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Morningstar | Cost Reductions Support Good First Half for Spark; No Change to FVE

Spark Infrastructure reported a good first-half result and is tracking a little better than we were expecting. Proportional EBITDA increased nearly 8% to AUD 420 million on stronger earnings at Victoria Power Networks and TransGrid, while earnings at SA Power Networks fell marginally. Proportional operating cash flow increased 7% to AUD 135 million, or AUD 8 cents per security, which was in line with distributions to security holders. We slightly increase our full-year earnings forecasts but remain comfortable with our AUD 2.40 fair value estimate. At current prices, Spark is fairly valued. It offers an attractive unfranked yield of 6.7%, likely growing above CPI for the next few years. Longer-term growth will be supported by ongoing investment in its networks, but regulatory attacks will cap profitability in an effort to improve utility bill affordability.

Victoria Power Networks, or VPN, was a surprise positive performer. Revenue rose 7% and operating costs fell 18%, driving EBITDA 15% higher to AUD 428 million. Some of the improvement appears to be one-off in nature, so we expect growth to moderate for the full year. First-half revenue benefited from regulated tariff increases of a little over CPI and large increases in semi- and unregulated revenue. Customer numbers rose 1.3%, though electricity demand was flat. The medium-term earnings outlook is relatively good, with regulated tariffs set to increase around 4% on Jan. 1, 2019 and closer to 5% on Jan. 1, 2020. The increase in VPN's semi and unregulated revenue relates to increased connection work and sales of properties among other things and can be lumpy and unpredictable. Likewise, the trend in operating costs shouldn't be extrapolated as something related to lower vegetation management costs and increased capitalisation of labour costs. These items can be volatile from half to half.

Management cited that productivity and efficiency improvements continued, though we note the number of full-time employees increased 1.5% in the past six months. VPN's regulated asset base, or RAB, which ultimately drives earnings, increased 1.8% to AUD 6 billion in the half.

SA Power Networks', or SAPN's, EBITDA fell 3% to AUD 335 million, though would have been broadly flat if release of unneeded storm provisions were backed out. Customer numbers increased 0.6% and electricity demand fell 1%. Regulated revenue rose 3% on regulated tariff increases and an increased bonus for good network reliability. RAB increased 1.7% to AUD 4.2 billion. Regulated tariffs increased 2.7% on July 1, 2018 laying a solid platform for earnings growth in the second half. Good momentum should continue next year, with the regulator allowing a 3.4% tariff increase in July 2019.

TransGrid EBITDA increased 8% to AUD 328 million on stronger unregulated revenue and good cost control. Unregulated revenue benefited from growth in contracted assets, mainly connections to new wind farms, and line relocation work. Regulated revenue fell 1%, but should increase in the second half following recent tariff increases. RAB increased just 0.5% to AUD 6.4 billion. Strategy is to organically expand its network of transmission lines while improving efficiency at this formerly government owned business. The number of full-time employees fell 2.4%. After having its returns substantially cut by the regulator for the past few years, TransGrid's medium-term outlook is good. Its regulated tariffs increased 3% on July 1, 2018 and are set to increase 4.5% in each of the next four years. In addition, we expect solid growth in the unregulated business and cost efficiency improvements.

Spark's financial position is sound. Gearing measured as net debt/RAB at the original assets--VPN and SAPN--is at reasonable levels of 71% and 74.7%, respectively. TransGrid's net debt/(regulated and contracted asset base) is too high in our opinion at 82.1%, though is tracking in the right direction, down 40 basis points in the past six months, as substantial free cash flows are retained in the business to fund growth projects. TransGrid's high gearing is a function of its expensive acquisition.