Infrastructure fund's sound income pipeline

Outperform with corporate potential

Writing analysis on any investment security is fraught with difficulty at present.

The political and financial imbroglio unfolding in the United States could resolve, roll forward or implode at any point. Therefore, while this week’s report is more tentative than normal, I do believe that any market gyrations to the downside will create some interesting opportunity for investors. To my mind Ethane Pipeline Income Fund (EPX) may represent such an opportunity for my income portfolio.

Consider the following current characteristics

EPX is a stapled security with an operating company and financing trust. From last financial year the fund moved into a tax-paying position, and so while distribution per unit fell it included a higher level of franking.

Readers can see from the above that EPX is forecast to generate a 10% pre-tax distribution yield at the current unit price. The fund pays quarterly distributions and therefore offers its owners an excellent income stream that is superior to anything that I can find on the sharemarket at present.

Further, the fund is managed and partly owned by APA Holdings, Australia’s premier pipeline manager.

What does EPX do?

Ethane Pipeline Income Fund (EPX) is the owner of a 1,375 kilometre long high-pressure gas pipeline. The pipeline was purpose built to transport ethane gas from a Santos processing facility at Moomba in South Australia’s Cooper Basin gas and oil fields to a petrochemical plant operated by Qenos at Botany Bay in Sydney. The pipeline was commissioned in 1996 and the technical life of the pipeline was estimated to be in excess of 60 years in the 2006 prospectus.

Current estimates suggest that the natural gas reserves at the Moomba fields are currently around 1,800 PJ (petajoules). To put this into context, the annual throughput to the Botany facility by EPX has historically been about 16 PJ per annum.

A key risk for EPX is that the ethane transported through the pipeline is delivered solely to Qenos. While EPX holds a long-term Product Transportation Agreement (PTA) with the plastics manufacturer until 2030, Qenos retains the right to cancel before then upon giving 12 months’ notice. In effect, Qenos rents the pipeline and until recently (October 1, 2013) it was base rental adjusted annually by CPI. Now the rental is made up from a base level and an adjustment for volume throughput. The annual rental has been around $26 million per annum, and it is envisaged that the annual rent will remain at about this level for the foreseeable future.

EPX is essentially a single asset business, and while this makes it simple to understand it also means the risks are moderately higher when compared to some other income-producing alternatives. In return, investors are paid a comparatively higher yield.

EPX recently declared the September quarter distribution of 3.29 cents per share, which when grossed up to account for attached franking credits equates to a gross distribution of 4.38 cents per share.

EPX has a strong balance sheet

The most recent audited balance sheet discloses that EPX has moved to a net cash position. This is very unique in the infrastructure sector and it does indicate a significant level of conservatism with management and the board. The lack of debt does reduce the financing risk of the pipeline asset, but it does lower the return on capital generated from the asset.

It is noteworthy that the current market value of EPX, adjusted for cash, is approximately $120 million. This market valuation is well below the replacement value of the pipeline.

Click to enlarge

Source: EPX ASX release 15 August 2013

Key financial comments

Apart from the improving strength in the balance sheet, EPX attracts as a fairly predictable earning asset. For instance revenue (rental income) increased from $26.1 million (2012) to $26.5 million (2013). Pre-tax profit lifted from $10.1 million to $11.9 million as interest expense declined. However, operating cash flow fell from $16.4 million to $12.4 million as income tax was paid for the first time.

The forecast for 2014 and 2015 is based on maintaining gas volumes at about historic levels subject to an expected short-term shutdown of the Botany plant for maintenance purposes. My confidence in suggesting that distributions are maintainable at current levels is based on the cash reserves that are held by the fund as a contingency.

Summary and conclusion

EPX does justify a serious consideration as a candidate for my income portfolio given its excellent yield characteristics. However, its relatively small size makes it difficult to justify a full weighting at present.

Apart from its size, there are other risks worth noting for investors. I mentioned earlier the single asset and single customer risk. There is also the risk of ethane supply running down, although this in not apparent from disclosures by Santos, and the chance that Qenos may stop manufacturing in Australia. This later risk is reduced as the $A depreciates, and arguably the worst is over here.

On the positive side, investors should note that the presence of, and management by, the acquisitive APA Holdings does suggest some potential for corporate activity at some point. Further, it is clear that the asset at present market values is yielding over 20% in gross rental. This observation suggests that Qenos and APA could well consider a simple financial joint venture that privatises this asset. Clearly Qenos could save many millions per annum by part owning the pipeline and funding it with debt.

Disclosure: Clime Asset Management has shareholdings of EPX across its portfolios.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Income Portfolio Statistics

Return since June 30, 2013: 6.26%

Returns since Inception (April 24, 2012): 36.05%

Average Yield: 7.29%

Start Value: $150,754.88

Current Value: $163,259.06

Dividends accrued since June 30, 2013: $2,441.44