Spark Infrastructure

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1 Vol m Energy Infrastructure Australia Equity research July 18, 2017 ADD Current price: Target price: A$2.48 A$2.62 Previous target: A$ Up/downside: 5.5% Reuters: Bloomberg: Market cap: Average daily turnover: SKI.AX SKI AU US$3,266m A$4,171m US$13.46m A$17.88m Current shares o/s 1,682m Free float: 100.0% Price Close Relative to S&P/ASX 200 (RHS) Jul-16 Oct-16 Jan-17 Apr-17 Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Nathan LEAD T (61) E nathan.lead@morgans.com.au Spark Infrastructure Yield and scarcity value We initiate coverage with a $2.62ps target price, estimated 12-month total return of ~12%, and an ADD rating. SKI provides investors with defensive earnings and a reliable and growing distribution (at least until 2021 on our forecasts). Estimated cash yield is 6.1%. While our investment view is set on a business-as-usual basis, we can see the logic of other owners of regulated assets in Australia pursuing an industry consolidation strategy with SKI a potential target. Low earnings growth with DPS supported by increase in gearing The bulk of SKI s proportional revenues through to 2020 are highly secure as a result of regulated revenue cap determinations for SAPN and VPN (both SKI 49% owned). TransGrid (SKI 15.01%, ~13% of SKI s EBITDA) is undergoing a reset process this year which will apply to its regulated revenues from July Across , we expect EBITDA to grow by ~2% CAGR, to be outpaced by net finance costs (~5% pa CAGR) as a result of rising cost of debt (rising market rates, short term swaps replaced with long term swaps) and growing debt from funding capex. We expect SKI s distributions to be funded by a mix of operating cashflow and asset level debt (assuming SAPN/VPN s gearing rises back to its 75% net debt:rab target). Distribution growth beyond 2021 looks less assured on our forecasts, albeit fund level cash and/or relaxation of the 75% net debt:rab target for SAPN/VPN may support distribution growth. 12-month target price of $2.62ps based on SOTP valuation Our sum-of-the-parts valuation implies an 11.6x EV/EBITDA (2018/19F basis) and 1.46x EV/RAB. The high EV/RAB can be explained by the relatively large contribution from unregulated low capital intensity activities, cost-out initiatives, and outperformance of regulatory trailing cost of debt. The key valuation sensitivities are cost of equity and terminal value. Our forward valuation over coming years indicates minimal equity value growth, due to declining-to-flat forecast equity cashflows as well as growth in net debt outpacing ~4% pa RAB growth across Investment view SKI may appeal to income-oriented investors seeking relatively defensive earnings. On a business-as-usual basis the estimated 12-month TSR of ~12% justifies an ADD rating. We note that COAG s decision to remove the Limited Merits Review process increases risk from future regulatory decisions. However, there is obvious scarcity value in SKI s high quality regulated assets, reflected in the prices paid for the NSW electricity network privatisations as well as the takeovers of DUET and Envestra by Cheung Kong (CK). We suspect a potential takeover play may see CK acquiring SKI so as to complete its ownership of VPN/SAPN and thus gain maximum benefits from a merging of operations with assets within DUET. If CK were to pay the same EV/RAB for SKI as we estimate it paid for DUET s regulated assets then SKI would be worth $2.95ps. Key value indicator events (i) TransGrid regulatory determination currently underway; (ii) evidence of strong costout (eg. statutory results, regulatory filings); (iii) upside from regulatory appeals; and (iv) evidence of rapid growth in TransGrid s unregulated earnings. We are skeptical that SKI can create per share value accretion through acquisitions at current M&A multiples. Financial Summary Dec-15A Dec-16A Dec-17E Dec-18E Dec-19E Dec-20E Distribution (cps) growth 4.3% 20.8% 5.2% 4.9% 2.5% 2.5% - yield on share price 4.8% 5.8% 6.1% 6.5% 6.6% 6.8% Proportional EV/RAB 1.67x 1.46x 1.44x 1.41x 1.39x 1.37x Proportional EV/EBITDA 10.8x 11.2x 11.5x 11.5x 11.6x 11.4x Proportional EBITDA ($m) Proportional RAB ($m) 4,643 5,690 5,935 6,169 6,401 6,618 SAPN+VPN net debt:rab 73.0% 72.0% 73.6% 73.9% 74.6% 75.0% TransGrid net debt:rab 88.4% 88.6% 88.6% 88.8% 88.9% SKI cash/(debt) ($m) (185) Look-through Operating CF (cps) SKI Operating CF (cps) IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN ) AFSL A PARTICIPANT OF ASX GROUP SOURCE: MORGANS, COMPANY REPORTS Powered by EFA

