Philippine Markets Newsletter

The light shining in this company is not as bright as it seems, with Uniform ROAs only sparking 4%, not 6%

November 10, 2021

This major electric power distribution company continued to light up people’s homes through its core business and diversification strategy despite the challenging environment. While as-reported data shows that this strategy is keeping the business profitable, its Uniform ROA actually says otherwise. 

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

Philippine Markets Newsletter: 
Wednesday Uniform Earnings Tearsheets – Philippine-listed Focus
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In 1890, the main provider of electricity in Manila was Sociedad Mercantil, which later on became La Electricista

The company signed a 20-year contract with the Municipal Council of Manila to provide electricity in the form of oil lamps along city streets, parks, and other public places, as well as in homes and establishments of private customers. 

By the early 1900s, Manila Electric Railroad and Light Company (MER:PHL), currently known as Meralco, was eventually founded to also provide power to the transportation system. 

However, World War II left so much damage to the country that it destroyed much of the country’s railway system. This forced the company to give up its transportation business and instead focus on providing electricity.

A group of Filipino investors led by Eugenio Lopez Sr. saw its potential and bought Meralco from its American owners. They built electric generating and distributing facilities to meet the demand of its franchise area. With this, Meralco became the first billion-peso company in the Philippines. 

As Meralco faced a new century, the company began diversifying its activities to reduce reliance on electrical power distribution. One of its efforts was the creation of the e-Meralco Ventures, which aims to launch and invest in the internet and other high-technology companies. 

On top of that, the company also established eSakay, Inc., which focuses on producing end-to-end electronic vehicle (EV) and charging infrastructure solutions for the commuting public.

Besides the overall potential of its diversified interests, Meralco’s core business of distributing electrical power continued to grow as well by expanding its total network of customers. 

Today, the company serves 36 cities and 75 municipalities across the country. 

With the longstanding effects of the pandemic, the demand for electricity increased by about 10% versus pre-pandemic levels. This increased Meralco’s customer base during the first quarter by 4% from last year. Meralco expects this to increase even further to a peak demand of 8,003 MW by 2022.  

Aside from the rise in residential consumption, Meralco’s PHP 11.4 billion core profit in H1 2021 largely came from the higher volume and contributions of its joint venture project with New Growth BV, San Buenaventura Power Ltd. 

Overall, the company’s focus on strengthening its core business, as well as its continued progress with its diversification strategy, seems to be working well with Meralco’s journey to market domination. This is what as-reported metrics would also show—a company that has achieved above cost-of-capital ROAs since 2010.

In reality, we see that the firm’s initiatives have only produced returns that have barely reached cost-of-capital levels.  

This marked difference lies in the treatment of operating leases.

Pre-2019 IFRS and GAAP accounted for operating leases by spreading the cost of the asset expense over several years without requiring recognition in the balance sheet.

A lot of companies, including Meralco, opted for this “off balance sheet financing” to show higher return on assets (ROA) from the lower reported asset base.

Uniform Accounting has taken care of this by adding operating lease expense back to earnings and capitalizing the asset.

Doing so for Meralco shows us that in 2020 alone, the company was materially underreporting its assets by nearly 2x.

Meralco’s earning power is much weaker than you think

As-reported metrics distort the market’s perception of the firm’s historical profitability. If you were to just look at as-reported ROA, you would think that the company is a much weaker business than real economic metrics highlight.

Meralco’s Uniform ROA has actually been lower than its as-reported ROA in the past thirteen years. For example, as-reported ROA was 9% in 2013, significantly higher than Uniform ROA of 5%.

Historically, as-reported ROA has improved from 3% in 2005 to a high of 9% in 2013, before compressing to 6% in 2020. Meanwhile, since 2005, Uniform ROA has only expanded from 3% to 5% levels in 2012-2019, before compressing to 4% in 2020.

Meralco’s margins and turns are a lot weaker than you think 

Trends in Uniform ROA have been driven by trends in Uniform earnings margin, coupled with generally declining Uniform asset turns. 

Uniform margins declined from 7% in 2005 to 5% levels in 2007-2008, before expanding to a high of 14% in 2016 and compressing to 11% in 2020.

Meanwhile, Uniform turns improved from 0.4x in 2005 to a high of 0.8x in 2012, before declining to 0.4x levels in 2014-2020.

At current valuations, the market is pricing in expectations for Uniform margins and Uniform turns to reverse recent declines.

SUMMARY and Manila Electric Company Tearsheet

As our Uniform Accounting tearsheet for Manila Electric Company (MER:PHL) highlights, the company trades at a Uniform P/E of 27.3x, above global corporate average of 24.3x, but around its historical P/E of 28.1x.

Average P/Es require average EPS growth to sustain them. In the case of Meralco, the company has recently shown a 24% Uniform EPS decline.

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, Meralco’s sell-side analyst-driven forecast is to see Uniform earnings grow by 27% and 5% by 2021 and 2022, respectively.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Meralco’s PHP 295.00 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow 9% annually over the next three years. What sell-side analysts expect for Meralco’s earnings growth is well above what the current stock market valuation requires in 2021, but below the said requirement in 2022.

Furthermore, the company’s earning power is below the long-run corporate average. However, cash flows and cash on hand fall above total obligations—including debt maturities, capex maintenance, and dividends. Also, intrinsic credit risk is 90bps above the risk-free rate. Together, this signals a low dividend risk.

Lastly, Meralco’s Uniform earnings growth is above its peer averages, but currently trades in line with its average peer valuations.

About the Philippine Market Newsletter
“Wednesday Uniform Earnings 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 IFRS, 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 Wednesday, 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 Earnings Tearsheet on a Philippine company interesting and insightful. 

Stay tuned for next week’s Philippine company highlight!


Angelica Lim
Research Director
Philippine Markets Newsletter
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