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.
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.