2 Figure 1: Financial summary Equity valuation DYE: VPN $m 2,194 2,199 2,199 2,197 2,196 2,201 2,206 2,229 2,253 SAPN $m 1,738 1,741 1,751 1,755 1,754 1,765 1,786 1,808 1,829 Transgrid $m Asset company equity value $m 4,421 4,441 4,450 4,455 4,460 4,487 4,523 4,574 4,627 Fund net cash / (debt) $m PV of fund opex $m (183) (183) (183) (183) (182) (181) (179) (176) (173) SKI equity value $m 4,381 4,426 4,471 4,506 4,531 4,546 4,586 4,634 4,691 Shares on issue mn 1,682 1,682 1,682 1,682 1,682 1,682 1,682 1,682 1,682 SKI equity value $ps $2.60 $2.63 $2.66 $2.68 $2.69 $2.70 $2.73 $2.76 $2.79 Distributions DYE: 2015A 2016A 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F Distribution per share cps % -1.3% - yield at current price % 4.8% 5.8% 6.1% 6.5% 6.6% 6.8% 6.9% 6.8% 6.6% 6.3% 6.3% - vs SKI Operating CF % 85% 80% 88% 93% 89% 92% 95% 100% 100% 100% 100% - vs look-through OCF % 42% 65% 90% 78% 84% 84% 90% 94% 84% 79% 75% SKI fund cashflows DYE: 2015A 2016A 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F Distributions from SAPN $m % -3.0% Distributions from VPN $m % -3.2% Distributions from Transgrid $m Distributions from DUET $m Distribution to SKI $m % -2.7% Fund net interest (paid)/received $m (9) (11) Fund corporate costs $m (13) (15) (15) (15) (16) (16) (17) (17) (17) (18) (18) SKI Operating CF $m % -3.0% - per share $m % -3.0% Investing CF $m (739) New equity (net of costs) $m 395 (2) Borrowings $m 203 (205) Distribution to investors $m (172) (223) (250) (263) (272) (279) (286) (296) (274) (270) (263) SKI Cash balance $m % 0% SKI net debt/(cash) $m 185 (101) (143) (169) (205) (234) (253) (240) (242) (236) (237) Look-through operating CF DYE: 2015A 2016A 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F Proportional EBITDA $m Proportional net finance costs $m (226) (190) (182) (200) (216) (231) (245) (266) (279) (291) (301) Tax paid $m (8) (15) (32) (31) Working capital $m (45) 4 2 () 1 0 () 0 2 Regulatory return of capital $m (192) (248) (231) (221) (228) (233) (252) (264) (242) (234) (220) Asset cashflows $m SKI corporate costs $m (13) (15) (15) (15) (16) (16) (17) (17) (17) (18) (18) SKI net finance (costs) $m (9) (11) Other $m Look-through operating CF $m per share $m Proportional consolidation DYE: 2015A 2016A 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F VPN $m SAPN $m Transgrid $m Asset EBITDA ex c/contr $m % 2.4% Fund costs $m (14) (14) (15) (15) (16) (16) (17) (17) (17) (18) (18) Proportional EBITDA $m % 2.4% VPN $m SAPN $m Transgrid $m Asset net finance costs $m % 5.4% Fund net finance costs $m 9 11 (1) (2) (3) (3) (4) (4) (4) (4) (4) Proportional net finance costs $m % 5.4% VPN $m 2,005 2,034 2,169 2,277 2,395 2,498 2,549 2,596 2,644 2,694 2,745 SAPN $m 1,384 1,383 1,498 1,565 1,641 1,698 1,740 1,783 1,826 1,870 1,915 Transgrid $m ,014 1,039 1,065 Prop. asset net debt $m 3,389 4,251 4,511 4,699 4,917 5,108 5,233 5,362 5,485 5,603 5, % 2.3% SKI debt/(cash) $m 185 (101) (143) (169) (205) (234) (253) (240) (242) (236) (237) Prop. net debt $m 3,574 4,150 4,368 4,530 4,712 4,874 4,980 5,121 5,242 5,367 5, % 2.4% VPN $m 2,718 2,810 2,960 3,093 3,216 3,329 3,391 3,454 3,518 3,584 3,651 SAPN $m 1,925 1,937 2,023 2,108 2,194 2,264 2,319 2,375 2,432 2,491 2,550 Transgrid $m ,025 1,063 1,106 1,143 1,172 1,201 Proportional RAB $m 4,643 5,690 5,935 6,169 6,401 6,618 6,773 6,935 7,094 7,246 7, % 2.3% VPN+SAPN ND:RAB % 73% 72% 74% 74% 75% 75% 75% 75% 75% 75% 75% Transgrid ND:RAB % 88% 89% 89% 89% 89% 89% 89% 89% 89% 89% 2

3 Company overview SKI is an internally managed, direct infrastructure fund with a staff of 13 and six non-executive board members. It currently holds equity stakes in three high quality energy infrastructure assets, which are summarised in the table below. Figure 2: Sum-of-the-parts valuation Network Description SKI % Co-investor(s) % of revenue regulated Victoria Power Networks (VPN) South Australia Power Networks (SAPN) Transgrid Holds the licenses for the PowerCor and Citipower electricity distribution networks in Victoria Electricity distribution network owner in South Australia NSW high voltage electricity transmission network privatised by the NSW state government in late 2015 RAB (100%) Credit rating Last ND:RAB vs target 49% Cheung Kong (51%) 85% $5,734m S&P: A- 72.4% vs 75% 49% Cheung Kong (51%) 75% $3,953m S&P: A- 71.4% vs 75% 15% Hastings (20%) CDPQ (25%) Abu Dhabi Investment Authority (20%) Kuwait Investment Authority (20%) 6% $6,284m Moody's: Baa2 88.4% vs 85-90% The Australian Energy Regulator s (AER) benchmarking reports indicate SKI s distribution networks are amongst the most efficient in Australia. However, TransGrid s efficiency ranking is relatively weaker, providing opportunity for upside if TransGrid is able to extract cost-out benefits typically seen with government privatisations. Figure 3: Efficiency benchmarking of distribution networks Network Rank Average CitiPower 1 1 United Energy 2 3 SAPN 3 2 Jemena 4 4 Powercor 5 5 Energex 6 6 Endeavour Energy 7 7 AusNet Services 8 8 TasNetworks 9 9 Ergon Energy ActewAGL Essential Energy Ausgrid Figure 4: Efficiency benchmarking of transmission networks Network Rank Average TasNetworks 1 1 ElectraNet 2 2 Powerlink 3 4 Transgrid 4 3 AusNet Services 5 5 AER s benchmarking is based on multilateral total factor productivity SOURCE: AER Annual Benchmarking Reports 2016 The median half-year closing cash balance at the SKI fund level over the five years to HYE-16 is $43m. However, SKI s cash balance had grown to $101m at FYE-16, indicating a degree of surplus cash available for investment or to support distribution growth. SKI itself incurs ~$15m pa in costs. The cash to pay distributions to SKI s shareholders is sourced from cash distributions from its asset companies (after deducting fund level costs). 3

