Philippine Markets Daily

Political headwinds have disrupted some of this company’s flow. Yet, an 8.1x Uniform forward P/E suggests it’s still not that cheap.

February 11, 2020

Most investors consider this company an automatic “sell”.

Its dispute with the government has served as a significant headwind while as-reported metrics have implied only modest profitability.

However, recent events provide a glimmer of optimism, and the firm’s Uniform earning power has actually shown robust results. As such, market expectations are too bearish.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Tuesday Uniform Earning Tearsheets – Philippine-listed Focus
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In the 1990s, 30% of Metro Manila had no access to tap water. For the 70% that did, access only lasted around 16 hours a day.

With the crisis escalating, the government had to ask themselves one question: Are they better than the private sector at running the water system?

The government was forthright about their shortcomings.

They quickly privatized and divided the water distribution system of the Greater Manila Area into two companies: Manila Water and Maynilad.

Manila Water served the eastern zone, while Maynilad handled the western zone.

This policy was met with heavy criticism. Many citizens were angry about leaving a resource as crucial as water to the hands of the private sector.

Yet, both companies achieved better results.

Today, almost everyone near the capital enjoys access to clean water.

Despite this success, however, both companies are once again receiving flak… this time from the government, particularly President Duterte.

The president is threatening to seize the operations of Manila Water and Maynilad for delaying construction projects, which caused a water shortage during the dry season.

Furthermore, the government lost an arbitration case to them and was urged to pay a total of PHP 10.8bn for losses incurred.

The president, calling provisions in their government contracts as onerous, wants to renegotiate the terms of their concession agreements.

Shares of Manila Water have sunk to historical lows, with investors seeing the worst of cases.

However, recent events have changed the story.

Just last week, Enrique Razon, Jr., the 4th richest man in the country, bought a 25% stake in Manila Water for PHP 10.7bn.

Not only does this bolster confidence that the government’s conflict with Manila Water can peacefully be resolved, but it also provides the needed capital for the firm to expand capacity.

Moreover, one of Mr. Razon’s companies owns the project that will develop Wawa Dam, one of the dams that will address Metro Manila’s future shortages.

This all but ensures Manila Water’s access once construction finishes.

But more importantly, for the government to take back control of the water utilities, they must again ask the same question they answered decades ago.

Are they better than the private sector at running the water system?

The current Justice Secretary recently admitted that they are unable to take over water operations.

While renegotiations have not yet concluded, it is safe to say that the market’s fears have been hugely exaggerated.

As such, Manila Water is most likely going to continue seeing robust profitability, considering how it has managed to maintain solid levels.

Adjusting for accounting distortions, the company has had Uniform earnings power at 10% or above in the past 16 years.

Analyzing Manila Water’s financial statements, the amortization of “service concession assets” is the largest expense impacting earnings.

Its non-cash nature means that it does not represent an actual outlay of cash every time amortization is recorded.

Additionally post-2016, amortization of some intangible assets changed from a straight line basis to the unit of production method.

This made Manila Water’s intangible assets less comparable against pre-2016 results or against its direct peer, Maynilad.

Therefore, in addition to the many other adjustments made, amortization expense is added back to calculate Manila Water’s true earnings power.

Manila Water’s earning power is more robust than you think

Historically, Manila Water has seen robust and and generally stable profitability.

From 2003 to 2005, Uniform ROA (blue bars) was at 23.7%, before it reached a peak of 27% levels in 2005, only to start falling beginning 2007. The as-reported ROA (orange bars) will tell you the company only achieved half of those ROA levels.

From 2007-2011, Manila Water’s earning power fell further from 20% to a new low of 14% levels. Uniform ROA then rebounded slightly to 15% in 2013, but this improvement did not last as the company saw declining earning power, hitting an all-time low of 10% recently.

As-reported metrics would have you believe that Manila Water struggles to surpass 10% profitability historically, when in reality the company managed to perform above 2x corporate average levels.

Manila Water’s asset turns are stronger than you think

The strength of their ROA lies on their asset turns. This implies that the company is more concerned about generating sales for every dollar spent in assets.

Beginning 2003, the difference between Manila Water’s Uniform and as-reported ROA was historically broader, similar to the difference between Uniform and as-reported asset turns.

For example, the as-reported asset turns for Manila Water have been in the range of 0.2x-0.4x historically, lower than Uniform asset turns of 0.3x-0.5x.

The as-reported numbers make Manila Water appear less efficient in churching revenue out of their asset base than real economic metrics highlight. It also distorts the market’s perception of the firm’s historical asset efficiency trends.

SUMMARY and Manila Water Tearsheet

As our Uniform Accounting tearsheet for Manila Water Company highlights, Manila Water UAFRS Forward P/E trades at 8.1x, below market and historical averages.

Low P/Es require low EPS growth to sustain them. In the case of Manila Water, the company has recently shown immaterial Uniform EPS growth.

Sell-side analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, sell-side analysts’ near-term earnings forecasts tend to have relevant information.

We take sell-side forecasts for Philippine Financial Reporting Standards (PFRS) earnings and convert them to Uniform earnings forecasts. When we do this, Manila Water’s sell-side analyst-driven forecast is for Uniform earnings to shrink by 21% in 2019, before showing robust growth of 24% in 2020.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify PHP9.34 per share. These are often referred to as market embedded expectations.

To meet the current market valuation levels of Manila Water, the company would need to have Uniform earnings shrink by 17% each year over the next three years.

What sell-side analysts expect for Manila Water’s earnings growth is below what the current stock market valuation requires.

To conclude, Manila Water’s Uniform earnings growth is below with peer averages in 2019. Yet, the company is trading below average peer valuations.

The company’s earning power is above the corporate average, but the company has high dividend risk given their available cash, signaling that their cash flow risk to the company’s operations and credit profile in the future is high.

About the Philippine Markets Daily
“Tuesday Uniform Earning Tearsheets – Philippine-listed Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under UAFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Tuesday, we focus on one Philippine-listed company that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform Earning Tearsheet on a Philippine company interesting and insightful.

Stay tuned for next week’s Philippine company highlight!

Regards,

Angelica Lim & Joel Litman
Research Director & Chief Investment Strategist
Philippine Markets Daily
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