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Morningstar | Spark Acquires a Small Solar Farm Development

No-moat-rated Spark Infrastructure acquired the Bomen solar farm development project near Wagga Wagga in New South Wales. The solar farm will start in mid-2020, will cost AUD 188 million, and should add around AUD 10.5 million, or 1.3%, to annual EBITDA. Management believes the acquisition is accretive to value and distributions, but we are not convinced. While tough regulatory conditions mean there’s logic in diversifying away from regulated assets, there are material risks with intermittent renewable energy developments. But overall the acquisition is value neutral, and regardless too small to impact our AUD 2.40 fair value estimate. At current prices, Spark trades at an 8% discount to our valuation.

We don’t like Spark’s strategy of growing by acquisitions, doubting it will add shareholder value. Infrastructure prices are elevated, and synergies are unlikely between the stand-alone assets Spark owns. APA Group is an example of an infrastructure firm that added value from acquisitions. APA started as one gas transmission pipeline and built and bought more pipelines to join them into a large network. This provided cost savings and extra revenue, as the network could offer more services than an individual pipeline could. We just don’t see the same benefits accruing to Spark from owning separate businesses spread around the country. And corporate costs are likely to rise, on greater staff numbers and larger salaries to run a larger, more complex company.

Our analysis of the project suggests it will generate a high-single-digit internal rate of return on equity, assuming power prices steadily rise. This is in line with our cost of equity for electricity generators of 9% and thus we consider the project value-neutral. For Spark’s core assets--regulated networks--a 7.5% cost of equity is justified.

If we were to take the view the project was lower risk, it would be value-accretive. However, power generation comes with greater uncertainty than regulated assets, so a higher cost of equity seems appropriate.

The acquisition is unlikely to be sustainably accretive to distributions in its own right. Rather, any benefit to distributions will come from being able to use accelerated depreciation of the development costs as tax deductions to shield profits from other parts of the business. This is only a short-term boost to distributions.

On our calculations, the solar farm will add AUD 12.8 million in revenue in the first year and AUD 10.5 million in EBITDA. Assuming gearing in the middle of the guidance range of 65% to 70%, interest expense will be at least AUD 5 million per year. This means look through cash flow will increase by around AUD 5.5 million, or 1.6%. Equity in the project will come from approximately 27.8 million new securities issued via a distribution reinvestment plan. This will increase securities on issue by 1.6%. As cash flow increases by the same percentage as securities on issue, we conclude the acquisition will be neutral to operating cash flow per security, the key metric for distributions.

While EBITDA should grow under initial power purchase agreements, tax payments and debt amortisation will detract over the longer term. Tax payments will ramp up as earnings increase, particularly once the asset is depreciated, and the project has a 30-year life, requiring debt to be repaid little by little over time. Additionally, solar panels will degrade as they age, so the firm may need to buy more to keep output steady.

Fixed price power purchase agreements cover 95% of volumes in the first five years, and 82% of volumes for the first 10 years. This provides a high degree of revenue certainty for 10 years, but the firm will have to recontract thereafter, and the prices it gets could disappoint. With so many renewable energy projects being built, wholesale electricity prices are likely to be depressed during the day because this is when solar farms, and often wind farms, produce power. If it’s cheap to buy on the wholesale market during the day, then the firm probably won’t be able to secure reasonable prices for its solar power after initial contracts end.