RDEIF - Redeia Corporación: Scaling The Business Resulting In Falling Returns

2024-01-16 17:19:02 ET

Summary

• Redeia Corporación is a Spanish TSO undergoing major investment to strengthen infrastructure and expand internationally.
• Expansion is resulting in a business with higher capital intensity, increasing financing costs, and a higher fixed cost base, which all point to falling returns.
• With weakening fundamentals, we believe downside risk remains. We reiterate our sell rating.

Investment thesis

The strategic business expansion by Redeia Corporación ( RDEIF ) will result in our opinion in a larger business with a lower return on equity, a weaker balance sheet, and a limited recovery profile for free cash flow generation. Weakening fundamentals point to downside risk, and we reiterate our sell rating.

Quick primer

Redeia Corporación is a Spanish TSO (transmission system operator) that runs and manages the electricity transmission grid in Spain and parts of South America, as well as providing telecommunications services via satellite and fiber networks. Previously known as Red Electrica Corporación, it changed its name in 2022.

The business is currently undergoing a period of major investment with its strategic 2021-2025 plan , to strengthen domestic infrastructure, and drive international and telecommunication sector expansion. This involves capex plans of over EUR3.3bn during these 5 years.

Key financials with consensus estimates

Assessing the longer-term outlook

Updating our sell rating from February 2021 , we see that Redeia's shares have underperformed the S&P during this timeframe by some margin even on a total return basis. Having a position would have been a drag in any portfolio allocation - we are therefore happy with our recommendation.

Two things have been a positive surprise to us. Firstly, despite the massive drop-off YoY in free cash flow generation estimated in FY12/2023 (see Key financial table above), the shares have remained relatively resilient. Secondly, despite the major EUR3.3bn capex drive which would equate to 40% of current market capitalization, balance sheet gearing declined in FY12/2022 - the company had sold a 49% interest in the fiber business (Reintel) to KKR ( KKR ) in December 2022 for EUR971 million - assets are being disposed for part-funding business expansion.

With future business plans priced in, we want to re-assess our rating for the medium term. The focus will be on funding capex and shareholder returns, and the potential for capital raising.

Highly limited free cash flow generation

Consensus estimates for FY12/2023 to FY12/2025 indicate a cumulative generation of only EUR59m in free cash flow, whilst the expected dividend payment will be EUR1.4bn for the same period. The cash will have to be generated elsewhere to cover shareholder distribution, either by raising capital or by asset sale.

In January 2023, the company raised EUR500 million in hybrid bonds with a 4.625% coupon. These are booked under equity due to their undated nature (no maturity date), but there is a rate reset in 5.5 years from issuance. The good news is that there is no dilution but there is a call option for the issuer, i.e. making it more expensive to issue.

We believe there will be more incidents of hybrid bond issuance in the next two years to fund both capex and shareholder returns; this issue will be more acute in FY12/2025 when the company has a total of EUR900m bonds maturing (with coupons below 1.2%). The company will be faced with increasing debt financing costs, increased underlying gearing (even if hybrid bonds are accounted for as equity), and limited capacity for allocating capital for distribution. To illustrate the company's limited options, the consensus is already forecasting the current ratio of the business to drop to 0.5x in FY12/2025, demonstrating tight liquidity.

Longer-term outlook

If we take the view that hybrid issuance is forthcoming, the company will have an inflating shareholders' equity base and resultant falling ROE, highlighting the fall in the efficiency of the business to generate returns. The target net debt-to-equity ratio of less than 5x in FY12/2025 can potentially be met, but from the viewpoint of investors may be a moot point as hybrid issuance is effectively interest-bearing debt although low in the ranking for debt hierarchy.

Whilst we appreciate that there are a lot of moving parts, what is perhaps most disappointing about Redeia's outlook is that despite major efforts being undertaken on business expansion, the current market outlook is for flat to falling earnings for 2 years.

The big question is whether annual free cash flow can recover to the pre-expansion era levels of EUR1.0 billion or so. If that is a realistic scenario, then we believe there is a case to be made for valuation support. However, given the increasing scale of business, we expect to see the following: 1) increasing spending on maintenance capex 2) higher debt financing costs, and 3) an overall increase in fixed operating costs, which all point to a limited recovery in generating shareholder value.

Valuation

On consensus estimates, the shares are trading on PER FY12/2024 16.4x, an FCF yield of 0.4%, a dividend yield of 5.5%, and an ROE of 10.2%. Although these metrics (apart from FCF yield) do not look particularly stretched, we note that compared to the 10-year average PER multiple of 14.3x, the shares are trading at a 15% premium despite weakening fundamentals.

Thesis catalysts

The company continues to fund its strategic business expansion, resulting in greater capital intensity, falling efficiency of returns, and limited recovery in free cash flow generation.

Risks to the thesis

The market welcomes hybrid bond-funded business expansion, as it does not impact leverage metrics on paper. If interest rates were to fall dramatically over the next five years, financing costs would fall.

Conclusion

Whilst we are relatively surprised at how well Redeia's shares have held up over the last two years, we believe that weakening fundamentals indicate downside risk to the shares. Whilst falling dividend expectations have been priced in, we believe the challenges of operating a larger and more complicated business are yet to be fully understood, culminating in the company being unlikely to generate high free cash flow and dividends as per its historic track record. We reiterate our sell rating.

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