Powering up: Spark Infrastructure

Rick Francis is the CEO of Spark Infrastructure which owns 49% of the Victorian and South Australian power networks, and 15% of TransGrid which is the transmission company in New South Wales. It's basically an income stock, 6.5% yield unfranked, but because of a decision in the federal court last month, they're going to have to start paying tax, so their dividends are going to be franked in future, which obviously will be not that exciting to a lot of people if the Labor Party wins the election because of the ban on cash refunds of franking credits. However, I don't think it will be 100% franked anyway, but they are going to start paying tax. The dividend might end up being a bit less, but they are in some growth businesses. 

In particular, TransGrid is starting to connect a lot of renewable energy generation, solar farms and wind farms, and that's providing a bit of juice. A bit of growth juice to the business while the rest of the distribution businesses in Victoria and New South Wales grow kind of steadily with population growth. Obviously, it's a regulated utility business, but with a bit of interest to do with connecting renewables which have grown quite quickly, 20% in the last 12 months. As well, there's the prospect of some franking of their dividends. 

Here's Rick Francis, the CEO of Spark Infrastructure.

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Rick, if you could just take us through what the highlights of the latest year were?

Okay.  All right, from the Spark perspective, the highlights are that we reported what we call a standalone operating cash flow of $290.2 million for the year, that's up 8.5%.  That is one of the key measures that our investors look at, because they're obviously very interested in the distributions and the generation of cash at the Spark level and that has underpinned the full year distribution for 2018 at 16 cents, which is a 4.9% increase on 2017.

But your payout ratio actually fell from 96 to 92%, I see.

I think that's probably right, 92%, yep.  We look to ensure that our distributions are basically fully cash covered and that is something that we look at across the regulatory period, but also look at it within years as well.  It can go up and down.

Anyway, I interrupted you.  Carry on.

Looking at our investments, the greatest share of our investments comes out of our investments in electricity, the electricity distribution networks that we part own in Victoria and South Australia.  They make up about 84% of our proportional asset base, and they saw good growth in 2018.  The Victorian business grew by 3.6%, 18 to 17, and the South Australian business grew by 3.8%.  Those businesses themselves, they are in year three of their five-year regulatory periods, so it is very much about business as usual for those businesses and looking to drive efficiency and operate them as efficiently as possible.

But as they've just finished year three of their five-year regulatory period, they're now looking ahead at the next five-year regulatory period and they've formally commenced their preparations around the next regulatory determinations.  They've now commenced their engagement with the regulator, interested stakeholders and the community at large, I guess.

The remaining 15% of our proportional asset base is our investment in TransGrid, which is the electricity transmission business.  The growth in the regulated asset base was much more modest at 0.8%, and that's a function of how transmission businesses tend to grow.  It's more lumpy when it comes through because the larger growth in the asset base often comes from one-off new interconnects and larger upgrades to the transmission system, so the growth tends to be a bit more lumpy. 

On the other hand, what gets a lot of focus in the TransGrid business is their unregulated or contracted asset base, so that's the connections business to new renewable generation coming into the grid and that's all very healthy growth of 21% in 2018.  In comparison to the distribution businesses, TransGrid has only just recently commenced its new five-year regulatory period, so midway through the 2018 year it launched into its new five-year period, so from 1 July.

How sustainable is that growth in unregulated business in TransGrid where you're connecting renewable assets like solar farms and wind farms?

Yeah.  What we saw during 2018 was around about 550 megawatts of connections into new renewable generation been completed.  The business has now, over the last couple of years, connected about 1100 megawatts of new renewable generation.  What it is has got in the pipeline and so has formally commenced construction, is a further 1800 megawatts of renewable generation, so that's a pretty healthy growth that's expected. 

It's been averaging about 100 million of capex per year.  We expect that level of capital expenditure to continue for at least the next couple of years.

What percentage of the new renewable energy generation are you connecting?  What's your share of that market?

You need to look across the whole national electricity market, obviously, the NEM, which spans Queensland, New South Wales, South Australia and ACT.  TransGrid's focus has been primarily on New South Wales and our TransGrid success in New South Wales has been very good.  They haven't missed a lot.  That's a function of obviously, TransGrid owning the transmission network itself, and having a very good understanding of the network capacity and demand and so on in the network. 

But it's also a very strong reflection that you build the connection, and these are 30 to 40-year assets, obviously, and then not only are TransGrid building it, but it's also maintaining the connection for that period.  It is absolutely vital to the success of the renewable generation, whether it be solar or wind, that the connection is always operating.  Having the skilled workforce that's geographically spread across the state that can quickly respond to any issues is just as important as the actual build itself.  Obviously, being the regulated monopoly supplier in terms of transmission in the state is a very strong position for TransGrid in that regard.

But are you picking up any connection deals at all in the other states?

They have been successful with one or two, but the lion’s share of what they've picked up is in New South Wales.

