Utility Deals Down Under

Editor's Note: The following is a free preview of our sister publication Australian Edge. It's the In Focus feature from the June 2014 issue.

Australia in general offers some of the highest-yielding stocks in the world. The companies profiled below provide generous dividends backed by essential-service businesses, the types of companies that populate the Utility Forecaster Portfolios and the How They Rate coverage universe.

For more on Australian Edge, go to www.AussieEdge.com.

Easy-to-understand businesses, low earnings risk, an average yield greater than 5 percent: The case for the seven companies in the Utilities group of the AE How They Rate coverage universe is pretty straightforward from an individual investor's perspective.

The attractiveness of these assets has been made even clearer in recent weeks with the announcement of several buyout offers and the emergence of a high-profile bidding war.

Of course the hunt for Australian infrastructure asset is not limited to the energy sector, as real estate investment trusts have also been in something of a buyout-frenzy, involving purely domestic competition as well as entreaties from abroad.

Witness Stockland's (ASX: SGP, OTC: STKAF) "loss" to Singapore-based Frasers Centrepoint Ltd (Singapore: FCL) for the office, industrial and land development assets of Conservative Holding Australand Property Group (ASX: ALZ, OTC: AUAOF).

And the sale of Queensland Motorways to AE Portfolio Conservative Holding Transurban Group (ASX: TCL, OTC: TRAUF) was the end result of an auction that drew interest from major global players.

That's to say nothing of a coming wave of asset sales by Australia's state governments that could involve several of the companies discussed below as well as pension fund and other major asset managers around the world.

Queensland’s government this week became the latest state to anno! unce sales, with a plan to unload nearly 12 percent of the state’s assets, which are worth as much as AUD34 billion. Attention will be on three energy distributors–Powerlink, Energex and Ergon–that together are valued at AUD28 billion.

New South Wales is seeking buyers for parts of or its entire state-owned power grid, which is worth an estimated AUD30 billion.

What will attract institutional investors–and probably some of the seven companies below–are the simplicity, the cash flow, the yield and the stability such assets provide.

Self-Dealing

Two different pairs of AE Portfolio Holdings are involved in significant transactions with each other that reveal the solid, long-term wealth-building capabilities of assets such as pipelines and transmission and distribution networks.

APA Group (ASX: APA, OTC: APAJF), Australia's biggest natural gas infrastructure company, has apparently lost the battle for fellow AE Portfolio Conservative Holding Envestra Ltd (ASX: ENV, OTC: EVSRF).

APA holds a 33.1 percent stake in natural gas distribution and transmission company Envestra and has an operating and maintenance contract for the latter's assets as well.

It made a AUD1.31 per share offer for Envestra, but Cheung Kong Infrastructure Holdings Ltd (Hong Kong: 1038, OTC: CKISF, ADR: CKISY), which owns 17.5 percent of the target, joined up with affiliates Cheung Kong Holdings Ltd (Hong Kong: 0001, OTC: CHEUF, ADR: CHEUY) and Power Assets Holdings Ltd (Hong Kong: 0006, OTC: HGKGF, ADR: HGKGY) to beat out APA with its own bid of AUD1.32 per share.

The cash offer is the latest in a string of overseas acquisitions by the Cheung Kong group of companies, headed by Li Ka Shing, Asia's richest person, as it rebalances its holdings in Hong Kong and on the Mainland in favor of international assets offering higher growth and returns.

Envestra gives it a strategic position in the Australian market. It's also interested in the certainty of ea! rnings En! vestra provides. If Envestra is acquired by APA Cheung Kong loses these exposures.

Cheung Kong's bid depends on approval from Australia's Foreign Investment Review Board, among other basic conditions, including acceptance by just 50 percent of Envestra shareholders.

Although the cash flow accretion full ownership of Envestra would likely create from fiscal 2015 through fiscal 2020 could justify a higher bid, APA is expected to concede defeat, which in this case means a profit on its Envestra stake of approximately AUD790 million.

That will certainly boost APA's capacity for a capital return to shareholders, as it's highly unlikely the company will remain a shareholder of Envestra under Cheung Kong's control.

Selling into the offer will generate significant cash that can be used to fund growth and/or raise the dividend. A share buyback is also possible.

The acquisition of Envestra will add to Cheung Kong's existing regulated assets in Australia, including 51 percent stakes in SA Power Networks in South Australia and CitiPower and Powercor in Victoria. Eighty percent of Envestra's gas coverage is in South Australia and Victoria, creating opportunities for cost savings.

We continue to be impressed by APA management's deliberate approach to acquisition-led growth in recent years, including the successful campaign for Hastings Diversified Utilities Fund in 2012. Managing Director Mick McCormack is aggressive in identifying and engaging targets, prudent in backing away from potential deals with mixed fortunes.

APA would surely benefit from consolidating ownership of Envestra's 13,950 miles of regulated networks in South Australia, Victoria, Queensland and New South Wales, which serve approximately 1.2 million consumers. But the price it would have to pay–likely 15 percent to 20 percent above its current bid–could eat away some of the value accretion.

