Don’t underestimate the listed network operators

Listed network stocks and the upside from the recent Victorian decision

There are three stocks listed on the ASX that have significant investments in Victorian electricity distribution and transmission assets.

They are Ausnet (formerly SP-Ausnet) which owns Victorian electricity transmission, distribution and Victorian gas distribution assets;

DUET, which owns Victorian electricity distribution, Victorian gas distribution, West Australian gas transmission and last year bought the remote energy and “clean” energy focused Energy Developments;

and finally Spark Infrastructure, which owns two Victorian electricity distributors, South Australian electricity distribution and is now a 15% part owner of the NSW electricity transmission network.

An indication of financials of these investments is shown in Figure 1. These numbers are only indicative and contain various assumptions which may not be apparent at first glance.

Investment Proposition

As a result these stocks tend to trade on a yield basis and are commonly compared with the banks, property stocks and other infrastructure stocks (Transurban, Sydney Airport) in investor portfolios. APA is another strong contender in this space. The Victorian utilities typically have higher yields than nearly all the above stocks but in general are forecast to have lower growth rates in their distributions.

This leads to the “total return” concept. If a stock sells at a yield every year of 5% and its dividend is growing 2% each year then an investor will get a compound return of 7% and this can be compared with yields on other stocks and and fixed interest investments.

The basic investment proposition of these businesses is to provide security holders with predictable and growing cash distributions. For that reason they are typically structured as stapled (ie indivisible) securities (a non trading trust and a trading company). The trust raises the money and pays out cash to equity holders, it onlends the capital to the companies which carry out the business.

The trust gets cash back from the company in the form of interest on loans, loan repayments and dividends and then passes the cash on to security holders. As a passive trust distributing all its profits the trust doesn’t pay tax. Typically some of the cash received by security holders is in the form of “loan note” repayments and this is free from income tax but reduces the cost base for capital gains tax.

For instance we estimate the three listed stapled securities with interests in Victorian distribution assets offer a total return of 7.4%-10% per year over the next three years. Since in most cases management have provided reasonably explicit distribution “guidance” this is not a particularly difficult calculation, but like anything else in the share market, readers are advised to do their own calculations and management forecasts are no substitute for proper analysis.

Looking at the recent final decision in Victoria we estimate that distribution yields can increase further if the ACT decision for the NSW distributors is upheld in the Federal Court. Basically the AER took no account of the ACT decision in making its revenue allowances. This means that it estimate a high “gamma” of 0.4 rather than o.25. Gamma the extent to which the market values dividend franking.

Much more significantly, the AER continue to apply its preferred measure of moving to a 10 year trailing average cost of debt whereby the averaging process starts in year 1. The utilities want their existing 10 year average to be used. Since interest rates were higher in the GFC than today this has a big impact on returns.

Fig 3 below shows that adopting the utilities preferred method would lift their return on capital by 20% for the Victorian electricity part of their assets.

Regulatory Monopoly Locks In Returns – Consumers Get No Choice , The Regulated Asset Owner Is The Gatekeeper

In Australia, and based on the UK model, electricity and distribution is rightly regarded as having monopoly characteristics. As such the prices charged are regulated and determined by the regulator which in this case is the Australian Energy Regulator [AER]. Although the method of revenue determination has seen some changes over the past decade the underlying premise remains the same and consists of four elements, return on capital, return of capital (depreciation), operating expenditure and an allowance for tax.

This sounds simple but tends to result in 1000s of pages of submissions and increasingly court cases. The so called “rates case” for each asset takes place once every five years. Under the most recent iteration the AER has moved to a “revenue cap” as opposed to the prior method of a “price cap”. Under a revenue cap the asset owner doesn’t take any volume risk. If the prices charged don’t recover the predetermined revenue then after a true up the prices are adjusted in the following year.

Since the fortunes of the regulated business depend on what the AER allows them there is a “robust” amount of toing and froing over the regulatory review process. One of the best gigs going in utility consulting land is providing advice to one or the other side about the appropriate return on capital or opex or capex requirements. Over a period of about 18 months the regulated business submits a “proposal” backed up submissions from its team of experts, the AER issues a “draft decision” backed up by its experts, the regulated business submits a revised proposal and the AER issues a “final decision”.

