Hydro One Update, August 2016

Hydro One Update

August 24, 2016

Michael Mountford and I sat down with the Michael Vels, the CFO of Hydro One as well as Omar Javed, the Director of Investor Relations also at Hydro One today (Aug 11, 2016) for a unique one on one meeting.  Below are some of the highlights from our meeting:

 Where does management see Revenue or Earnings gains coming from?

The shorter term goal is to focus on operational efficiency.  Hydro One’s revenue will grow by increasing their rate base, which is the value of property on which a public utility is permitted to earn a specified rate of return, in accordance with rules set by a regulatory agency. In general, the rate base consists of the value of property as used by the utility in providing service.  As the rate base grows they can ask for larger rate increases from the Ontario Energy Board (OEB).  The more efficiently they can grow the rate base the bigger their spread between revenues and costs and therefore the corresponding net income will be larger.  Management recognizes that there is limited scope for large scale increases in earnings from using this strategy.  That said these increases can provide very steady returns on investment.

Hydro One’s Acquisition Strategy.  We asked a general Question focused around following Canadian counterparts to USA and Hydro One’s strategy.

Current rumoured, but known, discussed acquisitions on the table include both Peterborough and Orillia energy providers.  These are not significant events and will only marginally increase EPS for Hydro One.  That said we did discuss the need or desire to grow south of the border.  The conversation was vague but Michael did indicate that it was on their radar and they are building out their capabilities in that area.  Mayo Schmidt (Hydro One’s CEO) and Michael Vels together in their previous roles had both completed over 100 acquisitions and have the skillset to carefully undergo a successful acquisition campaign.  They are not in a position to acquire now but when the timing is right will look for a good fit both from a strategy and regulatory perspective.  Michael Vel’s did indicate that a successful US acquisition could have a significant impact on Hydro One’s earnings.

Hydro One’s Pension Fund Funding and Strategy

The pension is currently 100% funded.  The assumptions in the pension require a 6.5% return in order to maintain that status.  Michael Mountford very politely suggested that 6.5% may be somewhat lofty in today’s environment due to current fixed income yields.  Michael Vels was quite confident that with a combination of both public and private market investments it would be fairly easy to obtain.  All new employees are no longer eligible for the Defined Benefit pension (guaranteed company pension) but rather Defined Contribution (DB).  A Defined Contribution (DC) pension plan switches the onus/risk of the plan from the employer to the employee.

How would alternative technologies such as a combination of affordable home power storage system (batteries) and low cost solar systems affect Hydro One?

Michael Vels was quite confident that this would unlikely be a threat.  The current regulatory regime would not allow for such a transformation en masse, in Ontario, and self-dependent hydro generation is an unlikely proposition currently.  The reason for this was that you are either on or off the grid and there is no allocation for a hybrid system.  Regulation seems inflexible in our view and technology is likely to leapfrog regulations at some point.  But for the foreseeable future Hydro One’s transmission service is unlikely to be disintermediated.  In their words they are the delivery system regardless of the generation method.  “They drive the truck”, I believe were their words.

Hydro One’s Current dividend payout ratio is somewhere between 70% and 80%.  Is there any room to raise the payout ratio?

The dividend payout ratio is the proportion of earnings that are paid out in dividends.  Hydro one has little room to increase the payout ratio currently.  Any dividend increases will likely come vis a vis a larger rate base and operational efficiencies as mentioned above.  One of the reasons for the inability to raise the payout ratio has to do with Capital Expenditures.  This does not mean the dividend can’t increase.  One of Management’s goals is to raise the dividend over time.  Currently Hydro One is re-investing in its rate base at multiples of two to three times the current depreciation rate.  This reinvestment allows for greater returns vis a vis increased allowable rate increases.

 Does the Government of Ontario’s ownership hamper decision making or operations? 

The short answer was no.  The Ontario government acts as a large shareholder and apparently was quite happy to be out of managing Hydro One.  In fact, according to Mr. Vels, the relationship with both the government and the regulator has improved significantly since Hydro One went public last year.

Does the Union Hamper Productivity Growth?

Again the short answer was “not really”.  Hydro One is working closely with the Union to see how they can roll out new technologies to increase worker efficiency.  For example, satellite positioning and online work orders and scheduling.  Again Hydro One is confident they can roll out new technologies in an appropriate manner.  Michael Vels feels that the company’s relationship with the union(s) has actually improved since listing on the TSX.  The company has a generous share purchase program which all employees can participate in.


Overall it was a very good meeting and we were quite lucky to get this time with Michael Vels and Omar Javed.  We left feeling very positive about our holdings in Hydro One.  In the short run we expect a steady return from dividend payments and earnings to increase steadily over time.  Owning Hydro One somewhat hedges us against future electricity rate increases in our hydro bills.  In addition we left feeling quite confident that when the timing is right and the opportunity presents itself management will undertake strategic accretive acquisitions that will benefit shareholders.

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Daniel Fearon | Investment Associate



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