Right.  I don't know whether this is connected or not, but it was an interesting point in one of the slides in your deck about your strategic vision and priorities, and it says here, "Growing through disciplined acquisitions."  What do you mean by that?

That means growing through acquisitions.

Right.  Acquisitions of what?

Acquisitions of any assets that are consistent with our strategy and consistent with the risk profile that we believe our investors, our security holders like and are comfortable with.  We are currently invested in regulated electricity networks, transmission and distribution.  We acquired the TransGrid investment back in December 2015, so that was a very logical acquisition.  We subsequently had a look at the Endeavour electricity distribution business in New South Wales, that was privatised.  They're obviously quite logical.  But those opportunities are not that frequent.

Then looking more broadly, Alan, we are comfortable to look at other secure types of assets, infrastructure based, that offer that reliable, secure level of earnings as well as cash flows.  They could be regulated in another sense, regulated gas or a telco, or whatever, or there could be an asset that is backed by a contracted revenue source.

I'm just wondering whether you're actively looking for acquisitions.  If so, what's your capacity to do that, given that you're paying more than 90% of your cash flow out in dividends?

We've always had a focus on acquisitions and we've always been interested in looking at adding to our portfolio, so that's been consistent.  We've looked at a number of assets.  Obviously, we were successful with TransGrid, but there are a number of similar assets that we've looked at over the years.  I can give one example.  We looked at the Sydney desalination plant when the New South Wales government was looking to sell that off at the time.  Obviously, that was a regulated water-based asset. 

But to answer your particular question, we don't reserve cash flow in the year to build up a war chest.  So, any sort of acquisitions that we would look at invariably if it was a significant size, we would need to go back to our investors in some form of equity raising, which is exactly what we did when we bought the TransGrid asset back in December '15.

Yeah, just looking at your business, obviously, the growth that you're getting, where the excitement in your company is, is in connecting renewable energy.  Are you thinking about maybe you should make acquisitions in that kind of business so that you get more of a national footprint?

To answer that question, I should probably just step back one step.  There is inherent growth in our existing businesses.  What you would call organic growth.  Those types of opportunities are normally funded from within the business, through some form of retained cash.  It is only when we then look outside the organic opportunities that then Spark itself would need to work out, what is the appropriate funding plan and potentially go back to security holders to raise new equity.

I could put into that camp other very significant organic, let's just call it organic growth opportunities, such projects as the New South Wales South Australia electricity interconnector, transmission interconnector, which is a very large transmission opportunity that's progressing currently.  It depends on the final solution, but the size of that could be in the order of 1.5 billion dollars of capital expenditure, which would be split between, if it gets the final approval, which would be split between the two transmission operators in South Australia and New South Wales.  A funding plan would be determined, but that would be funded within TransGrid, but it may well be that TransGrid, in forming its own funding plan, needs to come back to its own shareholders and require an equity injection, for example.

Yes.

They're all the organic opportunities.  The smaller ones tend to be funded from cash resources within the businesses, and that's historically what they've done over many, many years.  We'll need to address the larger organic opportunities such as an interconnector like that, where it is substantially larger than the smaller organic capital expenditure that goes on every day in the businesses.  And then we roll into the inorganic acquisition-based growth that may well occur at the Spark Infrastructure level. 

Which then sort of comes back a little bit to your question in terms of growth within the national electricity market itself.  And again, there's sort of two levels in terms of where does that growth naturally fit?  Does it naturally fit within one of our investment businesses, so either distribution transmission?  Or is it something that would more appropriately reside at the Spark Infrastructure level. 

There's a number of different frames that we need to look through when we're looking at opportunities.  For example, in the renewable generation space, a lot of that new renewable generation that's coming into the market is supported by long term contracts, PPAs.  There's an element of that capital expenditure that potentially resides in one of the network companies.  That's obviously what TransGrid has been focusing on.  Then there's the core underlying generation, whether it be a wind farm or solar farm or whatever.  Certainly, Spark is interested to have a look at those assets and to see whether it fits with the asset criteria that we think that our investors would be comfortable with.

Another line in your deck piqued my interest.  Obviously, a lot of the subscribers that we have, and a lot of your investors, are interested in Spark as an income producing investment.  It says here, under tax, "We expect to be able to distribute franking credits to security holders to the extent possible." So obviously your dividends are unfranked, or have been up to this point.  Are you expecting that at some point you might be able to start franking them?

Yeah, that's correct.  We're going through a change now.  Our current distributions are a combination of interest income and repaying the capital, which is really just being tax efficient.  And then what we've just recently announced is that our businesses are looking to pay tax in the not too distant future and there's a tax matter that's received a decision out of the federal court just recently.  That has potentially brought forward the payment of tax at the investment or asset level, which would flow through to Spark.  What we've been saying is, to the extent that there is tax payable, as a result of that and the bring forward of the tax obligation, that we don't see any sort of structural impediment to be able to pass on those franking credits to our security holders in due course.