4 Base case valuation Our 12-month target price of $2.62ps is based on our sum-of-the-parts (SOTP) valuation as at June This incorporates our forecast of net debt and shares on issue as at the valuation date. We show in the table the EV/EBITDA and EV/RAB implied by our DCF valuations. Figure 5: Sum-of-the-parts valuation Valuation as at June-18 EV COE EBITDA EV/EBITDA est. RAB EV/RAB Net debt 100% Equity SKI % SKI Equity ($m) (% pa) ($m) (x) ($m) (x) ($m) ($m) (%) ($m) SAPN 6, % , ,120 3,546 49% 1,738 VPN 9, % , ,538 4,471 49% 2,191 Transgrid 8, % , ,654 3,290 15% 494 Total AssetCos 24,618 2, , ,311 11,307 4,422 Fund net cash / (debt) (162) % 162 PV of fund opex (183) (16) 11.8 (183) 100% (183) SKI's proportional share 8, , ,439 4,401 4,401 Forecast shares (million) 1,682 SKI equity value $ps $2.62 The majority of revenues generated by SKI s asset companies is sourced from their regulated electricity networks. The AER sets revenue allowances for a five year regulatory cycle using the building blocks approach characterised in the chart below. We estimate across SKI s three asset companies the return on and return of capital contributes about 60% of revenues. This approach means that the Regulated Asset Base anchors long-term revenues and value. Our 12-month target price implies an EV/RAB of 1.46x and an EV/EBITDA of 11.6x (2018/19F basis). It also implies a yield of 6.1%, based on CY18 DPS guidance of 16 cps. We estimate the current share price implies 1.46x EV/RAB (HYE-17), 11.2x EV/EBITDA (2017/18F basis), and 6.3% yield (2017F basis). Figure 6: Allowed revenues building block SOURCE: AUSTRALIAN ENERGY MARKET COMMISSION Under our SOTP approach, we value each of the asset companies using an equity DCF approach. We discount forecast equity cashflows and our terminal value in 2038 using a cost of equity (COE) that incorporates a 3.75% pa risk free rate (thus implying a material uplift in the 10-year Commonwealth Government Bond (CGB) rate from the current rate of ~2.7% pa) plus equity risk premiums that differ due to differences in gearing (and thus financial risk) across the asset companies. Our terminal value estimates for 2035 are based on a 1.25x EV/RAB for the regulated assets and 10x EV/EBITDA for the unregulated activities. The valuation is insensitive to the EV/EBITDA applied to the terminal value unregulated activities. The sensitivity of our valuation to changes in the COE and terminal value EV/RAB applied to the regulated assets is shown in the table below. 4

5 Diff. from base case COE (% pa) Energy Infrastructure Australia Equity research July 18, 2017 Figure 7: Sensitivity of equity valuation to COE and terminal value EV/RAB EV/RAB terminal value (2035) $ x 1.05x 1.15x 1.25x 1.35x 1.45x 1.55x -0.75% $2.27 $2.46 $2.64 $2.82 $3.00 $3.19 $ % $2.23 $2.40 $2.58 $2.75 $2.93 $3.10 $ % $2.18 $2.35 $2.51 $2.68 $2.85 $3.02 $ % $2.13 $2.29 $2.46 $2.62 $2.78 $2.94 $ % $2.09 $2.24 $2.40 $2.55 $2.71 $2.86 $ % $2.05 $2.19 $2.34 $2.49 $2.64 $2.79 $ % $2.01 $2.15 $2.29 $2.43 $2.58 $2.72 $2.86 SOURCE: MORGANS Why does our valuation of SAPN imply a higher EV/RAB but lower EV/EBITDA than for VPN? SAPN has a higher proportion of unregulated earnings (that are low capital intensity) than VPN, helping to generate stronger credit metrics and thus lower financial risk. This and the lower discount rate contribute to the relatively higher EV/RAB. Our valuation of VPN implies a higher EV/EBITDA than SAPN, partly due to differences in long-term cashflows with SAPN having an earlier stepdown in regulatory depreciation of the current RAB than VPN. Why are the multiples implied by our TransGrid valuation less than SAPN/VPN? First, we think the $735m that SKI paid for its 15.01% interest in the business in 2015 was too high. The price paid implied an EV/RAB of 1.67x and ~16-17x EV/EBITDA (note TransGrid benefitted from catch-up revenues in 2015/16), well above the valuation multiples implied by our valuations of SAPN/VPN. SKI partly explained the acquisition cost by reference to unregulated opportunities available to TransGrid from a pipeline of renewable generation projects wishing to connect to its transmission network. However, capital investment is required to deliver these incremental earnings, compared to the low capital intensity of unregulated earnings of SAPN/VPN. This capital intensity has resulted in SKI indicating at its AGM that TransGrid is likely to retain more cash to fund its unregulated capital investment pipeline (we factor this into our TransGrid forecasts), which is no surprise given TransGrid s net debt:rab is close to the top end of its target range. At its FY16 result in February, SKI said that 466MW of existing connections costing $81m aggregate capex produced $16m pa of revenue. It had seven connections totalling 825MW under contract, and has since signed up Infigen Energy s 113MW Bodangora wind farm. In the context of SKI s overall asset portfolio, the combined unregulated capital investment and related earnings are relatively low. 5

