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Morningstar | Spark’s Distributions Growing for now, but Tough Regulation Is a Longer-Term Headwind

On Dec. 17, 2018, the Australian Energy Regulator, or AER, released its 2018 Final Report on the Review of Regulatory Tax Approach, where it outlined a list of recommended changes to its approach when setting tax allowances for regulatory energy networks. This initiative represents yet another regulatory attack to limit profitability of regulated utilities, after the cost of equity allowance was slashed in recent resets and limits were imposed on operating cost allowances. The systematic heavy-handed approach by the regulator reinforces our no-moat rating for Spark Infrastructure, with its potential for excess returns being constrained by tough regulation. We maintain our AUD 2.40 fair value estimate for Spark. The company’s shares looks reasonably priced, offering an attractive dividend yield of around 7%, but with headwinds to longer-term growth. We forecast distributions increase to AUD 17.0 cents per share in fiscal 2020 from AUD 15.2 cents in fiscal 2017. However, there could be some downside to distributions, following the next round of regulatory resets.

Each of Spark’s assets are on track to grow their earnings. The medium-term earnings outlook for Victoria Power Networks, or VPN, remains relatively good, with regulated tariffs recently increasing 4% on Jan. 1, 2019 and set to increase close to 5% on Jan. 1, 2020. Similarly, earnings momentum for SA Power Networks, or SAPN, is steady, with tariffs set to increase by 3.4% in July 2019. Last but not least, TransGrid is also well-poised to emerge from a trough in returns (after having its returns substantially cut by the regulator over the past few years), with its regulated tariffs set to increase 4.5% in each of the next four years.

Nevertheless, we remain cognisant of looming headwinds over the horizon. We expect further regulatory attacks to remain a drag on company earnings moving forward. To regulate the profitability of utilities, the AER has lowered the permitted rates of return, limited allowances for operating expenses and more recently, put tax allowances on the firing line. The increased scrutiny on tax came after preliminary advice from the Australian Tax Office, or ATO, which identified that regulated utilities are paying less tax relative to the tax allowances they are receiving. With the AER making changes to its regulatory tax approach, earnings are likely to be hit again and this could detract from growth in distributions to Spark’s securityholders. While Spark has targeted growth in DPS through to the end of 2020, the trajectory of DPS thereafter depends on the severity of regulatory suppression on infrastructure returns after the end of the current regulatory determinations. Interest rates are a key swing factor, as higher interest rates increase allowed returns, all else being equal.

We believe the regulatory environment should remain challenging due to political pressure to improve affordability of electricity, and we expect the AER to continue looking for ways to reduce utility profitability. After having its returns reduced in the past several years, Spark no longer boasts strong cash flow coverage of distributions. Thus, any further regulatory attacks will have a bigger impact on distributions than past attacks.

Regulatory headwinds, however, are not in any way marking the death knell for network owners like Spark. Growth opportunities are abundant in TransGrid’s semiregulated and unregulated revenue space. Spark has been expanding its network of transmission lines while improving efficiency at this formerly government owned business. While accounting for around 10% of group revenue at present, we believe the proportion of revenue sourced from these operations are well-positioned to grow as Spark builds connections to new wind farms and other projects. Apart from allowing Spark to buttress regulatory headwinds, unregulated operations also deliver higher returns.

Spark’s financial position is relatively stable. Gearing measured as net debt/RAB at the original assets--VPN and SAPN--is reasonable at 71% and 75%, respectively (as at June 2018). TransGrid is relatively highly geared, with net debt/RAB of 82%. We expect gearing levels to trend higher in the medium term given as expansion initiatives are mostly debt-financed. While regulatory pressure on returns could cause Spark’s financial position to slightly deteriorate, most of its underlying assets have good credit ratings and this should allow continuous access to debt finance.

We remain confident in Spark’s position as a solid and secure cash-generating business. Like all regulated utilities, however, returns are likely to be further restrained given the prevailing political focus on household and business utility bill affordability issues, which ultimately casts a shadow over the trajectory of future distributions.