TEZNY - Terna: An Infrastructure Giant That Should Be On Investors' Radars

2024-01-03 05:44:57 ET

Summary

• The utility sector, which has been overlooked in recent years, is attracting attention as a defensive investment option.
• Italian grid operator Terna SpA has outperformed popular utility-focused ETFs and offers solid financials and growth potential.
• Terna's planned investments to modernize the grid and integrate renewable energy make it a potentially attractive investment opportunity.

With the stock market trading at a high valuation, it is a good time to look at more defensive sectors. A classic one is the utility sector, which has not been very popular with investors the last couple of years, as investors chased after technology stocks and avoided interest sensitive sectors. In fact, the utility sector showed the worst performance of all sectors in 2023. This has many contrarians excited, and considering ETFs such as the popular Utilities Select Sector SPDR ETF (XLU), the Vanguard Utilities ETF (VPU), the iShares US Utilities ETF (IDU), and the iShares Global Utilities (JXI).

One utility company that outperformed all of these ETFs in 2023 is Italian grid operator Terna SpA (TEZNY)(TERRF). For a $16 billion dollar market cap company, which has delivered solid results for investors, it is extremely under followed. It has an ADR, TEZNY, with only 154 followers on Seeking Alpha, and last covered in 2013. The shares TERRF have 323 followers, and were last covered in 2019. The ADR to native share ratio is 1:3, in other words, one ADR represents 3 native shares.

Terna did not just outperform all the previously mentioned utility focused ETFs last year, it has also outperformed them on a total return basis in the last ten years. This is especially impressive considering that international stocks have underperformed the US the past decade, something that can clearly be seen in the poor showing of the iShares Global Utilities ETF, which includes some foreign utilities in its holdings.

Company Overview

Terna SpA is an Italian company whose shares mainly trade in the Milan exchange. Most of its operations are regulated, as it owns and operates the Italian National Transmission grid. It has a monopoly under an Italian government license, and moves electricity throughout the country. It has a smaller non-regulated business segment, as well as international operations. The majority of its revenues comes from transmission fees, with some non-regulated revenue coming in from producing and selling transformers and providing other additional energy related services.

Terna has big spending plans for the coming years, as it improves the grid and prepares it for a higher percentage of energy coming from renewables. To increase resiliency and the intermittence of some renewable energy technologies, it will be important to improve connections between different parts of the grid. Terna has over thirty new infrastructure projects in its ten-year development plan. This will bring benefits to the system, the environment, and electricity users, as well as Terna, which is expected to receive regulator incentives and rewards for making these investments.

For example, Terna has planned five new electricity backbones designed to integrate renewable energy capacity, representing investments of about €11 billion. Terna will modernize existing power lines on Italy's east and west backbones, down to the South and the Islands, accompanied by new 500 kV undersea connections. This will allow the company to transfer even more power generated by renewables in Southern Italy towards high-load areas in the North of the country.

Financials

Terna has enviable financials, with gross margins above 80%, and net profit margin above 30%. Currently margins are slightly below their historical averages, but remain impressive.

This is despite Italy experiencing a decrease in electricity demand in 2023 compared to the previous year of about 4%. The reduction in demand was due to a decrease in industrial consumption and an increase in average temperatures. In the first nine months of 2023 the company saw revenues increase 13% and EBITDA 10%, compared to 2022. Net income increased 9% in the same period, and CapEx was €1.4 billion, an increase of 39% compared to the same period in the previous year, confirming the company's investment acceleration to enable the energy transition.

Terna's ten-year return on equity average has been about 17%, but has been achieved with significant leverage, as its return on assets is much lower. Still, the risk from using leverage is mitigated with most of its revenue coming from regulated activities, where it has a monopoly license from the government.

Growth

The company is predicting the Group's regulatory asset base (RAB) will see a compound annual growth rate ((CAGR)) of 7% over the next few years, a sharp increase compared to the past.

It should reach around €22.7 billion in 2025, this is important as the company is able to increase revenue as it makes investments and increases its regulatory asset base. Growth rates in dollars for the past decade are a little lower compared to what the company achieved in euros, as the euro has depreciated considerably against the dollar in the past ten years.