6 Figure 8: TransGrid non-prescribed infrastructure opportunities SOURCE: SPARK INFRASTRUCTURE Figure 9: Regulated utility peer comparison Also, the materially higher gearing of TransGrid brings with it higher financial risk and thus higher required equity returns, which should depress the price. Where we could be wrong in our valuation is the cost-out opportunity within TransGrid, given the asset was previously government-owned. Redundancy restrictions through to 2020 restrict labour cost-out. Company Location Mcap 5yr beta EV:EBITDA Est. EBITDA Yield Est. DPS P:OCF Est. Op CF Net debt:ebitda (A$m) (next 12m) grwth (next 2yrs) (next 12m) grwth (next 2yrs) (next 12m) grwth (next 2yrs) (next 12m) Spark Infrastructure Australia 4, % 6.2% 5% 7.1-4% 5.7 Alliant Energy USA 11, % 3.3% 7% 9.7 8% 4.5 Atmos Energy USA 11, % 2.3% 7% % 3.5 AusNet Services Australia 6, % 5.5% 4% 8.5-2% 6.1 Consolidated Edison USA 31, % 3.5% 3% 8.3 2% 4.1 Eversource Energy USA 24, % 3.3% 7% 8.7-1% 4.4 Fortis Canada 18, % 3.8% 6% 6.8 8% 6.0 National Grid UK 53, % 4.9% 3% 8.2-5% 5.0 Pennon Group UK 5, % 4.8% 7% 8.6 8% 5.5 Severn Trent UK 8, % 3.9% 7% 8.8 1% 6.2 Southern Company USA 59, % 5.0% 3% 6.9 9% 5.4 Southwest Gas USA 4, % 2.7% 10% 8.4-8% 3.2 Terna Italy 14, % 4.5% 2% 8.2-1% 5.2 United Utilities UK 10, % 4.6% 3% 8.7-2% 6.8 Vector NZ 3, % 4.9% 1% 9.8-4% 4.0 WEC Energy USA 24, % 3.5% 5% 8.4 3% 4.0 Westar Energy USA 9, % 3.3% 5% n/a n/a 3.9 WGL Holdings USA 5, % 2.5% 5% % 5.6 Median % 3.8% 5% 8.5 2% 5.0 As at 18 July

7 EV/RAB (including contracted assets) Energy Infrastructure Australia Equity research July 18, 2017 M&A potential M&A has been a consistent theme in the regulated energy infrastructure space. The latest transactions include the NSW privatisations (TransGrid, Ausgrid, Endeavour Energy) and the takeover of DUET Group. Of interest is that CK acquired DUET Group earlier this year. One of DUET s assets is a 66% stake in United Energy. DUET s Independent Expert s Report noted the benefits of combining the operations of United Energy and VPN. If this were to proceed, SKI may get access to the merger benefits via its 49% stake in VPN without having to contribute capital to the DUET acquisition. We speculate that CK may look to continue this roll-up strategy by acquiring SKI. Figure 10: EV/RAB multiples implied by Australian regulated infrastructure M&A transactions Country Energy Gas Networks (100%) WA Gas Multinet (20.1%) Allgas (selldown, Networks (25.9%) 80%) ElectraNet (41.1%) SP AusNet (19.9%) Envestra (takeover, 82.5%) TransGrid (privatisation, 100%) Ausgrid (privatisation, 50.4%) DUET Group (takeover, 100%) Endeavour Energy (privatisation, 50.4%) Oct-10 Jun-11 Jun-11 Dec-11 Nov-12 May-13 May-14 Nov-15 Oct-16 Dec-16 May-17 Note the inverse relationship between transaction EV/RAB and interest rates, albeit this data is distorted by the NSW government privatisations (combination of transaction size and material cost-out opportunity). Figure 11: Relationship between EV/RAB and 10-year swap rates for Australian regulated infrastructure M&A transactions Endeavour Energy (privatisation, 50.4%) TransGrid (privatisation, 100%) 1.6 DUET Group (takeover, 100%) Ausgrid (privatisation, 50.4%) Envestra (takeover, 82.5%) ElectraNet (41.1%) SP AusNet (19.9%) Allgas (selldown, 80%) Country Energy Gas Networks (100%) WA Gas Networks (25.9%) Multinet (20.1%) y = x R² = year interest rate swap rate at time of announcement (% pa) Each +/- 0.1x change in the spot EV/RAB impacts our equity valuation by +/- 26 cps. If SKI was acquired on the 1.58x EV/RAB we estimate CK paid for DUE s unregulated assets, then we estimate SKI is worth $2.95ps. 7

