In East Africa, there are a number of investment opportunities within the listed utilities space, according to a recent research by Exotix Partners.

The firm’s top pick is Umeme, the largest electricity distribution company in Uganda.

According to Exotix, Umeme offers the highest potential returns with a fair value estimate of UGX682.2/KES20.4, which implies an ETR of 46.4% (inclusive of 7.1% expected dividend yield in FY17f). 

Silha Rasugu, Equity Research Analyst at Exotix Partners/ Equity Investment Bank, said: “At the current market price, we value the stock at 7.0x 2017f earnings and 4.3x 2017f EV/EBITDA. In addition to the undemanding valuation multiples, we recognise superior efficiency relative to peers measured by lower energy losses (17.9% FY17f) and an increasing load factor to 30.5% in FY15 vs 27.2% in FY14.” 

“Umeme’s investment case rests on: sustained cost rationalisation in FY16-17f owing to automation such as meter reading (64% of total customers are on pre-pay meters), meaning that we expect opex to decline by 12% yoy in 2016f to US$44mn (below the regulator’s cap of US$47mn, allowing for EBITDA margin expansion to 21.1% (vs 20.5% in FY15); and high returns on equity and capital with FY17f ROaE expectation of 19.5% and 40.9% headline return on capital invested,” he added.

Meanwhile, Exotix has cut its target price for Kenya Power (KPLC) to KES7.2 (from KES10.61), and its target price for KenGen to KES5.8 (previously KES6.24).

Rasugu cites high gearing ratio at 68% net debt to capitalisation in FY16 and market value of equity accounting for only 10% of capital, which may put constraints on future financing plans; and inefficiency, with adequate funding for large capex (KES47bn, +19% yoy FY16) seemingly having no benefits for operational efficiency - as key concerns for KPLC.

For KenGen, downside risks include  low equity returns of 5.0% in FY17f owing to the cyclical nature of its earnings, with the next peak expected in FY18-19f (ROaE 12.5-14.0%) if 276MW of additional geothermal capacity is delivered as scheduled; and non-compliance with certain loan covenants in 2016.

“Our decision to downgrade KPLC to Hold is a factor of its inefficiency and high gearing, which pose a risk to shareholder returns, in our view. Although Kengen’s recently concluded rights issue was positive for the company’s balance sheet, we found that except for an improved capital structure some other underlying concerns for equity holders remain,” commented Rasugu.

Overall, Exotix is optimistic on the utilities sector in East Africa, driven by the consistent delivery of necessary capital expenditure to increase national electrification rates and improved reliability of electricity supply, particularly for commercial and industrial productivity. 

Rasugu noted that investments in the utilities sector are also timely in that installed power capacity across key East Africa markets now exceeds peak demand, allowing regulators to focus policy on lowering price via the regulated tariff. 

“However, these positives are contrasted by individual company inefficiencies, high gearing levels due to debt-fuelled capex and weak execution crucial for profitable development of companies in this sector,” he said.