the natural gas transmission operator.  While this change applied only to a minority portion of non-transmission (storage and LNG) assets of ENG, the stocks of both ENG and REE sold off >20%.  Since this time REE has traded as if it is inevitable that REE will one day face a severely punitive regulatory haircut.  However, it is important to remember that the change did not impact ENG's transmission assets and that ENG itself had asked for the remuneration of its storage and LNG assets to be reviewed as low utilization rates were causing under-earning.  The regulators came up with a lower-risk framework for these assets that also haircut the NPV somewhat.  However, the recent passage of RD-2008, with its favorable treatment for new assets, as well as the regulatory "no action" on existing assets governed by RD-1998, suggest there is no regulatory motivation to haircut REE.  In fact, these recent proceedings suggest that the regulatory environment for REE is quite favorable and benign.
Bull vs Bear:  The bull / bear debate on REE is whether cash flows, or remuneration, for pre-2008 assets will last for the duration of the assets' useful life (as long as the assets are maintained in good working order) or be limited to the assets' original 40-year accounting life.  Or more simply, the debate is whether or not REE will suffer a punitive regulatory haircut at some point in the future.  It is critical to know / remember that RD-1998 specifically dictates that remuneration is for the useful life, so there needs to be an adverse regulatory change for the bear case to materialize.  Bears will argue that RD-1998 is flawed, that REE is over-earning its intended returns, and that RD-1998 assets will eventually be re-regulated.  As explained in more detail below, there is no reason to believe that RD-1998 is flawed and REE's regulators have just passed on their chance to change the framework for RD-1998 assets.  In fact, brand new RD-2008 itself provides for 50% remuneration beyond the accounting life to promote the extension of useful life.
Useful Life vs Accounting Life:  While bears may think asset remuneration beyond an accounting life is an obvious mistake, further analysis suggests that it is quite rational and undoubtedly regulators ran the framework through rigorous analysis.  Allowed returns for a utility are intended to provide an IRR that makes investment spending attractive to the utility in the form of positive net present value.  The RD-1998 framework was intentionally structured to reduce the near-term financial impact on the Spanish population, as the country expanded its electricity infrastructure, while still being accretive to the utility.  This was accomplished by structuring RD-1998 as a "gross rate base" framework versus the "net rate base" framework of typical utilities.  A net rate base framework is intended to provide a more constant return on a utility's net asset base, such that depreciation reduces earnings power unless it is offset with an equal amount of capital expenditures.  A gross rate base framework, however, does not deduct depreciation from the earning asset base.
The trade-off for this future benefit is lower returns in the early years of an asset life and the expensing of more maintenance items that otherwise might be added to rate base.  For example, the RD-1998 framework only provides first year ROE of ~5% despite generating attractive IRRs of 7.5-8.0% over the life of the asset.  This dynamic reverses in later years with a rapid escalation of ROE.  The value of an asset is the net present value of its future cash flow, and while net and gross rate base frameworks get there in different ways, both are intended to provide an IRR that makes investment spending attractive to the utility.  The gross rate base framework also encourages a utility to extend the life of an asset rather than unnecessarily expediting replacement just because the accounting life and remuneration have ended.  Conversations with REE and other transmission utilities, as well as additional industry research suggests that transmission assets can last well beyond a 40-year accounting life when properly maintained.
Why The Grid Will Not Be Re-regulated:  Here is a list of several factors which I believe mitigate the risk of a material regulatory haircut in the future.  1) The recent regulatory review and RD-2008 were passed without any change to existing assets, suggesting that any potential inefficiencies of the RD-1998 framework are not material enough to be changed retroactively.  2) RD-1998 provides for IRRs in-line with other attractive European and US frameworks.  3)  The Spanish government is motivated to promote stability, visibility, and attractive returns to help finance a robust electricity transmission network.  4) It is unlikely the Ministry will materially haircut REE during a huge 10-yr CX initiative intended to guarantee security of electricity supply.  5) Over-earning fears fail to fully understand the back-end weighted gross rate base framework of RD-1998.  6) Extending asset remuneration from 40-yr accounting life to a 55-yr useful life only increases going-in IRR by ~40 bps and therefore does not represent the windfall that some think.
7) Brand new RD-2008 itself provides for 50% remuneration beyond the accounting life to promote the extension of useful life.  8)  Spain's transmission cost on €/mwh basis is at the lower end of Western Europe and transmission itself represents only 4.2% of Spanish electricity sector revenues (see p16 of 2/27/07 presentation).  9) The Ministry and CNE previously encouraged, and law now mandates, that REE consolidate Spain's transmission network through acquisitions.  It seems unfair and poor policy that the framework would be changed after REE has made a huge acquisition investment.  10) Political will to change the framework for existing assets seems limited by many of the factors mentioned above, the fact that the Spanish government owns 20% of REE, and the tremendous complexity that re-regulation would involve.
Current Valuation:  REE is trading at only 9x €4.50/shr 2009 FCF (11% yield) on MCX spending.  Maintenance FCF should grow ~10% annually (on top of the dividend) for the next several years with the benefit of annual revenue escalators and attractive returns on NEP 2007-2016 growth CX requirements.  Most regulated utilities trade ~15x P/E, with D&A being an almost perfect proxy for MCX, and exhibit 5% +/- EPS growth.  However, 100% transmission utilities trade at premium multiples based on superior stability and growth with Italian comparable TRN.IM trading at 18x forward P/E (and P/FCF) and U.S. comparable ITC trading at 28x P/E.  The regulatory frameworks for REE and TRN both provide for an annual inflation factor that does not apply to most U.S. utilities, further justifying higher multiples.
