Philippine Markets Newsletter

Uniform Accounting shows how this utility company has been generating not just sustainable energy, but also sustainable profitability at 11%

July 28, 2020

The movement to “go green” has spurred many countries to start prioritizing developing technology for renewable energy to reduce their carbon footprint. Those countries might be reducing their dependence on coal, but production and demand for the fossil fuel is still very much in full swing in China and in Southeast Asia.

Still, people may be underestimating the market for clean and renewable energy within these countries.

We’ve discussed before how as-reported metrics have been materially understating the profitability of a Chinese solar inverter manufacturer. In the Philippines, this renewable energy producer has been generating returns almost double what as-reported metrics state.

Philippine Markets Daily:
Tuesday Uniform Earnings Tearsheets – Philippine-listed Focus
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With coal companies like Semirara mining at record-high volumes, the dominance of coal in the Philippine power generation industry is unlikely to decline any time soon. Coal is said to be the cheapest energy option, hence why it remains widely used.

The industry has also focused more on keeping up with the rapidly growing demand rather than developing alternative power sources. For decades, Filipinos have been no stranger to power outages or routine brownouts. It is especially true these days when residential power demand is peaking amidst the COVID-19 pandemic.

On the supply side, many of the country’s existing power plants have become severely outdated and inefficient, with some in operation since the 1940s and 50s.

The building of a new plant is a tedious and heavily bureaucratized process, needing 160 government clearances to get started. Nevertheless, coal power capacity is estimated to triple if all current construction plans are executed successfully.

Despite coal’s leadership, natural gas and renewable energy were able to carve out a substantial piece of the market. The discovery of the Malampaya gas field in 1989 opened the country to begin producing large amounts of natural gas.

Moreover, the country’s position near the equator and the Pacific Ring of Fire has made solar and geothermal power production more feasible. Collectively, the market share of alternative energy sources stood at around 43% in 2019.

As global warming worsens, many are becoming conscious of the negative effects of coal energy. Although cheap, coal’s price fails to factor in the costs to people’s health and to the environment.

Many businesses are capitalizing on this long-term trend, entering into renewable energy with the expectation that coal will turn into a minor energy source with insignificant market share.

Among the local players today, First Gen Corporation (FGEN:PHL) is the largest clean and renewable Independent Power Producer. The firm owns multiple power plants across the country, utilizing natural gas and almost every renewable energy source.

The company is also the largest electricity supplier of Meralco and, through its ownership of Energy Development Corporation, is the largest geothermal power producer in the country.

Unlike its main competitors Aboitiz Power Corporation (AP:PHL) and SMC Global Power Holdings, First Gen does not possess any ownership in coal and oil-fired power plants.

At first glance, it seems that First Gen is locking itself out of business opportunities with their devotion to clean energy. The firm’s as-reported metrics imply that its exclusively clean energy strategy isn’t paying off, with the company generating less revenue than its peers.

In the past ten years, the firm has had stable returns near cost-of-capital levels, implying that the firm has generated little economic value for its stockholders.

More importantly, the market is expecting First Gen’s profitability to maintain current levels within the next five years, in accordance with the historical trend of its as-reported ROA.

However, looking at First Gen’s real economic profitability, we see that the firm’s strategy has actually been seeing success. Although Uniform ROA has been similarly stable in the past decade, it has been sustaining levels almost double as-reported ROA levels.

Whether or not current valuation levels are still justified is up for debate, the more important takeaway here is that accounting distortions can entirely change a company’s market valuation and, in turn, an investor’s stock decisions.

Historically, one of the largest distortions for First Gen comes from the treatment of minority expenses or the income attributable to the non-controlling interests of a company’s subsidiaries.

The Philippine Financial Reporting Standards (PFRS) allows minority interest expense to be recognized under operating cash flow, misleading people to think that it is essential to the firm’s core operations.

In reality, it should always be classified as a financing cash flow. Minority shareholders provide capital to the subsidiary in exchange for a piece of the company’s profits. As a result, minority interest expense should not be subtracted from revenue when calculating a company’s real core earnings.

In 2019, First Gen recognized PHP 118.0 million in minority interest expense, resulting in a PHP 296 million net profit and a 7% as-reported ROA. Adding this back alongside the many other adjustments Valens makes, the company should actually be recognizing PHP 416 million in Uniform earnings and an 11% Uniform ROA.

First Gen’s earning power is stronger 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.

First Gen’s Uniform ROA has actually been higher than its as-reported ROA in the past sixteen years. For example, as-reported ROA was 7% in 2019, significantly lower than Uniform ROA of 11%.

Moreover, since 2008, Uniform ROA has expanded from 8% to 11% in 2019, while as-reported ROA has only improved from 3% to 7% over the same timeframe. The as-reported metrics are misleading investors’ perception of the firm’s historical profitability trend.

After rising from 15% in 2004 to 18% levels in 2005-2006, Uniform ROA fell to 8% in 2008. It then gradually improved to 11% in 2019, excluding a 12% outperformance in 2010.

First Gen is more efficient with its assets than you think

Trends in Uniform ROA have been driven by trends in Uniform asset turns. Since 2004, as-reported metrics have significantly understated First Gen’s asset utilization, a key driver of profitability.

Uniform turns improved from 0.6x in 2004 to 1.1x in 2006, before falling back to 0.6x in 2007 and rebounding to a peak of 1.2x in 2012. Since then, Uniform turns have declined to 0.5x-0.6x levels from 2014-2019.

Meanwhile, after expanding from 0.4x in 2004 to 0.6x highs in 2005-2006, as-reported asset turnover dropped to a low of 0.2x in 2007, before recovering to 0.5x levels in 2009-2012. Then, Uniform turns compressed to 0.3x levels in 2015-2017, before slightly rising to 0.4x levels in 2018-2019.

As-reported metrics have been making First Gen appear to be a far less asset efficient business than real economic metrics highlight.

SUMMARY and First Gen Corporation Tearsheet

As the Uniform Accounting tearsheet for First Gen highlights, the Uniform P/E trades at 9.6x, which is far below corporate average valuation levels but near its own history.

Low P/Es require low EPS growth to sustain them. In the case of First Gen, the company has recently shown a 48% 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 PFRS earnings and convert them to Uniform earnings forecasts. When we do this, First Gen’s sell-side analyst-driven forecast calls for a 4% Uniform EPS decline in 2020 followed by a Uniform EPS growth of 8% in 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify First Gen’s PHP 23.85 stock price. These are often referred to as market embedded expectations.

The company can have its Uniform earnings shrink by 15% each year over the next three years and still justify current valuations. What sell-side analysts expect for First Gen’s earnings growth is above what the current stock market valuation requires.

The company’s earning power is about twice the long-run corporate average. In addition, cash flows and cash on hand are above its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.

To conclude, First Gen’s Uniform earnings growth is well above peer averages, and the company is trading well below its peer average valuations.

About the Philippine Markets Daily
“Tuesday 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 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 Earnings Tearsheet on a Philippine company interesting and insightful.

Stay tuned for next week’s Philippine company highlight!


Angelica Lim
Research Director
Philippine Markets Daily
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