Duet changes its tune

In the same year The Karate Kid introduced the world to the crane kick and Philips introduced the CD player, the Dampier to Bunbury pipeline (DBP) connected gas from the newly discovered North West Shelf to the metropolis of Perth. It was, of course, 1984 (did anyone other than Miyagi fans get that right?), and the 1,500km pipeline – among the longest in the world – started flowing with up to 360 terajoules of gas a day.

Unlike CD players and the disappointingly ineffective crane kick (as the author's teddy bear can apparently testify – Ed), the DBP has thrived. After various expansions, capacity today sits at over 850Tj/day. The DBP is now 80% owned by Duet Group (the rest being owned by Alcoa) and accounts for 50% of earnings before interest, tax, depreciation and amortisation (EBITDA, see Chart 1). It is the single most important asset in Duet's portfolio and a marvel of Western Australia.

Buried underground for its entire length, the DBP comprises enough steel to make 400,000 cars and runs through busy suburbs, vineyards and desert. It has a fusion bonded epoxy coating which means that today, 25 years after construction, it shows no signs of decay.

Unlike the spaghetti network of pipes along the east coast, there is no way to bypass the DBP. If shippers want to move gas from offshore fields, they must move it along this pipeline. It is a true monopoly asset.

Reversion to regulation

Like most monopoly assets, it is regulated to limit excessive returns. Every five years, Duet (and Alcoa) must approach the Economic Regulation Authority of WA which decrees the tariffs to be charged. In the past, the regulated price has only applied to spare, uncontracted capacity, while more than 90% of revenue on the DBP comes from contracted capacity where negotiated contract prices, rather than regulated prices, are used. But that may soon change.

After 2016, contracts will revert to new regulated prices unless Duet renegotiates with its customers. The ERA decision for post-2016 prices will be vital in determining cash flow, and there's a good chance it will be lower than today.

In its most recent ruling, Duet sought a 10% annual return on the uncontracted portion of the pipeline but the regulator approved a return of just 5%. Since the bulk of revenue currently comes from negotiated contracts, the ruling makes little difference, but it does highlight the gulf between the ERA and Duet. That gap, unless closed, will affect revenue after 2016.

Lower gas volumes

There is another threat to pipeline profits. WA generates 60% of its power from gas and lower electricity demand threatens gas volumes through the DBP. Last year, for example, gas volumes fell 3% largely because of additional renewable capacity.

In the short term this has a limited impact because 80% of contracted revenue is collected regardless of volume (EBITDA actually rose 1% last year despite the lower volumes). But the contracts will be renegotiated over time, so a permanent fall in gas demand could have a more significant impact.

The effect, though, is hard to predict. Usage data confirms that total demand is falling but it’s also more volatile. Shippers may choose to pay for peak power rather than ‘always on’ base load power so the DBP might be insulated from lower gas volumes.

We expect little immediate growth from the DBP and assume both the regulatory asset base (RAB) and EBITDA remain steady between now and 2015 but, for a seemingly reliable asset, cash flows from the DBP are harder to predict post-2015.

The DBP is Duet’s most important asset, but United Energy (66% owned by Duet) and Multinet Gas (100% owned) should deliver faster RAB and EBITDA growth. The regulator has already approved an 8% a year rise in tariffs between now and 2015 for United and the RAB will increase 6% over that time. At Multinet, modest gains have been approved until 2017. So cash flows from these Victorian assets should rise steadily for the next two years.

The same forces affecting Spark Infrastructure (see Storm brews for Spark Infrastructure on 24 Sep 13 (Hold – $1.60)), however, also stalk United. The next regulatory reset is likely to trigger lower returns, raising questions about the sustainability of the current yield.

Too dear

As Table 1 shows, Duet paid out 88% of adjusted earnings in 2013 and 95% in 2012. Next year, when distributions rise to 17 cents – a yield of 7.8% – the payout ratio will sit at about 90%. This is the highest yield in the industry, perhaps reflecting some scepticism about its sustainability. With so much cash allocated to distributions, there is little left to pay for additional investment and even mildly unfavourable regulatory outcomes will result in lower distributions.  

That would be an acceptable risk if the stock was cheaper but, with an enterprise value to RAB of about 130%, that isn’t so. Factoring in future RAB growth still generates an EV/RAB of over 120% in 2015.

Simplification of the structure, changes to its asset mix and a management internalisation have all made Duet a better business than it has ever been. The DBP in particular is an excellent asset. We would consider upgrading at lower price, but with the price up 6% since 19 Aug 13 (Under Review – $2.04), Duet is simply not cheap enough today. HOLD.