With interest in renewables and 5G ramping up, an allocation to utilities may be the key to unlocking hidden value, argues Mellon fund manager Jim Lydotes.
It’s hard to think of a sector packing less pizzazz than the utilities sector. While other parts of the index (think tech or finance) have enjoyed a wild ride over the past decade and more, companies producing the necessities of everyday life – water, electricity, gas, telecoms – have been, well, utilitarian.
For fireworks and excitement, the story goes, look to the high-wire, high-growth innovators in the world of 5G connectivity or the companies enmeshed in Industry 4.0. Utilities, on the other hand, are the tortoises of the equities world: Slow and steady, trading on lacklustre P/E multiples, valued far more for their promise of income than for any growth potential.
But what if this were only part of the story? What if, behind the utilities sector’s bland façade there were a series of growth opportunities waiting to be unleashed?
This, according to Mellon fund manager Jim Lydotes, is the hidden story of utilities Yield Cos and similar assets in other sectors. Here, ostensibly slow-growth, ‘sleepy’ companies look to spin off assets, often operating in more dynamic parts of the market, as standalone entities. This might be the renewables division of an energy company, for instance, or the tower assets of a traditional telecoms company.
“In each case, the key is to seek out the opportunity buried in larger businesses or conglomerates,” says Lydotes. “These larger entities might be trading at 5X EBITDA but contain businesses with the potential to reach far higher multiples if they stood alone.”
Why standalone makes sense
Often, says Lydotes, the decision to spin off a part of the business such as a utility Yield Co is a win-win. For the parent company, the benefit is a capital windfall they can reinvest in future projects or return to shareholders. For the Yield Co or similar spun off entity, the benefit is a market-driven – and therefore more accurate – assessment of value. For investors, it’s an opportunity to buy into situations offering the prospect of both income and future growth.
“The Yield Co story isn’t a new one,” observes Lydotes, “but we think it’s still under-appreciated by the wider market. We believe there are companies out there, trading on fairly mundane multiples, due a rerating once their plans for spinning off Yield Cos or similar assets becomes clear.”
In line with this thinking, utilities on Lydotes’ Global Infrastructure Income strategy now account for 53.0% of the portfolio sector weighting, it highest ever allocation since inception. Energy follows with 17.6% then industrials with 14.8%.
In the past, the strategy maintained exposure to the utilities sector but this was often for the opportunity created by political headlines rather than a hidden value play. In the UK, for example, fears of nationalisation under a prospective Labour government sparked a selloff of UK water companies – signalling a buying opportunity for Lydotes. Following the recent Conservative general election victory, this sector rerated, Lydotes reduced the allocation to UK utilities, and the strategy changed focus.
Today, says Lydotes, the team sees potential in southern Europe where the renewables story is yet to reach its full potential and where fears of regulatory interference or political instability have arguably been overblown.
“In Spain, for example, investors have long worried about regulators changing the renewables tariff,” he says. “In Italy, frequent changes of government have tended to spook the market. In both cases, we’d argue, the fears are exaggerated and energy policy has continued to plot a steady course relatively unscathed. It’s similar to the US where there’s been a lot of noise around the retreat from the Paris Accords. But as we’ve argued before, it’s really at the State level – not in the White House – that US energy policy is set. In reality, if anything we’ve actually witnessed an acceleration of renewables policy since President Trump’s election, particularly in California. It’s an example of why it’s necessary to try to cut through the noise to get an idea of what’s really going on.”
To illustrate how the Yield Co situation might work in practice, Lydotes highlights the example of a French energy provider with a specialised engineering division. This division recently won a contract to install and manage energy efficient heating and air-conditioning to a US university at a fixed rate for 20 years. A decision by the parent company to spin off this division would likely result in an immediate rerating, says Lydotes.
Elsewhere, he highlights the example of a French telecoms company with a portfolio of tower assets. As interest in 5G gathers pace, this has become a ‘hot’ segment, says Lydotes, spawning a raft of M&A and with standalone tower companies trading at ‘sky-high’ multiples. Again, all things being equal, a decision to spin off these assets should drive an uptick in that parent’s share price, he concludes.
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1 Sector weights as of 31 December 2020.
2 The structures on which mobile operators install their antennas.
