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Spark stands out as a defensive value pick

Glenn Freeman  |  09 Jan 2020Text size  Decrease  Increase  |  
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Among the seven utilities in Morningstar Australasia's research stable, Spark Infrastructure (ASX: SKI) stands out as a defensive play trading below its fair value estimate.

Companies that provide basic amenities such as electricity, water, sewage services and natural gas are usually described as defensive because they're heavily regulated and deal in long-term contracts that help them ride out volatility.

And like other "defensives" including property trusts and infrastructure stocks—which are sometimes also known as bond proxies because of their fixed income-like characteristics—they usually provide a reliable income stream.

Aus Utilities

Source: Morningstar Direct

At a time when most higher yielding stocks are considered expensive, Morningstar senior equity analyst Adrian Atkins views Spark as good value.

Its closing share price of $2.10 on Thursday sees it almost 13 per cent below Morningstar's $2.40 fair value estimate. Atkins has this week lifted his fair value estimate by 4 per cent from $2.30.

Branching into renewables

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Purchased by Spark in April 2019, Bomen is a solar farm located in Wagga Wagga in central NSW. It is expected to come online around June 2020 when construction of the project is complete.

"While lower regulated returns and rising tax payments will cause earnings and distributions to investors to fall in coming years, the hit should be softened by the start of revenue from the Bomen solar farm, cost-saving initiatives and bonuses for good network reliability," Atkins says.

Also in NSW, Spark owns 15 per cent of electricity transmission network TransGrid.
The company also owns a 49 per cent stake in three electricity networks—CitiPower and Powercor in Victoria and South Australia's SA Power Networks.

The Victorian networks contribute around half of Spark's earnings before interest, depreciation and amortisation. SA Power provides 40 per cent of earnings, and TransGrid makes up the remainder.

A different kind of tariff dispute

Regulated tariffs comprise between 80 per cent and 90 per cent of Spark’s group revenue, the rest comes from unregulated and semi-regulated tariffs.

These tariffs are set in negotiations with a government entity, the Australian Energy Regulator, which resets the tariffs every five years.

Unregulated tariffs include services on power distribution networks owned by other entities or which are leased.

The semi-regulated component includes public lighting and meter-reading services.
Atkins says these operations are generally higher-margin but are more volatile.

"To diversify away from regulated assets, Spark has been growing its unregulated asset base by building transmission connections to new wind and solar farms," he says, the most recent being the Bomen solar project.

"Regulated revenue is highly secure and predictable between regulatory resets. Unregulated and semi-regulated revenue can be lumpy, particularly as a result of externally initiated projects."

But overall, Atkins says group revenue is highly defensive.

A government focus on cutting power bills for Australian consumers has increased the red-tape Spark and its rivals face.

"For now, the regulator continues to attack network companies to improve utility bill affordability after significant growth in retail electricity prices in the past decade," Atkins says. "Nevertheless, there are a few reasons for optimism."

The intense scrutiny from the Australian Energy Regulator has forced power companies to pass on the benefit of falling interest rates to households and business—which Atkins says is fair enough.

But he doesn't expect much further pressure from the AER to cut the equity returns operators are allowed to generate.

This is largely because of the record low yields on 10-year government bonds, which dipped below 1 per cent for the first time last August.

"Essentially, network investors can expect a return equal to the bond yield plus a premium to compensate for higher risk," Atkins says.

"As the bond yield falls, so too does the return the regulator allows. That's fine in a normal market, but bond yields are being suppressed by extraordinary global central bank intervention, with the Reserve Bank of Australia potentially joining the fray in 2020 with quantitative easing."

Atkins questions whether the government will expect energy networks to generate ultra-low returns given that bond yields are being artificially suppressed.

The next round of regulatory resets take effect from 1 January—including for Spark's South Australian and Victorian grid networks—and allowed returns on equity are set at just 5 per cent.

"After adjusting for inflation, that's a real return of a little over 3 per cent," Atkins says.

"That's a paltry return considering risks from regulation, the potential for another credit crisis, and, over the longer term, falling usage as residential solar and battery solutions become cheaper."

Problems could arise if utility companies then struggle to attract the institutional investment required to fund network upgrades.

These risks are further heightened by the removal of a regulatory appeal mechanism, the Limited Merits Review. This was scrapped in 2017 because successful appeals by power companies were "getting in the way of reducing utility bills," says Atkins.

"Returns can only fall so far, however, before companies baulk at funding upgrades. We think 2020 could see a compromise to get Australia's transition to renewable energy back on track."

is senior editor for Morningstar Australia

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