However, it’s generally not final because the regulated business then “complains” to a legal body the Australian Competition Tribunal and as we saw from Is better regulation dead on arrival there are now subsequent appeals to the full Federal Court. In this analyst’s view the consumer is ill-served by the entire process. Management of the regulated business are typically able to out maneuver the AER and the businesses are often successful in the ACT.

Since some, although less and less, of the business are owned by State Govts and State Govts are the vast majority of the ultimate policy maker, the Standing Committee on Energy and Resources [SCER] there is something of a potential conflict of interest. A better system would be to encourage competition within the networks and try to reduce their monopoly characteristics. This is one reason why distributed PV and storage are such important drivers of change. They represent a disruptive potential to the networks that can’t be managed as easily. That said PV has not been able to slow down regulated asset performance in South Australia.

Capital Structure – debt is managed to a credit rating and runs 70-80% of regulated asset base

In any event the Victorian electricity networks are generally regarded as some of the most efficient in Australia. In addition PV is less of an issue in colder Victoria than it is in NSW or QLD or South Australia. Despite all the worries most of the businesses are still well regarded by their investors and are still pretty much growing as they have since the financial crisis. In fact the market’s rating of these businesses has rarely been higher.

If we look at the capital structure the first thing to note is the operating cash flows are very predictable. Revenues are locked in and opex is generally a small proportion of revenue so there is little chance of a cost blow out causing problems. As a result most regard these businesses as being able to manage far more debt in their capital structure than “normal” businesses. The only major threats are regulatory and a capital strike. If the regulator were to make a step change reduction in cash flows this might hinder payments to either debt or equity or both.

On the other hand if banks just decide they don’t want to provide as much debt finance as previously, as happened during the GFC this is also a problem. Fortunately that’s rare. These days these stocks target a credit rating, BBB- in the case of DUE, BBB for SKI and A-for AUS and this drives the quantity of debt. The key financial ratio tends to be net debt: ebitda. The good thing about this ratio is its independent of interest rates. Rates are low and perhaps the biggest fallacy in financial markets is that low interest rates mean you can borrow more. In fact, low interest rates are typically associated with low or even negative inflation and this makes debt hard to pay off. Its better to have lots of debt when inflation and interest rates are high rather than the reverse.

Networks may turn PV and storage to their advantage

There is a lot more to be said about these businesses but we only want to note here how the networks are coping with and adapting to new technology (PV and storage). In our view consumers best protection is to do it for themselves. Storage may seem expensive today but the independence and bargaining power it brings shouldn’t be underestimated.

Firstly here are some comments from a recent AST presentation:

“Mooroolbark Mini Grid Project – first trial of its kind in Australia, involving 14 homes enabled with solar panels and battery storage, with a common connection to the grid. Each house will be capable of generating and storing its own electricity and can share electricity with other houses in the mini grid.

› Residential Energy Storage trial – 3 year trial of 10 homes in outer Melbourne found that a typical residential customer with solar panels could save $1,500 over five years by adding a battery storage system. However, the potential benefit for a network from the same customer system could be up to $3,000 over five years (depending on location), or double the direct customer benefit.

› Grid Energy Storage System (GESS) – 1MW battery system and smart inverter located at Thomastown Terminal Station providing network support. Recently a network fault resulted in an outage located on the same feeder as the GESS. The GESS was able to power 104 commercial and industrial customers, downstream of the facility, via battery storage. This was the first time it had been initiated in response to live network conditions, reducing customers’ outage by around 2 hrs & 20 mins.” Source: AST presentation May 12, p 28

Secondly we show some data over the past 6 years for SA Power networks, a significant part of the SKI portfolio. This is interesting to us because South Australia has 24% of households with PV on the roof and also a relatively small percentage of industrial and large commercial businesses.

Figure 4 below shows that for better or for worse the business has coped very well with the widespread penetration of PV. Volumes have declined, particularly in residential (including hot water) and in large business, but revenues, profits and the asset base have grown at about a 5% compound pace. The return on capital is marginally higher than it was in 2010. Of course this may not persist indefinitely but we doubt that PV by itself will have much impact on investor returns under current regulatory arrangements.