Just taking those things one at a time, the tax decision that was in the court, will that result in a lower profit for you and therefore possibly a lower dividend?

It'll result in lower cash flows as a result of the tax, but of course then you can then on-pay the franking credits as a result.  It's actually a timing difference.  These items that were in dispute, and it was an industry matter, Alan, it wasn't specifically to our business, but we...

Yeah, I understand that.  I suppose I'm wondering whether investors need to...  Because at the moment you're yielding about 6.5% unfranked.  I'm just wondering whether in the future your yield is likely to be 6.5% grossed up, or is it likely to be 6.5% before franking and then something more than that grossed up?  What do you think?

What we actually announced, so we reaffirmed at this results announcement, but we actually had a separate announcement on the 11th of February where we actually addressed that point.  We paid a distribution of 16 cents in relation to the 2018 year, and then we reported that, this tax matter as you’ll see, the decision from the federal court should that proceed through and not be challenged and that be accepted, what we have said is that our distribution, and we get guidance out of that distribution for 2019 of being one cent lower.  So, our guidance for 2019 is at least 15 cents per security.  With that reduction of one cent effectively reflecting what we believe to be the annual top tax impost in the ‘19 year.

Right.  I get it.

Matters still potentially need to bed down, and we're reserving our rights currently around the federal court decision and there's been no decision yet as to whether we will appeal.  But the directors felt it prudent, to put forward this revised guidance and say what it looks like at the annual tax impost for 2019 if it rolled through, would effectively reduce our distribution by that one cent.

But that's guidance as opposed to a promise, right?  That's what you think will happen but it might get a bit more growth or you might win some more renewable connection deals and be able to pay 16 cents.

Hence why the guidance is actually at least 15 cents per security for 2019.

Right.  So that's a promise at least 15 cents is a promise, is it?

It's a pretty firm guidance, but it's always subject to business conditions, obviously, Alan.

Yeah, of course.  We could have a recession.

But of course, what is very important with these businesses is that they're operating under the regulatory determinations, which are locked in, so we do have very good visibility for the remainder of the regulatory periods and that comes off the 2019 year.  We do have very good security or visibility, and we are very quietly confident.  I don't think we've ever missed guidance, in that respect but there is always that caveat that I think you just need to prudently apply.

Just finally, if the Labor Party wins the election and we get a 45% renewable energy target, is that good for your business?

Look, I think any energy policy with some certainty will help.  There are multiple lenses to your question there.  At face value, anything which provides some certainty in energy policy should be good for the industry.  Because what we've seen is that if a loss of investors being concerned about the uncertainty and not investing, and of course as the coal fired generation retires and there's not the level of renewable generation support there to replace it, so a strong, certain energy policy will be beneficial for the investors.

Obviously, a higher target will mean that more renewables will be looking to come into the system.  That's a positive.  That provides opportunity in its own right as well as the connection into the current grid.  It means the grid needs to be strengthened and reinforced and expanded to deal with that, which is also positive.  What I question about, and been fairly vocal on, is in terms of the other subsidies that are often rolled out around residential batteries and so on. 

I'm wary of the level of subsidies required when there’s changes already on the way.  The problem with subsidies at the residential level is that it's encouraging rollout of batteries on sides of houses, and to the extent that the network and AEMO, who tries to manage the demand and supply in the electricity industry, the extent that they don't have any visibility or control over the use of the batteries and where the electricity is flowing in and out of the premise makes that whole exercise extremely difficult, and generally more expensive.

I suppose I'm not surprised you don't like subsidies for solar on houses, because that gets people off the grid.  That's bad.

They'll never go off the grid, Alan.  They'll stay on the grid.  There's no question about that.  There is no way people will go off the grid, or sensible people, because it's just not commercial.  You just don't have one battery, you need to have a couple of lines of support, so the grid will absolutely be used.  But the grid will be used in a different way.  It'll be used as a second or third line of support, and that leads you to reflect on the current tariffs and tariff reform that you'd need for the users of the grid.

So, is this something long term for investors in your sorts of businesses, investors in the grid, the transmission and distribution and so on, is this something that those people should be worried about long term?

The network companies and ourselves are very much looking at, what are the appropriate technologies that should be employed as part of the grid.  A better economic solution for all consumers is large-scale renewable and large-scale storage.  That can be a combination of batteries and pump storage and gas leakers, and that cost being shared across the whole economy.  That is the most efficient solution, rather than piecemeal PV and batteries in houses.  We are looking at it as to how the rollout of that new technology is affecting the demand and supply and the frequency and intermittency issues across the grid, and our businesses are evolving to respond to those new challenges.

Yep.  We'll have to leave it there, Rick.  It's been really good to talk to you, thank you.

Pleasure, Alan.  Cheers.

That was Rick Francis, the CEO of Spark Infrastructure.