AE Portfolio Aggressive Holding Spark Infrastructure Group's (ASX: SKI, OTC: SFDP! F) portfo! lio includes 49 percent interests in two entities that control three power companies: SA Power Networks, the South Australia-focused unit formerly known as ETSA Utilities, and Victoria Power Networks, the holding company for CitiPower and Powercor Australia that recently changed its name from CHEDHA Holdings Ltd.

So Spark is essentially a junior partner of Cheung Kong's in Australia.

Spark recently made a move to expand its footprint, announcing on May 20, 2014, the acquisition of a 14.1 percent interest in Conservative Holding DUET Group (ASX: DUE, OTC: DUETF) at an average price of AUD2.16 per share.

Spark will fund the AUD405 million investment with a fully underwritten AUD200 million equity placement and AUD250 million of corporate debt.

Spark's statement announcing the deal noted that the acquirer "does not intend to make a takeover bid for DUET."

But the size of the position, which due to the structure allows for an increase to up to 16.6 percent, sparked significant speculation in the market that DUET is in play. DUET surged from AUD2.20 on the ASX on May 15 to AUD2.46 as of June 12, reflecting some suspicions about Cheung Kong's intentions and a possible joint bid with Spark.

In the immediate term management expects the deal for DUET to "provide cash flow accretion and create optionality for future value extraction."

For DUET the Spark investment provides a floor for the share price. And the share price certainly reflects a takeover premium.

Spark reported that total revenue for 2013 rose 8.9 percent to AUD2.1 billion, as it continued to benefit from rising regulatory tariffs. Citipower and Powercor tariffs rose approximately 8.9 percent and 8.4 percent, respectively, on Jan. 1, 2013, while SA Power Networks tariffs rose 9.7 percent on July 1, 2013.

Operating cashflow was up 6.1 percent to AUD189.3 million, while EBITDA were up 8 percent to AUD1.403 billion.

DUET, meanwhile, reported NPAT of AUD146.6 million for the half y! ear, reve! rsing a loss of AUD46.6 million for the prior corresponding period.

Revenue fell by 3.4 percent to AUD620.8 million. Management noted that DUET is on track to deliver its full-year distribution guidance of AUD0.17 per stapled security. 

The fifth network service provider in the How They Rate coverage universe and the only one not in the AE Portfolio, SP AusNet (ASX: SPN, OTC: SAUNF) owns and operates electricity transmission and electricity and gas distribution networks in Victoria.

It's one of Australia's largest energy delivery businesses, managing AUD6.3 billion worth of electricity and gas networks and servicing more than 1 million customers in southeast Australia.

Sp AusNet's largest shareholder is Temasek Holdings, a sovereign wealth fund backed by the government of Singapore. The share price hasn't bounced like those of other NSPs in recent weeks, its steady uptrend interrupted in early June by proceedings in an ongoing trial in a class-action lawsuit related to the role of its down power line in a Feb. 7, 2009, bushfire that left 119 people dead.

Even if the Victorian Supreme Court finds that the bushfire came as a direct result of SP AusNet's failures it may not have to pay damages because it doesn't have a duty of care to victims under Victorian legislation. The scope of current laws only required the company to take "reasonable care" in maintaining a safe electrical network and to run a bushfire mitigation program, which is not the same as a prevention plan.

SP AusNet also argued that the company didn't have control over a wide swath of other problems that contributed to the scale of the bushfire, including failures in emergency warnings
as well as the firefighting effort and controlled burnoffs.

Judgment in the class action, the largest in Victoria's history, is not expected to be handed down until early 2015.

SP AusNet reported net profit from continuing operations for fiscal 2014 (ended March 31, 2014) of AUD178.3 m! illion, d! own 34.8 percent from AUD273.5 million in fiscal 2013.

Revenue for the period was up 9.8 percent to AUD1.799 billion.

Profit from continuing operations includes a net charge of AUD86.7 million for the potential liability stemming from a dispute with the Australian Tax Office and AUD40.4 million for the termination payment and restructuring provision arising from the termination of SP AusNet's management agreement with Singapore Power International Ltd and SPI Management Services Ltd as well as the termination of an IT services and an IT licensing agreement.

Excluding these one-off items NPAT from continuing operations would have been AUD305.4 million, a year-over-year increase of 11.7 percent.

Diversified Heavyweights

Deal-making for Australia's biggest integrated energy companies hasn't been as rampant, though The Australian recently reported, without naming sources, that Wesfarmers Ltd (ASX: WES, OTC: WFAFF, ADR: WFAFY), flush with cash after disposing of its insurance business, could be interested in acquiring fellow AE Portfolio Conservative Holding AGL Energy Ltd (ASX: AGK, OTC: AGLNF, ADR: AGLNY).

Fiscal 2014, particularly the first half of the year, was always going to be tough for AGL and its chief rival and Aggressive Holding Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY).

Competition has wreaked havoc on electricity customer rolls, but switching activity reverted to a downward trajectory in April.