The RD-1998 framework, as previously mentioned, does not deduct depreciation from the earning asset base, allowing REE to maintain its cash flow and earnings power without making additional capital expenditures.  So all network capitalized expenditures generate attractive incremental earnings with excellent visibility.  Whereas a net rate base framework requires capital expenditures to offset a depreciating asset base.  REE's EPS, therefore, understates sustainable cash flow, which is why we focus on FCF and DCF.  EBITDA, similarly, should really be viewed as EBIT or EBITDA less MCX when comparing to other utilities.
Risk / Reward and Target Price:  REE offers excellent risk-reward asymmetry.  I think REE has fundamental downside to €41/shr (-2%) in the event of a severe regulatory haircut and upside to €67/shr (+60%) if regulatory status quo is maintained long-term, as it has been recently.  I have also developed a midcase scenario with a more modest regulatory haircut that targets a valuation of €56/shr (+33%).  The big upside potential and asymmetrical risk-reward are unusual for a defensive, regulated business model.  Because the existing regulatory framework supports the upside scenario, it is reasonable to think that it is the highest probability outcome.  Weighting the probabilities at 20% for downside, 30% for midcase, and 50% for upside justifies a target price of €59/shr (+40%) at year-end 2008.  This target cross-checks with 13x 2009 FCF.  The stock has held up reasonably well relative to European markets and should re-rate over time toward comparable multiples as the market absorbs the significance of recent regulatory proceedings, which confirm that REE enjoys a favorable and benign regulatory environment.
See below for scenario methodology.  All scenarios assume a 6.1% WACC based on 4.35% risk-free rate, 0.50% debt spread (AA- rating), 30.0% tax rate, 4.35% equity premium, 0.75 asset beta (low risk business model), and 36%/64% debt/equity.  Of note, while the potential for REE to be worth >€65/shr under the existing frameworks is not in great dispute, most bullish analysts have price targets ~€50/shr as they do not want to be perceived as outliers and therefore factor in some regulatory haircut in the future.
Upside-Midcase-Downside Scenarios:  Upside >> Asset remuneration continues through a useful life assumed to be 55 years (i.e. Status Quo).  DCF at 6.1% WACC justifies €67/shr (including €8/shr NPV for growth CX program).  This valuation target also cross-checks with conservative 15x multiple on €4.50/shr 2009 FCF.  Midcase >> Asset remuneration in its current form lasts only for the remaining 19-yr accounting life (estimated weighted average life is 21 years), followed by a 50% EBITDA haircut remuneration for an additional 15 years of useful life.  My assumed haircut replicates the new RD-2008 provision for remuneration beyond an assets' accounting life.  DCF at 6.1% WACC justifies €56/shr (including €8/shr NPV for growth CX program).  This target represents 12.5x 2009 FCF.
Downside >> Asset remuneration lasts only for remaining 19-yr accounting life.  DCF at 6.1% WACC justifies €41/shr (including a reduced €4/shr NPV for growth CX program).  This target represents 9x 2009 FCF.  This scenario assumes that even post-1997 investment remuneration is limited to the accounting life, notwithstanding that these assets were put-in-place under the modern RD-1998 framework, which should be less vulnerable to such a severe regulatory haircut.  I also believe that there is no justification for why a post accounting life haircut should be any worse than that provided for in the new RD-2008 framework.
Catalysts:  Next catalysts include the finalization of the NEP 2007-2016, which is expected by mid-year 2008, and REE's 5-year strategy review which is likely to come soon after the NEP finalization.  REE is likely to maintain or increase its robust growth targets and the passing of these last hurdles should enable the sell-side to re-market a clean and compelling story with a stable regulatory backdrop.  REE should see a material re-rating as downside fears continue to subside and the stock emerges as a defensive growth story.
Risks:  1) Regulatory haircut (if this ever happens it would be several years down the road).  2) Delays to NEP 2007-2016 finalization.  3) Growth CX placement.  4) Maintenance expense inflation to prolong useful life.  5) Interest rates.  6) Secondary placement of government's ownership stake.
Company Guidance and Visibility:  2007-2011 guidance is for >15% EPS CAGR, >15% dividend CAGR, €600mm average annual growth CX, and 300 bps EBITDA margin expansion.  Visibility into baseline earnings and growth is excellent given regulated nature of the business, no dependence on volumes, annual evaluation of new assets put-in-place, and NEP promoting infrastructure spending.
What You Need To Believe:  After delving into REE and its regulatory background, I think it is important to step back from the details and assess what you need to believe to buy the stock.  I will offer my thoughts ahead of time as a reminder while you are doing the diligence.  First, you need to understand that EPS is misleading as the RD-1998 gross rate base framework does not reduce the company's earning asset base by its depreciation.  In other words, maintenance capex is zero through an assets useful life as all maintenance requirements are expensed.  The visibility of REE's growth CX flowing into incremental earnings is excellent, so it is not difficult to get comfortable on this point.  Second, you need to realize that history, including very recent events, suggests that REE is more likely the long-term beneficiary of a benign regulatory environment rather than the inevitable victim of a hostile one.  I believe REE will re-rate to a comparable FCF multiple, or its full DCF valuation, as investors absorb the recently favorable regulatory outcome.  Third, you need to understand that REE is already pricing in a downside regulatory scenario, therefore creating exceptional risk-reward asymmetry.


Finalization of the NEP 2007-2016, which is expected by mid-year 2008, and REE's 5-year strategy review which is likely to come soon after the NEP finalization.
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