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Morningstar | APA Brushes Off Regulatory Attack but Headwinds Remain; FVE Increased to AUD 9

We’ve moderately upgraded narrow-moat APA Group’s medium-term earnings forecasts after discussions with management. Of most interest was the lack of effectiveness of adverse gas market rule changes. As a result, we increased our fair value estimate 6% to AUD 9 per security. Nonetheless, our valuation can’t get anywhere near the current share price of AUD 11.30 without factoring in record low interest rates permanently. As we believe interest rates will rise over the medium term, we consider APA significantly overvalued.

Our main point of discussion with management was the impact of gas market rule changes following reviews by the Australian Competition and Consumer Commission, or ACCC, and Gas Market Reform Group. As with other utilities, APA has been under attack from the government in an effort to improve utility bill affordability. Pipeline owners, of which APA is the largest, have been accused of monopoly pricing by the ACCC. But because most of APA’s assets are unregulated, it is more difficult to reduce its returns. Hence, new rules were introduced to improve pricing transparency and help customers secure lower tariffs. However, calculating fair tariffs depends on subjective assumptions and customers, particularly smaller customers, may find it difficult to challenge APA’s view.

APA dismisses rule changes as having limited impact, with tariffs only falling by a few percent as contracts roll, which probably would have happened anyway given depreciating asset values. Conversely, the ACCC celebrated the success of rule changes in its December 2018 interim gas market report, though noting prices remain too high. It said it will continue to monitor the market and may further refine gas market rules to achieve its aim of reducing pipeline returns. That’s the key for us. If current rules don’t dampen APA’s market power, we expect more changes will be made until the government’s goal is achieved.

The positive for APA though is that these processes generally take considerable time.

We wrote a special report on APA and the changing gas market on July 12, 2017. The report focused on new rules forcing APA to disclose high levels of financial information on each pipeline to help customers negotiate better deals, backed up by binding arbitration if no agreement could be reached. The changes are designed to indirectly reduce pressure on utility bills by weakening APA’s bargaining power and helping customers like gas retailers and gas-fired power stations secure better deals. We concluded the changes would weaken APA’s competitive advantages but not enough to challenge its narrow moat rating. This view is intact.

APA is adamant rule changes haven’t materially impacted its business. It continues to set tariffs as it has always done, and customers are yet to challenge via the arbitration process. This doesn’t come as a surprise as new rules only started last year and APA works on long term contracts, meaning only a small number of contracts have rolled since new rules were introduced. Additionally, only certain pipelines—such as those with heavily depreciated asset values--would be at risk from major tariff cuts.

We accept APA’s assertion that rule changes haven’t been as impactful as we initially expected. As a result, we now expect EBITDA to grow at 4.1% annually on average over the next five years, compared with 3.5% previously. Part of the reason APA has not been materially impacted is there is substantial wriggle room in determining asset values. Unsurprisingly, APA calculates high values for its pipelines, which makes it appear the firm is making only modest returns.

Guidelines require two methods for calculating asset values. The first is to depreciate a pipeline over its useful life, regardless of how much money it has made and how many times over it has recovered its construction cost. With physical lives of around 80 years, APA’s pipelines retain a large portion of their original value under this method. The second asset valuation method, known as the recovered capital method, recognises how much of the construction cost and subsequent capital expenditure has been recouped from customers. The amount of capital recovered is calculated as revenue less theoretical operating costs, interest expense, tax and a fair amount of profit. But if recovered capital is negative according to this subjective formula, asset values appreciate over time, rather than depreciate.

For example, the Moomba Sydney Pipeline, or MSP, is 40 years old. While it has undergone extensive upgrades and improvements, one might expect it to have depreciated to a fairly modest value. Not so according to APA’s calculations. Under the first valuation method it is worth AUD 1.1 billion and under the second supposedly more conservative method it has a value of AUD 2.1 billion. The MSP’s return on assets is just 4.4% under the first method and 2.4% under the second. These returns are a long way from what anyone would consider excessive, so a tariff reduction would be unjustified. The problem for customers wanting tariffs to fall, therefore, is they must prove the assumptions used by APA to calculate MSP’s value are way off. This will be a difficult task.

Another key point worth reiterating is that APA’s free cash flows appear stronger than they really are. This is because the massive Wallumbilla Gladstone Pipeline--which contributes around a third of EBITDA--has a finite life, with earnings finishing in 2035 as agreed when APA bought the pipeline from the LNG exporting customer. APA must use a substantial portion of cash flows to either pay down debt or fund new investments so that when the WGP contract ends, APA will retain reasonable credit metrics. Management confirmed to us that if APA runs out of growth projects, it will use surplus cash flow to pay down debt rather than materially increase distributions to investors.

With net debt/EBITDA of around 6 times, APA’s financial leverage is already towards the top of what we consider reasonable for infrastructure firms. It will need to grow EBITDA faster than debt over the next 15 years to get net debt/EBITDA down to around 4 times so that when WGP earnings disappear net debt/EBITDA will stabilise back around 6 times. We don’t think it will be too difficult to achieve this, even with headwinds from gas market reform.