(Published Jan. 12 by The Financial Canadian)
Geographic diversification is something generally accepted as beneficial to investors. By purchasing shares with exposure to various countries, one can diversify away from the risk of localized economic downturns.
What most investors do not know is this sort of international exposure can be achieved by purchasing shares of select U.S. corporations.
There is no need to venture out to international stock exchanges – many companies, such as Coca-Cola (KO, Financial), Apple (AAPL, Financial) and Johnson & Johnson (JNJ, Financial), derive a significant portion of their earnings from international operations.
Many investors (including myself) would be surprised to find out there is an American Dividend Achiever that generates more than 50% of its earnings from the United Kingdom.
The Dividend Achievers are a select group of stocks with at least 10 consecutive years of dividend increases. You can see the full list of all 272 Dividend Achievers here.
The company is PPL Corp. (PPL, Financial), a large-cap utilities company based in Allentown, Pennsylvania.
To follow is a discussion of the investment prospects of PPL in detail.
Business overview
PPL is a holding company that owns PPL Electric Utilities, which stands for Pennsylvania Power & Light Company (the former legal name of this entity).
The company can trace its roots back to the 1920s, when PPL was created from the merger of eight smaller utility companies. After decades of continuous expansion, PPL now has annual net income of $1.4 billion and a market capitalization of about $23 billion.
PPL is diversified into three geographic segments for reporting purposes:
- Pennsylvania (23% of EPS)
- Kentucky (28% of EPS)
- United Kingdom (54% of EPS)
Source: PPL Mid-Atlantic Investor Presentation, slide 3
Growth prospects
PPL was one of the worst-performing utility stocks of 2016. While much of the sector was up significantly, often over 10%, PPL remained flat.
Determined to drive growth, PPL management is aggressively investing in their business. The planned capital expenditures over the next few years are significant. These plans are outlined in the following diagram.
Source: PPL Mid-Atlantic Investor Presentation, slide 7
These capital expenditures are significant – this is a company with a market cap of $23 billion that is planning to execute $3 billion of capital expenidture per year. PPL expects this to translate into earnings growth and even has expectations related to how quickly this capital expenditure will be recovered as earnings.
Source: PPL Mid-Atlantic Investor Presentation, slide 8
The above slide can be viewed almost as a mathematical equation: rate base growth plus recovery of capex equals annual EPS growth. It is encouraging to see the company has so precisely identified what they expect to be the two drivers of growth.
Further, I am impressed with the company’s ability to recover capital expenditure – receiving almost three-fourths of it within the first six months is excellent.
PPL’s growth prospects are completely tied to its ability to grow the rate base. As the left section of the above slide indicates, the company expects to compound the rate base at a 5% compound annual growth rate (CAGR) between 2017 and 2020. This growth appears to be evenly distributed across the operating segments.
Competitive advantage & recession performance
One of the major competitive advantages of PPL is its exposure to the United Kingdom. PPL is the first U.S. utility I have seen that generates more than half of its earnings overseas.
In fact, PPL’s U.K. operations have done well enough that the company is bringing back its overseas earnings (a process called repatriation) to fuel domestic growth. When companies repatriate foreign cash, this domestic transfer of funds is subjected to the U.S. corporate tax rate minus taxes already paid in overseas countries. Companies avoid repatriating all their tax at once because it would trigger a hefty tax bill.
PPL’s U.K. cash repatriation strategy is outlined in the following diagram.
Source: PPL Mid-Atlantic Investor Presentation, slide 40
One potential catalyst for this company comes in the form of President-elect Donald Trump. As a strategy to fuel domestic economic growth, Trump has suggested implementing a “cash repatriation holiday” that would reduce the one-time corporate tax rate on international earnings from 35% to as low as 10%.
While it is difficult to say precisely what will occur in the event of a tax repatriation holiday, there is some historical basis for this type of tax policy.
