Ecofin Global Utilities and Infrastructure Trust (EGL) has announced its annual results for the year ended 30 September 2018. During the year, EGL provided an NAV total return of 4.8%n and a share price total return of 1.1%. According to EGL, this compares against a 4.9% return for the MSCI World Utilities Index. The superior Nav return reflects a widening of the discount over the period (the discount averaged 11.3% during the year and was 13.6% as at 30 September 2018). These returns were provided during a year which the trust, as described by its chairman David Simpson, “faced considerable headwinds”. David goes on to say that these took the form of volatile equity markets, rising interest rates in the US and rising global bond yields, together with continued political uncertainty. EGL’s dividend was 75.3% covered but the manager expects this to improve aided by a reduced management fee.
Dividends – 75.3% covered with shortfall drawn from capital
Dividends totalling 6.40p per share were paid to shareholders during the year (these being equivalent to a dividend yield of 4.4% based on net asset value at 30 September, 2018 and 5.1% based on our share price at the same date). EGL says that income from investments grew in line with the Investment Manager’s forecasts and rose by 6.0% year-over-year on a comparable basis. However, the revenue return after tax was negatively impacted by the changed categorisation of research costs post MiFID II and by the cessation at the end of September 2017 of a management fee rebate from Ecofin. As a result, the dividends paid were 75.3% covered by net revenues – approximately the same as in the previous financial year – and the shortfall was drawn from the capital account.
Reduced management fee and other measures should improve the dividend coverage ratio
EGL reports that it will be benefitting from a reduced management fee. With effect from the passing of the continuation vote at the AGM, the annual investment management fee will be reduced to 1% net assets. Furthermore, EGL has also advised that it will cease to pay a contribution to the Investment Manager’s research costs from this date. In addition to these significant cost savings, the Investment Manager says that it fully expects that income from our investments will continue to grow by 6-7% per annum, permitting the dividend coverage ratio to improve and enabling an increase in the dividends paid to shareholders in due course.
Ecofin limited acquired by Tortoise Investments LLC
On 3 December 2018, it was announced that EGL’s investment manager, Ecofin Limited, had been acquired by Tortoise Investments LLC (Tortoise). Tortoise is a privately owned U.S. investment management firm based in Kansas City, USA. Tortoise is a specialist investor in energy infrastructure and manages some US$20 billion of client funds, including five New York Stock Exchange listed closed-end investment funds. EGL’s manager says it expects that the new combination will enhance the resources available to Jean-Hugues de Lamaze and his team and the expertise dedicated to the Company’s portfolio, especially in North American companies.
Manager’s commentary on performance
For the year as a whole, the NAV per share increased by 4.8% on a total return basis, in line with the return on the MSCI World Utilities Index and ahead of the iShares Global Infrastructure ETF. After a difficult first half of the financial year when investors favoured sectors likely to benefit most from the boost to earnings and GDP growth triggered by US tax reform and the NAV declined by 6.4%, the Company’s sectors recovered during the second half of the financial year and the NAV rose by 12.1%. While markets coped with escalating trade and geopolitical tensions, bond yields and risk tolerance retreated during the summer months and more defensive sectors gained favour.
Share prices in our sectors remained more volatile than usual, impacted regularly by the course of interest rates in the United States – which affected sentiment everywhere – and by political risk in the U.K. and Italy. The Company’s sectors tended to advance and outperform the broader averages at times when investors believed that economic and inflation data would moderate or else that trade protectionism would dampen growth. Companies in our sectors were also benefitting from improving fundamentals, years of cost cutting and asset reorganisations. The sectors came under real pressure however, when we saw an acceleration higher in longer term bond yields.
By region and by sub-sector, the majority of the advance in the NAV over the course of the year was generated by the North American and ‘Rest of World’ portfolios, and amongst integrated utilities and renewables. The best performers included NextEra Energy, Exelon and Covanta in the US and a trio of names in the Company’s relatively small non-OECD and emerging markets portfolio: China Longyuan Power, B Grimm Power and APA Group. B Grimm Power and APA Group were both the subjects of take-over bids. In the pan-European portfolio, EDF and Drax Group performed extremely well, countering the weakness in other U.K. utilities, Suez and Enel. Beijing Capital International Airport also performed poorly reflecting market weakness and an earlier than expected halt to its receipt of refunds for certain construction fees. Despite a significantly lower allocation to US equities than the MSCI World Utilities Index (circa 41% versus the Index’s 59% as at 30 September, 2018), the NAV managed to perform in line with the Index due to good stock selection.
Manager’s commentary on sector and portfolio developments
Top-down macro pressures on the Company’s sectors persisted through the financial year. At the same time, most companies in our space were delivering improved results and our confidence in their future earnings and cash flow potential was being fortified by company guidance and capital expansion programmes – focussed on clean energy and new infrastructure – and by significantly higher power prices. Take-overs and asset-swapping have also re-emerged after years of inactivity.
Most of the material changes to the portfolio occurred in the first half of the financial year and were outlined in the Interim Report. We were active in repositioning the portfolio in the first calendar quarter of 2018 when President Trump’s tax reforms were introduced; they were expected to super-charge the domestic economy and triggered a swift rotation into cyclical areas of the market. The portfolio’s exposure to regulated utilities, regarded as bond proxies, was reduced significantly in favour of renewables and integrated utilities with more diversified business models. This strategy proved worthwhile. More recently, the Company’s holdings in renewables, specifically holdings in emerging markets and of “yieldcos”, have been pared. As a risk reduction measure and with profits on both, we sold the positions in China Longyuan Power, the wind developer, as volatility in emerging markets became uncomfortably high, and in the US yieldco Pattern Energy when a new provincial government in Ontario cancelled some new green energy projects. Additionally, the acquisition announced in February of the yieldco 8point3 Energy Partners by Capital Dynamics closed in June, returning cash to the portfolio. Some of the proceeds were invested in under-rated European shares such as Engie, which is emerging from a multi-year restructuring with a low-carbon generation business, RWE, the baseload power generator which will soon be one of the largest wind operators worldwide, and National Grid, partly reflecting our view that the company’s US assets and operations are undervalued compared to US peers.