8 cents per share Energy Infrastructure Australia Equity research July 18, 2017 Distribution outlook reaffirmed at May AGM SKI reaffirmed its distribution guidance of cps (+5.2% growth) for 2017 and 16 cps for 2018 (+4.9%). It also restated its goal of steadily growing DPS instead of paying out 100% of cashflow (which it believed would result in volatility in distributions over time). From F, we can see the cashflow support for at least CPI-equivalent growth in the DPS on the basis of existing and highly predictable regulated revenue allowances, cost-out initiatives, utilisation of spare capacity within balance sheet gearing targets, and an increasing payout ratio of SKI s operating cashflows. Beyond 2021, the outlook is more clouded as we expect operating cashflows to tighten (particularly given we assume rising interest costs) and the spare capacity within gearing targets being fully utilised. Our approach assumes distributions decline in line with stand-alone cashflows. However, we note a build-up in SKI s forecast cash balance through to 2021, which may support distributions above our forecast beyond In addition, CK and SKI could agree to relax the 75% net debt:rab gearing target in order to support distribution growth beyond Figure 12: DPS vs look-through CF and stand-alone CF A 2016A 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F Distribution per share SKI stand-alone CF SKI look-through CF A point to highlight from the above chart is that SKI s look-through cashflows were boosted across by: (i) materially beneficial working capital movements; (ii) a tax refund; and (iii) distributions from the equity derivative position in DUET Group, which SKI exited in Over the last five years, SKI s forward yield based on median Factset consensus estimates has fluctuated between 5% and 7%, and currently is trading at about 6.1% based on 2017 DPS guidance. The spread of SKI s cash yield over the yield-to-maturity on 10-year CGBs has ranged between 2% and 4.5% over this period, and currently trades at ~3.4%. 8

9 Figure 13: SKI s 12-month forward distribution yield 8.0% 7.5% 7.0% 6.5% 6.0% 6.1% 5.5% 5.0% SOURCE: MORGANS, FACTSET Figure 14: The spread of SKI s yield over 10-year CGBs 6% 5% 4% 3% 3.4% 2% 1% 0% SOURCE: MORGANS, FACTSET The table overleaf summarises SKI s yield and short-term distribution growth outlook against its domestic infrastructure peers, banks, property trusts, and Telstra. In general, energy infrastructure has higher yield/lower growth characteristics than transport infrastructure and is similar to banks and AREITs overall (albeit without the franking credit benefit of the banks dividends). Telstra s yield is relatively high due to the market s concern regarding the sustainability of its dividend at the current level. Within the energy infrastructure sector, SKI s yield is higher than its peers with broadly similar growth. 9

10 Figure 15: Distribution yield and growth comparison Stock Price Est. cash yield 2 yr est. DPS CAGR Energy infrastructure APA $ % 6% AST $ % 4% SKI $ % 5% Transport infrastructure AIA $ % 13% AZJ $ % 4% MQA $ % 31% SYD $ % 7% TCL $ % 10% Non-infrastructure comparisons S&P/ASX 200 Banks $8, % 2% S&P/ASX 300 AREITs $1, % 4% Telstra $ % 0% Other AGL $ % 26% CWY $ % 27% EPW $ % -14% IFN $ % n/a QUB $ % 0% As at 18 July SOURCE: MORGANS RESEARCH, FACTSET, IRESS Figure 16: TransGrid regulatory reset Key upcoming events July Jun 2023 Transgrid Morgans Comments initial proposal estimate Date published 31-Jan-17 The AER is due to release its draft TransGrid determination for the 2018/ /23 regulatory control period in September Our modelling assumptions for the opex, capex, and return of capital allowances may be viewed as aggressive as we have used those in TransGrid s proposal (typically higher than the final decision). However, we have assumed lower WACC and dividend gamma parameters. RAB start of cycle $m 6,406 6,406 Regulatory capex $m 1,785 1,787 Commissioning of capex projects is back-ended in the regulatory cycle Return of capital $m Does not reflect full step-up of depreciation on capex incurred during regulatory cycle RAB end of cycle $m 7,512 7,549 Risk free rate % pa Cost of debt % pa Anchored by 10-year trailing cost of debt approach Cost of equity % pa Reflects lower RFR and lower MRP (6% vs 7.5% than TGR) WACC % pa Return on capital = WACC x RAB $m 2,234 2,124 Return of capital $m Opex $m 1, We assume lower cost allowances reflecting actual costs Incentive mechanism $m Cost of tax $m We assume 0.4 gamma (as per Fed Crt decision) vs 0.25 Building block revenue $m 4,270 3,945 'Smoothed' revenue $m 4,270 3,945 SKI s asset companies are pursuing significant cost-out and efficiency gains as a result of carrot (incentive revenues) and stick (benchmarking) incentives within the AER s Better Regulation reforms. We look for SKI reporting season updates and regulatory submissions (eg. RIN filings) to monitor the financial success of such initiatives; VPN regulatory appeals regarding gamma (the upside is now limited as a result of the Federal Court s ruling in favour of the AER over the ACT in the 10