According to Bloomberg, the last time a tax holiday occurred (which was in 2004), more than 90% of repatriated cash was used for share buybacks, special dividend payments and increases to executive compensation.
If Trump’s cash repatriation plan is successful, it is likely to be a positive for PPL shareholders.
Next, consider the company’s recession performance. Below are PPL’s EPS during the 2008 to 2009 financial crisis:
- 2007: $2.63
- 2008: $2.45 (6.8% decrease)
- 2009: $1.19 (51.4% decrease)
- 2010: $2.29 (92.4% increase)
- 2011: $2.61 (14.0% increase)
PPL’s earnings were more than cut in half during the financial crisis. In fact, PPL’s earnings have never beaten the $2.63 high-water mark the company set in 2007. This historical performance does not give me confidence in the safety of an investment in PPL.
That being said, PPL is making efforts to solidify its balance sheet. This begins with the company’s debt profile. As the following diagram illustrates, PPL’s current liquidity profile is more than enough to pay off short-term debts (those that are due in 2019 and earlier).
Source: PPL Mid-Atlantic Investor Presentation, slide 8
This strong financial position has led to investment grade (BBB or higher) credit ratings for PPL and all of its operating subsidiaries, which should reassure investors that are worried about PPL’s creditworthiness.
Source: PPL Mid-Atlantic Investor Presentation, slide 43
Financial considerations aside, the other significant risk PPL is exposed to is foreign exchange fluctuations.
As mentioned earlier, PPL’s international exposure gives the company a distinct competitive advantage. Unfortunately, this exposure could also be a double-edged sword for PPL investors. Foreign currency fluctuations can affect the company’s earnings.
Investors who held the company’s stock through Brexit earlier this year watched as the stock declined from $38.57 to $36.36 overnight (a decrease of 5.7%) as geopolitical concerns surrounding the event were realized.
Source: Yahoo! Finance
Luckily, the company has a hedging program in place to minimize these currency effects. PPL’s exposure to the British pound was 91% hedged in 2016 and the company has raised that number to 94% in 2017.
Source: PPL Mid-Atlantic Investor Presentation, slide 33
The following slide outlines a bit more of its hedging strategy, including what is (in my opinion) the most important outcome of the hedges: a more predictable U.S. dollar earnings stream for investors.
Source: PPL Mid-Atlantic Investor Presentation, slide 33
To conclude, PPL has not performed exceedingly well during previous recessions, but the company’s strong financial profile and substantial hedging strategy should leave the company strengthened going forward.
Valuation & expected returns
Over the past five years, PPL has traded in a valuation multiple range between 10.5 times and 14.1 times TTM earnings. The company is currently trading at 12.6 times TTM earnings, which is roughly in the middle of this range. Compared to PPL’s historical valuations, the company appears to be reasonably valued.
Source: Value Line
The company’s current valuation is particularly attractive when compared to valuation multiples in the most recent years (14.1 in 2014 and 13.9 in 2015).
PPL’s management is very candid. They clearly communicate their targeted total shareholder returns in investor presentations. The following slide outlines how the company is targeting 8% to 10% total returns by combining earnings growth with the company’s dividend payments.
Source: PPL Mid-Atlantic Investor Presentation, slide 12
Total returns for PPL investors will be composed of:
- 4.4% dividend yield
- 5% to 6% EPS growth
Over the long run, total expected returns will be in the range of 9.4% to 10.4%. While I do not expect valuation changes to significantly affect these returns since the company appears fairly valued, currency fluctuations could move the needle in either direction due to the company’s significant exposure to the United Kingdom.
Final thoughts
PPL is a rather unique investment prospect – a Dividend Achiever in the utility sector with significant exposure to the United Kingdom. The company also appears fairly valued compared to historical levels.
For an investor looking for a solid total return play with exposure to the U.K. economy but limited currency risk, initiating a position in PPL will help achieve this goal.
Disclosure: I am not long any of the stocks mentioned in this article.
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