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Morningstar | Good Result for Spark, but Regulatory Headwinds Damp Longer-Term Outlook. See Updated Analyst Note from 26 Feb 2019

Spark Infrastructure posted a solid 2018 result, with proportional EBITDA up 5% to AUD 825 million. Distributions of AUD 16 cents per security were comfortably covered by look-through operating cash flow of 19.5 cps. The result was in line with our expectations. We have made minor adjustments to our earnings forecasts and remain comfortable with our AUD 2.40 fair value estimate. At current prices, Spark appears fairly valued. There is no change to our opinion that the firm lacks an economic moat, as heavy-handed regulation offsets monopoly benefits. This is becoming more evident as the regulator turns the screws in an effort to improve utility bill affordability.

The main issue for Spark is the sustainability of distributions. The company was recently forced to cut distributions to AUD 15 cents per share in 2019 following an adverse tax ruling. There could be further downside after the next round of regulatory resets, which will incorporate lower return settings and allowances to cover tax. Management suggests these unfavourable changes will shave AUD 60 million-75 million per year from revenue on a proportional basis from 2021. To put it in perspective, this could reduce free cash flows by around 4 cents per security, all else being equal. With reduced cash flows and a related deterioration in credit metrics, combined with ongoing reinvestment needs at the underlying companies, we doubt Spark will be able to maintain distributions at current levels. We now factor in distributions falling to around 13 cents per security in 2021, though even this requires a more aggressive distribution payout ratio than the company has used in the past.

Financial health remains sound for now, but ongoing regulatory attacks will weaken credit metrics after the next round of regulatory resets. Management is highly focused on maintaining current credit ratings, suggesting it won’t try to prop up distributions from 2021 with debt.

Victoria Power Networks' EBITDA increased 6% to AUD 830 million on regulated tariff increases and cost-out initiatives. This trend should continue until the next regulatory reset in December 2020, with tariffs increasing at mid-single-digit rates in January 2019 and 2020. After the 2020 regulatory reset, tariffs are likely to fall because of increasingly tough regulatory conditions. A key driver of profits, regulated asset base, increased 4% to AUD 6.1 billion. It should continue growing over the longer term on reinvestment in the network and inflation, helping to partially offset regulatory headwinds.

South Australia Power Networks underperformed with EBITDA flat at AUD 656 million as regulated tariff increases and cost-out initiatives were offset by lower unregulated revenue and higher emergency response costs. Nonetheless, the near-term outlook is positive as earnings should benefit from a 2.7% tariff increase in July 2018 and a similar increase in July 2019, combined with ongoing cost-reduction measures. SAPN’s next regulatory reset is in mid-2020, and it should also be tough. RAB increased 4% to AUD 4.2 billion.

TransGrid's EBITDA increased 13% to AUD 669 million as new renewable energy connections drove a strong increase in unregulated revenue. Regulated tariff increases and cost savings also helped. RAB increased just 1% to AUD 6.4 billion, but unregulated assets, such as new renewable energy connection lines, swelled 21% to AUD 431 million. Having just undergone a regulatory reset, TransGrid’s earnings should grow solidly until June 2023.