The regional composition of the portfolio did not change greatly but there were developments influencing investment strategy. As they did in the previous year, utilities in the U.K. came up against significant political risk and regulatory uncertainty. The prospect of nationalisation of parts of the sector under a possible Labour government and the continuing calls for caps on pricing and lower allowed returns in retail electricity and water supply caused prolonged weakness in share prices. SSE and National Grid, together accounting for about 6% of the portfolio on average, cost the NAV nearly 0.9% during the year. SSE’s profit warning in September was disappointing and unhelpful to already poor sentiment in the sector. On a more positive note, one of the best performers during the year was a new holding, established in November 2017, in Drax Group which generates 6% of the U.K.’s electricity and 11% of its renewable electricity. As power prices in the U.K. have increased by 25% since 1 January, 2018 (to 30 November, 2018), Drax shares have performed strongly and alone contributed about 1% to NAV performance.
European power prices have also risen substantially. French and German 1-year forward power prices are 23% and 37% higher, respectively, since 1 January, 2018 (to 30 November, 2018) as a result of much stronger commodity prices (mainly coal and natural gas). Demand for electricity, and therefore high quality thermal coal, has been strong in Asia. Additionally, a tight market and hence rapidly rising prices has emerged for carbon emission allowance certificates, a meaningful component in power prices and generation margins. Agreement to reforms of Europe’s Emission Trading Scheme reached earlier this year should reduce the outstanding supply of emission allowance certificates. CO2 prices have responded impressively; having moved between €5/mt and €8/mt for about 5 years, they have increased by 150% this year-to-date to €20.4 now (as at 30 November, 2018). The prime beneficiaries of higher CO2 prices are fixed cost generators – nuclear, hydro, wind and solar – which reap higher power prices without the corresponding cost increases. EDF’s shares have performed very well as the company’s earnings margin is one of the most exposed to improving power and CO2 prices.
Even though they lagged behind the S&P 500’s advance, US utilities performed well compared with other regions during the year, and particularly since March as Sterling-based investors had the benefit of an appreciation in the US dollar of nearly 7%. Power prices increased but the main driver was a flattening of the US yield curve. Several of our best performers during the year, especially in the last 6 months, were US utility and power infrastructure names: NextEra Energy, Exelon, Covanta and NextEra Energy Partners. These companies are among the Company’s largest holdings and their businesses are described on pages 7 and 8 of the Annual Report and Accounts. For the most part, they are large, cleaner than average electricity generators and suppliers and major investors in infrastructure for electricity and gas transmission & distribution. Capital investment programmes are typically orientated toward grid modernisation, reliability and inter-connection and designed to support the rapid growth in generation from clean fuel sources. A new holding in Public Service Enterprise Group, an integrated utility, is a good example in this respect. The company will invest over $15bn over the next several years to upgrade energy infrastructure in its region and its rate base should grow by 8-10% per annum, setting the stage for dividend growth.
In addition to the widespread exposure to energy infrastructure within major utilities’ businesses, we also invest in infrastructure directly, for example in pipelines (Williams Companies, owner and operator of infrastructure to process and transport the growing volumes of output from shales), in airports (Beijing Capital International Airport, Flughafen Zurich and Spain’s Aena), and in diversified infrastructure groups such as Ferrovial and Vinci. Airports proved to be the most challenging sub-sector during the year as traffic growth subsided after several years of recovery.
Manager’s commentary on outlook
We are confident that the sectors we invest in – essential assets and services – will provide attractive returns for shareholders over the next few years. Equity valuations are reasonable by historic standards and by reference to the growth in earnings and dividends that we expect. Companies are being incentivised by governments and regulators to commit the capital required to decarbonise electric power by investing heavily in renewables and to substantially overhaul existing energy infrastructure. The portfolio, we believe, includes the top-flight renewables developers globally, such as NextEra Energy, Iberdrola and Enel, as well as offering exposure to turnaround situations such as Engie and emerging markets. It also includes companies like National Grid whose shares would be priced very differently if the company was rated like its US peers. Our stock selection will continue to focus on balance sheet quality and the prospect for growth in cash flow and dividends.
For much of this year, rising interest rates have put share prices in the Company’s universe under pressure; there is also considerable uncertainty around future energy policy in the U.K. which is damaging to valuations. Sentiment has weighed heavily on U.K. utilities to the extent that there is now deep value in names such as National Grid, SSE and Pennon. However, we will continue to invest the majority of the Company’s assets in North American and continental European utility and energy infrastructure businesses where regulatory frameworks are stable and growth prospects are clearer.
In the US, interest rates are likely to continue to rise but we know how to diversify the portfolio so as to perform in such an environment. The need to upgrade or replace the existing network infrastructure, which was built in the middle of the twentieth century with a life expectancy of about 50 years, coupled with the requirement to accommodate the penetration of renewables and the digitalisation of the supply network are the drivers for growth for the companies in our universe.
In continental Europe, economic growth is not sufficient to encourage the ECB toward a sooner or more rapid rise in policy rates. Companies in our sectors are making real progress in terms of profitability, balance sheet strength and simplification. They are reorganising their stables of assets and services and, for the most part, the era of severe cost cutting post the financial crisis is behind them. Recently, these strides have been masked by macroeconomic and political concerns. Continuing improvement in corporate fundamentals and the expected benefits from the recovery in power prices should be positive for portfolio returns.