11 appeals by the four NSW distribution networks) and labour escalation (relatively minor revenue uplift), with an ACT decision due 21 August 2017; SAPN regulatory appeals regarding gamma (see comment regarding Federal Court decision above) and return on debt, with a Federal Court decision expected July or August 2017; and Legislating the Council of Australian Government s decision on the Limited Merits Review, which looks to remove the right of appeal against the AER s regulatory decisions for regulated networks. Key risks Economic regulation is the key influence on the business. Regulatory resets can cause material changes in earnings, given this is when real revenue changes for the following regulatory control period are determined. TransGrid is the next asset of SKI s facing a regulatory reset, applicable for the five year period from 2018/19. Figure 17: Timing of SKI s regulatory control periods Timing Quarter M J S D M J S D M J S D M J S D M J S D M J S D M J S D VPN SAPN 2015/ / / /25 Transgrid 2014/ / / /23 Within a regulatory control period tariffs are adjusted annually based on real price changes, changes in CPI, implementation of the trailing 10-year average cost of debt, incentive schemes, and pass-through amounts. The stability of revenues generated by SKI s assets has been enhanced by the revenue cap form of regulation (no volume risk) now applied by the AER, as opposed to price cap regulation previously applied. Regulated businesses have the ability to enhance equity returns above the regulator s cost of equity allowance by achieving lower cost of capital than the AER s allowances. Regulatory incentive schemes 1 provide further potential upside to the regulatory allowance, albeit the benefits are somewhat transitory in nature. Unregulated earnings further enhance returns above the regulatory benchmark. Debt management (interest rate, refinancing), given interest costs make up about one-third of SKI s ongoing asset-level cash costs. These risks are managed through staggered debt maturities, a mix of bank debt and bonds, interest rate swaps, strong credit ratings, and no fund level debt. The AER is now utilising a trailing cost of debt approach to determining the cost of debt parameter within the return on capital allowance. This should also reduce volatility of revenues with respect to interest rate fluctuations. This approach has also created a value wedge for the benefit of the asset companies. 1 The Service Target Performance Incentive Scheme (STIPS), Efficiency Benefit Sharing Scheme (EBSS), and Capital Expenditure Sharing Scheme provide incentives/penalties related to supply reliability, actual vs forecast opex, and actual vs forecast capex, respectively. 11

12 % pa % pa % pa Energy Infrastructure Australia Equity research July 18, 2017 Figure 18: VPN forecast actual cost of debt vs regulatory cost of debt allowance 6% 5% 4% 3% 2% 1% 0% actual regulatory SOURCE: MORGANS RESEARCH Figure 19: SAPN forecast actual cost of debt vs regulatory cost of debt allowance 6% 5% 4% 3% 2% 1% 0% actual regulatory SOURCE: MORGANS RESEARCH Note we expect the trailing cost of debt allowance for TransGrid to decline over time, given interest rates are currently significantly lower than TransGrid s current regulatory allowance. Figure 20: TransGrid forecast actual cost of debt vs regulatory cost of debt allowance 7% 6% 5% 4% 3% 2% 1% 0% actual regulatory SOURCE: MORGANS RESEARCH 12

13 Asset stranding risk caused by disruptive technologies, noting the rapid development of distributed generation (solar PV), storage (batteries), and smart metering. There is a low probability / high impact risk that SKI s assets will be stranded if a death spiral scenario eventuates whereby volumes decline, causing pricing to increase, causing even greater volume decline, and so on. SKI provided a strong rebuke to this outlook at its AGM, highlighting the importance of electricity networks in facilitating the transition to a low emissions economy, by providing greater grid interconnectivity (eg. NSW/SA interconnector) and access (particularly for renewable projects via its TransGrid investment), and greater reliability and stability to the grid. In addition, SKI is seeking to benefit from technological advances, via unregulated opportunities within SAPN/VPN for 'behind-the-meter' customer solutions, distributed battery storage, and consulting services. We also note that the majority of the current RAB is recovered by the early- 2030s (SAPN and TransGrid) to mid-2030s (VPN). Capital discipline. While asset level performance has been positive with deleveraging and cost-out, recent M&A activity seems to have squandered some of this value creation (eg. equity derivatives play on DUET Group, high price paid for TransGrid). SKI reminded investors at its May AGM that its investment mandate is to invest in regulated electricity and gas distribution and transmission infrastructure, and water and sewerage assets in established regulatory jurisdictions with Australia being a key focus that offer predictable earnings and reliable cashflows. Low inflation continues to be viewed as a headwind (regulated utilities bear the risk of any difference between forecast and actual inflation in regulatory determinations of revenue allowances). 13

