Solid dividend, earnings outlook for this utility

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<p><strong>Glenn Freeman</strong>: I'm Glenn Freeman for Morningstar, and I'm joined today by Adrian Atkins, one of our Senior Equity Analysts.</p> <p>Adrian, thanks for your time today.</p> <p><strong>Adrian Atkins</strong>: No problem, Glenn.</p> <p><strong>Freeman</strong>: Now, Adrian, we are talking about Contact Energy, a New Zealand-listed utility company. Why is this one of your preferred picks in this space and what distinguishes it from some of its competitors?</p> <p><strong>Atkins</strong>: All the New Zealand generators have a lot of renewable energy and that's coming from hydroelectricity and geothermal, and we think they are really good quality renewable assets. In contrast, here in Australia, we mostly rely on coal and gas-fired power. We have a small amount of renewables, but that's mostly wind and solar, and they are not as good because it's intermittent supply. You are not getting the power when you want it; you are getting the power when the wind blows. So, we think for that reason New Zealand is actually really well placed. It's kind of future proofed in that they already have very good quality renewable assets.</p> <p>Contact, like most of the utilities, is a good quality company. What differentiates it from the peers is that it's a lot cheaper. It generates very strong free cash flows and it's got a big dividend yield with pretty decent longer-term earnings potential.</p> <p><strong>Freeman</strong>: And Adrian, can you talk us through a bit about what Contact does and what is a gentailer?</p> <p><strong>Atkins</strong>: Well, gentailer is just a term combining the two words, generator and retailer. So, these guys both produce electricity and sell that into wholesale markets and then also a retail division which sells to your residential and business customers. So, very similar to AGL in Australia.</p> <p><strong>Freeman</strong>: And more broadly speaking, utility companies are generally regarded as defensive stocks and as dividend payers. Where does Contact fit within this context?</p> <p><strong>Atkins</strong>: Yeah, that's exactly how we think about Contact. It's pretty defensive kind of company, and it's got a big chunky dividend yield. We think it will pay a yield of about 6.5%, mostly franked, in fiscal 2019. So, that's very attractive compared to what you are going to get in the bank and to most other companies.</p> <p>Utilities provide an essential service. So, there's always going to be demand. And the good thing about these utilities is, they are vertically integrated. So, they are both generate electricity and sell to retail customers. So, they know at what kind of price they are going to be generating an electricity for and also, what price they are going to get for selling it. And so, that keeps their earnings fairly stable, though there can be a bit of volatility based on rainfall patterns meaning that so much of the power they produce comes from hydroelectricity.</p> <p><strong>Freeman</strong>: And Adrian, what are some of the potential business risks that Contact faces which investors should be aware of?</p> <p><strong>Atkins</strong>: There's a couple of risks, but we are not too concerned with them. The first is the Tiwai Point Aluminium Smelter. That's a major electricity user in New Zealand. It was considering closing a couple of years ago. And if did close, then the industry would be oversupplied electricity and that would keep the wholesale price low and reduce the ability to make profits. But we don't think that it's going close in the foreseeable future because the aluminium price has increased significantly and the business has also stripped out some costs. So, it should be making pretty good money at the moment.</p> <p>Another risk is regulation. Once again though, we are not too concerned by that because regulation only really becomes an issue when companies are pushing up prices and making big profits and that hasn't been the case in New Zealand recently.</p> <p><strong>Freeman</strong>: And lastly, as a dual-listed company in Australia and New Zealand, are there any aspects that investors should be aware of?</p> <p><strong>Atkins</strong>: Yeah, that's a good question. Unfortunately, the liquidity on the ASX is very low. So, it makes it very difficult to buy and sell shares in Contact Energy on the ASX. I would actually recommend seeing if you can open an international account where you can buy shares on the NZX. I think CommSec and other major brokers do offer that service.</p> <p>Another thing to consider is the franking. So, the dividends are imputed for NZ residents but not for Australian residents. But you do get a small supplementary dividend which is worth a few cents per year. So, instead of getting the 6.5% yield in FY '19, I think you'll probably get a 7% yield but with no franking.</p> <p><strong>Freeman</strong>: Thanks very much for your time today, Adrian.</p> <p><strong>Atkins</strong>: No problem, Glenn.</p> <p><strong>Freeman</strong>: I'm Glenn Freeman for Morningstar. Thanks for watching.</p>

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