Tax dispute creates Spark interest

This week I am bringing Spark Infrastructure Group (ASX:SKI) into the Income Portfolio.

To make way for SKI I have decided to exit the holding in Woolworths’ floating-rate debt securities (WOWHC). In doing, so I am increasing the yield of the portfolio and using the elevated price of WOWHC to avoid a likely loss in the future when WOWHC are redeemed.

At current prices of around $1.63, and taking into account the company’s forecast distribution yield, its steady growth outlook, and its discount to net tangible asset (NTA) backing, SKI is worthy of inclusion into the portfolio.

Specifically, the forecast 2013 yield is approaching 7% (taxable and/or tax deferred) and is generated from regulated revenue, and this is forecast to grow by 3-5% annually in coming years. The growth in distributions is based on steady deleveraging plus the predictable growth from SKI’s investments in the regulated power distribution assets based in South Australia and Victoria. The forecast distribution is covered by operating cash flows.

Assuming the maintenance of low cash rate settings by the Reserve Bank, there is also an opportunity to earn a capital growth return of around 10% within a year. In my view regulated utilities growing at low single-digit are worth NTA per share – $1.81 in SKI’s case.

The opportunity in the stock is the security’s price discount to NTA, which reflects a dispute with the Australian Tax Office (ATO). This dispute concerns the deductibility of various claimed expenditure, mainly interest payments, in the stapled structure.

According to the Trust, it strongly disputes the claims of the ATO and its carried forward losses will offset most of the claim should it be lost. Therefore, success by the ATO would appear to bring forward the ability of the trust to frank distributions although it may reduce cash flow available to pay down debt.

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Source: StocksInValue.com.au

Apart from the tax dispute, readers should note that the security’s price also tends to rise and fall substantially as the stock accrues the next distribution and then trades ex this distribution. This is another source of capital upside. After going ex the 5.5c first-half distribution on August 29, SKI’s security price is about to begin its next distribution cycle upswing – if history repeats itself. Management guided a second-half distribution, also of 5.5cps.

In my view the downside at current prices is limited because the bad news concerning the ATO dispute is reflected into the security price and the distribution yield should provide support.

What does SKI do?

SKI invests in regulated electricity distribution businesses in Victoria (VIC) and South Australia (SA). The portfolio comprises a 49% interest in three regulated electricity distribution companies: SA Power Networks in SA, and CitiPower and Powercor in VIC. Hong Kong-based Cheung Kong Infrastructure owns the remaining 51% interest. SKI securities have a stapled structure, comprising one unit in Spark Trust and one loan note issued by the Trust’s responsible entity. Distributions comprise interest on the loan note and capital returns on the unit.

The first-half result highlights SKI’s reliable regulated revenue streams. Total regulated revenue was up 8.2% to $871.8 million, with earnings before loan note interest and tax 3.4% higher at $146.7 million due to strong operating results across the portfolio. Operating cash flow rose 4.1% to $83.3 million.

Rising regulatory tariffs boosted revenue despite declining electricity consumption, in particular a soft contribution from SA and VIC. Grid volumes in these states are flat or declining due to a rise in solar power usage and energy saving initiatives. CitiPower and Powercor tariffs rose about 8.9% and 8.4% respectively at the start of the year, while SA Power tariffs rose 6.6% on July 1.

The electricity distribution market comprises several regional monopolies. The Australian Energy Regulator determines an appropriate rate of return on regulated assets and the revenue charges to be allowed to achieve this. Regulated revenue is calculated by multiplying SKI’s RAB (regulated asset base) by its WACC (Weighted Average Cost of Capital), adjusting for operating expenditure, tax and depreciation. Every dollar of capital expenditure therefore increases the RAB and earns a guaranteed rate of return.

High capital expenditures translate to higher dollar returns. The current RAB is $8.3 billion, up 8.7% over the year to June 30. RAB growth of 3.1% in the first half reflected capital expenditure of $422 million. Management flagged 7-8% compound annual growth in RAB over 2010-2015.

The regulated nature of the industry restricts growth but also ensures reliable revenue flows. SKI has regulatory certainty until 2015-16, with no regulatory resets until then. All three assets also earn unregulated revenue.

The tax dispute

The weight on the security price is the ongoing dispute with the ATO over amended tax assessments for the SA and VIC power networks. In July 2012 the ATO delivered amended tax bills to all the partners in SA Power Networks covering 2007-2010. In March 2013, Victoria Power Networks received an amended tax bill for 2006-2007 totalling $296 million, resulting in tax payable of $18 million after incorporating earlier tax losses. SKI has lodged objections to the assessments and said it will “vigorously defend its position”. In the first-half no accounting adjustments were made with respect to the ongoing disputes.

For SA Power Networks, the matters in dispute involve rent instalments under land lease, labour and motor vehicle costs and the denial of deductions for some interest costs relating to 2007-2010. In the case of Victoria Power Networks, the dispute centres on tax assessments for 2006 and 2007 over various deductions and interest.

The outcome of the disputes could reduce the balance of carry-forward tax losses and alter the Trust’s taxpaying status.

Why switch out of WOWHC?

As WOWHC’s share price approaches $105, there are two things that happen. First, the running yield of this security declines and second, the yield to maturity declines. WOWHC has a distributable yield based on the 90-day bank bill swap rate plus 3.25%, and this currently equates to 5.6%. Whilst this is superficially attractive and there is no doubt regarding the quality of Woolworths’ credit, I just do not believe that a redemption yield of less than 5% (my current forecast is about 4.8%) justifies holding this security. Investors need to realise that the redemption is just over three years away in November 2016, and at that time they will receive $100 back.

The switch to SKI, even with the tax issues, appears a better portfolio investment in the income portfolio at this point.

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): 33.49%

Average Yield: 7.40%

Start Value: $150,754.88

Current Value: $160,191.90

Dividends accrued since June 30, 2013: $1,541.73