14 Figure 21: SAPN financial summary (100% basis) Regulatory forecasts JYE: RAB o/b $m 3,674 3,863 3,965 4,135 4,314 4,486 4,662 4,773 4,886 5,002 5,120 Capex (inc 50% x WACC) $m ,767 1,790 RAB inflation $m Reg depreciation $m (242) (218) (287) (296) (309) (326) (335) (351) (365) (382) (390) RAB c/b $m 3,863 3,965 4,135 4,314 4,486 4,662 4,773 4,886 5,002 5,120 5, % 2.4% - growth $m Risk free rate % pa 5.9% 3.0% 3.0% 3.0% 3.0% 3.0% 3.8% 3.8% 3.8% 3.8% 3.8% -2.9% 0.8% Cost of equity % pa 11.1% 7.5% 7.5% 7.5% 7.5% 7.5% 8.3% 8.3% 8.3% 8.3% 8.3% -3.6% 0.8% Cost of debt % pa 8.9% 5.3% 5.3% 5.3% 5.3% 5.3% 5.3% 5.4% 5.4% 5.4% 5.5% -3.6% 0.2% Gearing % 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 0.0% 0.0% WACC % pa 9.8% 6.2% 6.2% 6.2% 6.2% 6.2% 6.5% 6.5% 6.6% 6.6% 6.6% -3.6% 0.4% Return on capital $m ,283 1,604 Return of capital $m ,212 Reg opex $m ,394 1,342 Incentives $m () (5) (2) 5 () (2) 124 Tax net of imputation $m Revenue requirement $m ,916 4,616 Allowed revenue + STIPS $m % 2.4% - growth % -24% 8% 9% 0% 3% 2% 2% 2% 2% 2% Revenue and EBITDA DYE: Regulated revenue $m % 2% Non-regulated rev exc c/contr $m % 2.5% Underlying revenue $m 1, ,002 1,030 1,055 1,081 1,107 1,134 1,136 1% 2% Regulated activity opex $m (269) (296) (253) (257) (265) (271) (275) (280) (286) (292) (298) -2% Non-regulated opex $m (115) (130) (104) (93) (96) (98) (100) (103) (106) (108) (111) -7% Underlying opex $m (384) (427) (357) (351) (361) (369) (375) (383) (392) (400) (408) -4% 2% EBITDA excl c/contributions $m % 2% - from regulated ops $m % 2% - margin % 69% 60% 68% 69% 69% 69% 69% 69% 69% 69% 69% - from non-regulated ops $m % 3% - margin % 44% 47% 40% 40% 40% 40% 40% 40% 40% 40% 40% Cashflows and debt DYE: EBITDA excl c/contributions $m Working capital $m (81) 2 () (2) () () () () 5 Net interest paid $m (185) (132) (144) (154) (164) (171) (178) (193) (200) (208) (214) 7% 5% avg interest rate % pa 5.5% 4.5% 4.7% 4.8% 4.9% 4.9% 5.0% 5.3% 5.3% 5.4% 5.5% 0.4% 0.6% Tax paid $m (16) (31) (31) (28) Free CF before investing $m % 0% Net Investing CF $m (310) (278) (370) (370) (379) (354) (332) (347) (361) (373) (367) (1,474) (1,781) Free Cashflow $m % -2% Borrowings $m 3 (33) Free CF + borrowings $m % -2% Sub debt interest to CKI $m (73) (73) (73) (73) (73) (73) (73) (73) (73) (73) (73) - -0% Pref share distribution to SKI $m (70) (70) (70) (70) (70) (70) (70) (70) (70) (70) (70) 0% -0% Residual CF for distribution $m Distribution to CKI/SKI $m (91) (101) (102) (104) (105) (106) (114) (85) (68) (68) (72) 1% -8% Equity contribution $m Net cashflow $m 48 (26) (30) (4) (19) (7) (3) Cash balance $m (53) Debt balance $m 3,064 3,035 3,240 3,374 3,510 3,618 3,702 3,789 3,877 3,966 4, Net debt $m 2,824 2,822 3,056 3,195 3,350 3,465 3,552 3,639 3,727 3,816 3, Credit metrics DYE: FFO:debt % 17% 15% 15% 15% 14% 14% 14% 14% 14% 14% 13% -1% -1% FFO:interest x (1.0) (0.6) Net debt:rab % 71.9% 71.4% 74.0% 74.2% 74.8% 75.0% 75.0% 75.1% 75.1% 75.1% 75.1% 4% 0% Total distribution to SKI DYE: Pref share distribution to SKI $m % -0% Ordinary distribution to SKI $m % -8% Total distribution to SKI $m % -3% 14

15 Figure 22: VPN summary (100% basis) Regulatory modelling DYE: RAB o/b $m 5,530 5,785 6,093 6,364 6,614 6,845 6,971 7,100 7,231 7,365 Capex (inc 50% x WACC) $m ,464 1,825 RAB inflation $m Reg depreciation $m RAB c/b $m 5,530 5,785 6,093 6,364 6,614 6,845 6,971 7,100 7,231 7,365 7, % 1.9% - growth $m Risk free rate % pa 5.1% 2.5% 2.5% 2.5% 2.5% 2.5% 3.8% 3.8% 3.8% 3.8% 3.8% -2.6% 1.3% Cost of equity % pa 10.3% 7.0% 7.0% 7.0% 7.0% 7.0% 8.3% 8.3% 8.3% 8.3% 8.3% -3.3% 1.3% Cost of debt % pa 9.0% 5.5% 5.4% 5.4% 5.4% 5.4% 5.4% 5.4% 5.4% 5.4% 5.4% -3.6% 0.1% Gearing % 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 0.0% 0.0% WACC % pa 9.5% 6.1% 6.0% 6.0% 6.0% 6.0% 6.5% 6.5% 6.6% 6.6% 6.6% -3.5% 0.6% Return on capital $m ,835 2,328 Return of capital $m ,149 1,167 Reg opex $m ,855 1,701 Incentives $m 6 (6) Tax net of imputation $m Revenue requirement $m 1, ,003 1,056 1,079 1,145 1,124 1,137 1,152 1,168 5,124 5,726 Allowed revenue + STIPS $m 1,068 1,039 1,009 1,027 1,037 1,078 1,099 1,120 1,143 1,164 1, % 1.9% - growth % -3% -3% 2% 1% 4% 2% 2% 2% 2% 2% Revenue and EBITDA DYE: Regulated revenue $m 1,054 1,008 1,009 1,027 1,037 1,078 1,099 1,120 1,143 1,164 1,185 2% 2% Non-regulated rev exc c/contr $m % 2.5% Underlying revenue $m 1,191 1,180 1,146 1,167 1,181 1,226 1,250 1,275 1,302 1,327 1,352 1% 2% Regulated activity opex $m (268) (294) (292) (305) (315) (323) (328) (332) (337) (341) (345) 2% Non-regulated opex $m (100) (103) (103) (106) (109) (111) (114) (117) (120) (123) (126) 2% Underlying opex $m (368) (396) (396) (411) (424) (434) (442) (449) (456) (464) (471) 2% 2% EBITDA excl c/contributions $m % 2% - from regulated ops $m margin % 75% 71% 71% 70% 70% 70% 70% 70% 71% 71% 71% - from non-regulated ops $m % 3% - margin % 27% 40% 25% 25% 25% 25% 25% 25% 25% -0% 0% Cashflows and debt DYE: EBITDA excl c/contributions $m Working capital $m 84 (9) (11) Net interest paid $m (259) (174) (173) (188) (207) (224) (237) (260) (271) (283) (294) avg interest rate % pa 6.2% 3.9% 4.1% 4.2% 4.4% 4.5% 4.6% 5.0% 5.1% 5.2% 5.3% 0.6% 0.8% Tax paid $m (34) (35) Free CF before investing $m Net Investing CF $m (464) (405) (523) (477) (469) (447) (341) (349) (358) (366) (376) (1,915) (1,790) Free Cashflow $m % 8% Borrowings $m (41) Free CF + borrowings $m % -3% Sub debt interest to CKI/SKI $m (168) (162) (147) (127) (106) (82) (54) (24) () - - Residual CF for distribution $m (25) Distribution to CKI/SKI $m - (133) (165) (189) (219) (247) (273) (290) (315) (282) (280) Equity contribution $m Net cashflow $m (25) (5) (1) - 0 () () - () 0 () Cash balance $m Debt $m 4,148 4,203 4,477 4,696 4,937 5,149 5,252 5,348 5,446 5,548 5, Net debt $m 4,092 4,152 4,427 4,646 4,887 5,099 5,202 5,298 5,396 5,498 5, Cashflows and debt DYE: FFO:debt (VPN target > 11%) % 14% 15% 13% 12% 11% 11% 11% 11% 11% 10% 10% -4% -1% FFO:interest x (1.5) (0.6) Sr ND:RAB % 73.8% 72.4% 73.3% 73.6% 74.5% 75.1% 75.2% 75.2% 75.2% 75.2% 75.2% 3% 0% Total distribution to SKI DYE: Sub debt interest to SKI $m % -100% Ordinary distribution to SKI $m % 3% Total distribution to SKI $m % -3% 15

