Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Today, I’m considering whether FTSE 100 utility company SSE (LSE: SSE) (NASDAQOTH: SSEZY.US) is a wonderful company, and whether its shares are trading at a fair price.
A wonderful company?
Buffett’s Berkshire Hathaway investment company holds just shy of 90% of the equity of an unlisted utilities group called MidAmerican Energy. MidAmerican has a portfolio of regulated utilities businesses, mainly within the US, but also within the UK in the shape of Yorkshire Electricity and Northern Electric.
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Buffett says he trusts utilities regulators to allow reasonable returns. His confidence is based on both “our past experience”, and “the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects”.
Buffett is happy to make the necessary “huge investment in very long-lived, regulated assets, … partially funded by large amounts of long-term debt”.
So, in turning to SSE, let’s begin with debt. MidAmerican has net debt of $20.85bn against equity of $15.91bn, giving net gearing of 131%. Another utilities company, called NV Energy, which MidAmerican has recently bid for, has net gearing of 133%.
Now, SSE employs something called ‘hybrid capital’ in addition to its regular debt. Hybrid capital is a peculiar beast, with some of the qualities of debt and some of equity. If we add this to both sides of the equation, we get net debt of £7.35bn on equity of £5.55bn, giving net gearing of 132%, bang in line with that of MidAmerican and NV Energy.
Wonderful companies deliver a high return on equity (ROE), something Buffett looks for as measure of “managerial economic performance”. For the latest financial year, MidAmerican delivered an ROE of 9.4%, NV Energy of 9.1% and SSE of 8.8%. So, I’d say SSE is in the wonderful-company ballpark on this measure.
A fair price?
MidAmerican’s bid for NV Energy, gives us the opportunity to look at the so-called ‘takeover multiple’ of EV/EBITDA. EV stands for enterprise value, which is a company’s market capitalisation, plus net debt. EBITDA stands for earnings before interest, tax, depreciation and amortisation.
MidAmerican has bid $23.75 a share for NV Energy. At that price the EV/EBITDA works out at 8.9. Now, with SSE we again have the problem of hybrid capital. However, at a share price of 1,422p, no matter how favourably I treat SSE, the most attractive EV/EBITDA I can get is 11 — in line with the wider sector average.
SSE has similar debt and ROE qualities to Buffett’s utilities businesses, so I reckon it comes close to being a Buffett wonderful company. In terms of valuation, while not at the ‘bargain’ level of NV Energy, I’d say SSE is at possibly a ‘fair’ price.