After successive increases in February and March, churn fell sharply back to trend, declining by 195 basis points to 18.2 percent from 20.1 percent. According to the Australian Energy Market Operator, electricity churn across the National Electricity Market fell in all regions.

At the same time, the impact of mainly regulatory energy efficiency programs, structural change in the economy away from electricity-intensive industries, including the shutdown of smelters and refineries, and, since 2010, the response of electricity consumers, ! especiall! y residential consumers, to higher electricity prices have crimped demand.

And prior investments in generation based on strong demand growth projections prior to 2008 and Australia's Renewable Energy Target (RET) forcing continued investment in wind capacity have boosted supply.

Wholesale energy costs are coming down due to excess supply. But the RET target requires a level of continuing investment that's driving up consumer bills and putting additional pressure on demand, as end-users look for ways to save money in a still-uncertain economic environment.

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Financial and operating numbers for Conservative Holding AGL Energy Ltd (ASX: AGK, OTC: AGLNF, ADR: AGLNY) and Aggressive Holding Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY) reflect this difficult environment.

Both companies should benefit from the April 2014 decision by the New South Wales state government to deregulate electricity pricing, as they will from prior decision by South Australia and to do the same.

Queensland's reform of the electricity is in process, though one key move is the anticipated removal of retail electricity price regulation and the introduction of price monitoring in south east Queensland by July 1, 2015.

But AGL, which reported average consumer market demand declines in all states for both electricity and gas during the six months ended Dec. 31, 2013, with average electricity consumption down 10 percent and average gas consumption down 9 percent, expects subdued demand conditions to continue.

Growth for AGL will be driven by acquisition of generation and energy retail assets, boosting scale and reducing costs, providing customer service and limiting churn. An additional boost will come from its expanding wholesale gas business, supported by development of the Gloucester coal-seam gas project.

The Newcastle Gas Stora! ge Facili! ty is on track for completion by mid-2015, and AGL continues to grow its solar portfolio.

 AGL reported a decline in statutory NPAT of 27.1 percent for the first half of fiscal 2014, while underlying profit was down 11.4 percent. Underlying operating cash flow before interest and tax was up 49 percent to AUD963 million.

Revenue for the period was down 2.6 percent.

Management reaffirmed guidance for 2014 underlying profit of AUD560 million to AUD610 million.

AGL added to its customer base, and it continued to improve its customer service, indicated by recognition as Australia's "favourite Utilities Brand" by Canstar Blue. Management expects a big step up in Queensland gas sales in fiscal 2015 and to see the benefits of reduced customer churn and discounting begin to flow through to earnings and cash flow.

AGL is still contesting the decision by Australian Competition & Consumer Commission to prevent its acquisition of Macquarie Generation from the NSW government. And it's also suffered due to the public debate over coal seam gas and has been forced to accept a
compromise deal in NSW on access to farm land for drilling.

But its long-term cash generation potential is intact.

Origin, in addition to its power generation and energy retailing operations, has an active natural gas exploration and production business.

Indeed its participation the Australia-Pacific LNG project at Gladstone in northern Queensland will provide a boost to cash flow and earnings that isn't properly reflected in its share price.

Bu still weighing on the mind of the market is a 7 percent budget overrun to AUD24.7 billion due to increased drilling costs announced along with weak fiscal 2014 first-half results, which included a 38.5 percent decline in net profit after tax.

Weak power demand has hampered results for Origin's largest unit, Energy Markets, though the E&P unit and its New Zealand-based retail energy business Contact Energy posted double-digit EBIT! DA growth! .

Underlying NPAT and underlying EBITDA were up by 5 percent and 3 percent, respectively, as Origin posted a net gain in customers of approximately 14,000 during the half year.

Natural gas customer accounts increased by 25,000 compared to the prior corresponding period, primarily in New South Wales and Victoria. Electricity customer accounts were down by 11,000, primarily in Queensland. But this rate of attrition was actually an improvement on the prior period.

Regarding AP LNG, the cost overrun is actually relatively good news. Projects operated by BG Group Plc (London: BG/, OTC: BRGXF, ADR: BRGYY) and Santos Ltd (ASX: STO, OTC: STOSF, ADR: SSLTY) last year revealed even larger cost blowouts on a need to drill more wells and the strong Australian dollar.

And CEO Grant King noted that he's "a lot more confident" that AP LNG's costs won't go up again, his belief rooted in the fact that enough work has been done and enough contracts have been let, along with experienced gained, that current assumptions are sound.

As of March 31, 2014, AP LNG was two-thirds complete, with work done on approximately 67 percent of the upstream component and 68 percent of the downstream component. The project is on track to deliver first LNG in mid-2015.

Origin's LNG assets provide a significant driver for revenue and earnings growth at a time when its electricity assets are maturing.

Origin posted strong production numbers for the third quarter of fiscal 2014, with gas output up 10 percent to 32.4 petajoules equivalent (PJe). Sales revenue climbed 27 percent to AUD253 million on increased production, higher average commodity prices and higher third-party sales volumes.