16 Figure 23: TransGrid summary (100% basis) Regulatory forecasts JYE: RAB o/b $m 6,076 6,191 6,285 6,335 6,406 6,532 6,739 6,974 7,241 7,549 7,738 Capex $m ,787 RAB inflation $m Reg depreciation $m RAB c/b $m 6,191 6,285 6,335 6,406 6,532 6,739 6,974 7,241 7,549 7,738 7, % 3.3% - growth $m Risk free rate % pa 2.6% 2.6% 2.6% 2.6% 2.5% 2.5% 2.5% 2.5% 2.5% 3.8% 3.8% 0.0% 0.0% Cost of equity % pa 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 8.3% 8.3% 0.0% 0.0% Cost of debt % pa 6.7% 6.5% 6.4% 6.2% 6.1% 5.9% 5.8% 5.7% 5.6% 5.5% 5.4% -0.6% -0.6% Gearing % 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 0.0% 0.0% WACC % pa 6.8% 6.7% 6.7% 6.6% 6.5% 6.4% 6.3% 6.2% 6.2% 6.6% 6.6% -0.4% -0.4% Return on capital $m ,668 2,139 Return of capital $m Reg opex $m Incentives $m Tax net of imputation $m Revenue requirement $m ,179 3,959 Allowed revenue + STIPS $m ,060 3,960 - growth % -11% -2% -1% 3% 3% 2% 2% 2% 11% 5% Revenue and EBITDA DYE: DUoS revenue $m Non-prescribed revenue $m Underlying revenue $m ,026 1,074 Regulated activity opex $m (162) (160) (157) (158) (162) (166) (170) (179) (189) (193) Unregulated opex $m (21) (20) (21) (23) (24) (24) (24) (25) (25) (25) Operating costs $m (183) (180) (179) (181) (185) (190) (194) (204) (214) (219) EBITDA $m from regulated ops $m margin % 79% 78% 79% 79% 79% 79% 79% 80% 80% 81% - from non-regulated ops $m margin % 62% 64% 66% 67% 68% 68% 68% 69% 69% 69% Cashflows and debt DYE: EBITDA $m Working capital $m (31) (1) (3) (1) (1) (1) (1) (4) (2) (3) Net interest paid $m (193) (190) (228) (248) (273) (303) (323) (345) (361) (374) avg interest rate % pa 3.6% 3.4% 4.0% 4.4% 4.6% 4.9% 5.1% 5.2% 5.3% 5.3% Tax paid $m Free CF before investing $m Net Investing CF $m (10,503) (267) (302) (272) (340) (380) (426) (406) (375) (403) Free Cashflow $m (10,072) (46) (4) Borrowings $m 5, Free CF + borrowings $m (4,540) Sub debt interest $m (94) (90) (100) (103) (108) (113) (117) (119) (121) (122) Residual CF for distribution $m (4,634) Distribution $m 0 (129) (76) (170) (139) (107) (86) (93) (119) (122) Equity contribution $m Net cashflow $m (4,633) (17) - 0 () () () Cash balance $m Debt balance EoP $m 5,617 5,669 5,754 5,914 6,119 6,337 6,590 6,805 6,970 7,139 Net debt EoP $m 5,554 5,623 5,708 5,868 6,073 6,291 6,544 6,759 6,924 7,093 Credit metrics DYE: FFO:debt % 8% 7% 7% 7% 7% 6% 6% 6% 6% 7% FFO:interest x Net debt:rab % 88% 89% 89% 89% 89% 89% 89% 89% 89% 89% Total distribution to SKI DYE: Sub debt interest to SKI $m Ordinary distribution to SKI $m Total distribution to SKI $m

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