Dividend

Terna's dividend yield is currently around 4.3%, which compares favorably to XLU's dividend yield of about 3.4%. Terna's dividend has grown with a CAGR of ~2.9% in the past decade when measured in dollars. Italy has a withholding rate of 26%, and the ADRs have an ADR fee as well.

For years 2024 and 2025, expectations for the payout ratio were confirmed to be 75%, with a guaranteed minimum dividend equal to the dividend for the year 2023.

Dividend growth in Euros looks better at ~4.6% CAGR for the past decade. It looks lower in dollars, as the Euro is now meaningfully lower in relation to the dollar, compared to where it was ten years ago.

ESG

Terna has been listed for 13 consecutive years in the Global ESG leaders index, and is considered an example of an example company in this respect. This has also befitted the company, as it has enabled Terna to issue lower cost green bonds. For example, it recently issued ten-year green bonds that will pay 3.87%, an attractive rate considering the current interest rate environment. The company also has a €1.8 billion ESG-linked revolving credit facility.

Balance Sheet

At the end of September 2023 the company's net debt was €9.5 billion, compared to €8.6 billion at the end of 2022. Most of its debt has fixed interest, with roughly 87% of gross debt being fixed, and the average debt duration being around six years. The cost of debt at the end of the third quarter was a low 1.7%, and the company expects cost of debt for the full year 2023 to come end up slightly below 2%, as the company has had to finance part of its CapEx at higher rates in recent months.

As most utilities, the company has a high degree of leverage, but we believe it remains at a reasonable level.

Financial debt to EBITDA has come down, and recently Moody's ( MCO ) upgraded its credit rating outlook. Moody's affirmed in November 2023 the long-term rating of Terna S.p.A. at 'Baa2', a notch above the rating of the Italian Republic. The ratings agency also upgraded Terna's outlook to stable from negative, after the recent assessment of the Italian Republic by Moody's.

Outlook

The company has identified more than €30 billion in potential investments it can make over the coming decade and beyond. These include undersea high-voltage direct current power links, modernization of its AC grid, and upgrading some of its AC grid to direct current. It is also planning new interconnections, monitoring capabilities, and grid developments, that will permit the integration of more renewable energy into the grid.

This will require significant CapEx, but it also means the company has growth potential. It also has high expectations for growth in its non-regulated business, and increasing its international operations.

Valuation

Terna is currently trading close to its average valuation multiples, for example the price to cash flow from operations per share is slightly below its ten-year average.

Similarly, the price to book value is slightly below its ten-year average. We can therefore see that most of the share price increase has come from fundamental growth, and not multiple expansion.

The price/earnings ratio is a slightly above the ten-year average, but still within the normal range where it has traded the past decade. It is also below the average for XLU's holdings, which currently is at ~18.7x.

Looking at the EV/EBITDA we see the same thing, the multiple is very close to the ten-year average, and relatively close to its industry's average of ~12x.

Looking at XLU's index characteristics, we find Terna trading at similar valuation multiples, despite its above-average performance in the past decade. We also see more growth potential with Terna, as the estimated 3-5 year EPS growth for XLU is -0.38%, while Terna expects significant revenue and earnings growth from the investments it is making to enhance the grid's capacity for integrating more renewable energy sources. Terna also adds some diversification, as it mostly derives its revenue in euros.

Risks

There are some important risks to consider with Terna, including the fact that most of its revenues are generated in Italy, and it is subject to significant government regulation. Its profitability could be significantly impacted should the government decide to change fees, incentives, license costs, etc. These risks are mitigated by the fact that the government, and the European Union in general want companies to heavily invest in the transition to renewable energy.

Conclusion

We are impressed by the performance that Terna has delivered over the past decade, outperforming most of the popular utility focused ETFs. It has delivered this performance despite the headwind of a lower euro exchange rate compared to the US dollar. We believe it is currently trading at a very reasonable valuation, and close to its historical ten-year averages on various valuation indicators. We see significant growth potential from the planned investments to modernize the grid and prepare it for more renewable energy generation. It is surprising how little following the company has despite its significant market cap and we believe investors should keep it on their radars. Given the reasonable valuation and the growth potential, we are starting coverage with a 'Buy' rating.

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