Pacific Hydro's price fall

Before we consider whether it's now attractive let's briefly re-cap. Pacific Hydro is the archetypal ethical stock.

Coal burning power stations – the source of much of our electricity – are expensive, polluting leviathans. Pacific Hydro produces electricity from wind and water, a far cleaner and environmentally friendly method.

Evidence mounting

The evidence is slowly mounting that increased greenhouse gas emissions, of which coal-fired power stations are a major source, are contributing to global warming.

As a response a global system of carbon trading is being introduced. Essentially, it's a way for countries to buy and sell their right to pollute.

This, plus government-backed renewable energy legislation pushed Pacific Hydro's share price from around 70 cents in 1998 to over $4.50 in 2001.

Best of all, the company has managed to take advantage of this potential very profitably.

Over the past few years Pacific Hydro has achieved a return on equity of 20% (see issue 87's Investor's College). What prevents us from recommending the stock now is that we believe this handsome figure is likely to fall.

This is a capital-intensive business. The company's next project is for a $300m wind farm in Portland, Victoria. It will be ten times bigger – and ten times more costly – than its current biggest plant in Coddrington.

This will be followed by another wind farm, expansion of its Philippine's hydro project and a new project in Chile in a joint venture with German company Lahmeyer International – a 270mw hydro plant due to start construction in mid-2003.

All up, Pacific Hydro will need over $600m in new capital to get these projects running. Now, considering the company's current capitalisation stands at $439m, that's a fair whack.

The use of debt will increase fundamental risk and interest payments and share placements or issues will dilute earnings per share.

Again, it's a case of the pizza base getting bigger (see the feature in issue 93).

Good income

This is not to say that this expenditure is a bad thing. The fact that in its latest December half-year, Pacific Hydro generated operating cash flow of $17m is testament to the fact that these projects will produce a good income stream. But that is some way off and as we have seen with Energy Developments, any technical delays will hit the share price.

Given the future capital demands, the time lag in their ability to produce an income, a paltry dividend yield of 0.9% and a share price that still looks a little expensive, the risk-reward profile is not sufficiently attractive to tempt us.

Indeed, we'd go as far as saying that the share price could still fall a good deal further, which is why we're sticking with SELL.

The share price would have to fall back towards $3.00 before we'd review this position.