On pipelines and poles

Shtokman is one of the largest undeveloped gas fields in the world. Discovered in 1988, many have toiled to extract gas trapped under arctic waters 600kms off the north coast of Russia. It’s hard, freezing and expensive work.

Infrastructure needs to be encased in concrete to protect it from ice and, to dodge rogue icebergs, the equipment needs to be towable. Drilling seasons are short and costs are high. Yet for decades, and despite the hazards, about a dozen companies have tried to extract gas from one of the most remote fields on earth. Yes, gas is valuable.

Actually, there’s a caveat to that; it’s valuable if it can be transported. Carrying it in sacks or barrels just won’t do, which is why pipelines are so important to this industry. They pressurise gas to a point where it can be transported from where it's found to where it’s needed.

The expense in constructing gas pipelines means the companies that build and operate them tend to be profitable monopolies collecting stable revenues and paying handsome distributions. That’s nice. But it also means they tend to carry terrifying levels of debt, which isn’t.

Table 1 shows that in full view. It also reveals that reported profits typically don’t cover distributions paid. Because accounting depreciation typically exceeds economic depreciation, these businesses record depreciation higher in their accounts than the cash consumed in maintaining the assets. As depreciation is a non-cash charge, it lowers reported profits but not real cashflow, from which the pipeline companies pay distributions.

That limits the usefulness of reported profits in analysing the sector. Instead, we use operating cashflow, adjusted for interest payments, tax and maintenance costs to estimate the cash available for reinvestment and distributions.

But there’s a further trap set even with this approach. Regulated businesses grow by adding to their asset base, which requires cash. So distributions that are too high are a guarantee that capital demand, either from more debt or equity, will soon follow. So beware of those companies with a high payout ratio - it’s often a sign of dilution risk (for more information on valuing infrastrucure stocks we recommend reading The case for essential infrastructure special report).

Let’s now examine the three major pipeline operators listed on the ASX.

APA Group

APA Group is the largest transporter of gas across the country. Its 14,000kms of transmission pipelines account for 65% of the country’s total, and about half the gas used in Australia is moved through APA-owned or invested pipelines.

Among its assets are; the Victorian Transmission System, a collection of 14 high pressure transmission lines that transports all gas consumed in the state; the Moomba to Sydney pipeline, which links Cooper Basin gas with distribution networks in Sydney; and the Goldfields Gas Pipeline, which transports gas from the WA coast to the Pilbara.

APA also has an investment arm which owns, among other things, a 34% stake in Envestra and a 6% stake in Ethane Pipeline Income Fund, with management rights attached to each. Management revenues are lucrative but APA earns most of its cash from its pipelines. In fact, about 95% of all revenue is regulated or contracted.

Shippers of gas – the parties that contract the use of pipelines – typically pay both a fixed amount for pipeline capacity and a volume charge. The volume of gas flowing through the pipes is therefore crucial in determining the revenues of operators.

Owners of pipelines have benefited from two key sources of growth: the increasing use of gas fired peaking power stations and the high volumes of gas used by the mining industry. APA has been a beneficiary of both trends.

Peaking plants require a large idle capacity to handle maximum, rather than average demand, and storage facilities are needed to quickly access generation fuel. That means plenty of pipeline capacity is contracted out and, when peak demand hits, so do higher volume charges. Although plenty of new peaking plants have been built in recent years, we don’t believe any more will be needed for the rest of the decade. As a source of growth for APA, peaking plants may have, um, peaked.

The mining boom has also increased gas volume growth. The largest component of APA’s earnings before interest, tax, depreciation and amortisation (EBITDA), for example, comes from Western Australian and Northern Territory pipelines that services industrial users, mainly miners. Pipeline capacity is contracted for periods of between 10-20 years, but falling gas volumes can still affect revenue.

All pipeline owners can increase gas volumes without building new pipelines. The trick is to add compressor stations (see Shoptalk) that will physically compress gas and allow more volume. It’s a common trick; on the Goldfields Pipeline, for example, APA recently increased volume by 28% by adding three compressor stations. The additional gas capacity was then sold to major miners on 10-15 year contracts.

At some point however, new pipelines needs to be built to accommodate volume growth. That makes capital expenditure occasional but when it does occur, huge. This isn’t a great concern for APA because it operates many non-regulated pipelines. It will typically pre-sell capacity for at least 10 years before committing to expansion.

APA’s growth has been selective and successful but that doesn’t make it a buy. It may be a utility owner but it is also a conviction stock – a business for believers in gas. Management are positioning the business to take advantage of a future gas boom, the arrival of which is no certainty. On a free cash flow yield of 5.5%, APA is fairly priced rather than cheap. HOLD.

Envestra

Envestra is a major owner of distribution pipelines in Victoria, South Australia, Queensland and New South Wales. Along the eastern seaboard, it owns about 22,000km of distribution pipelines that bring gas from high pressure transmission pipes direct to consumers.

Whereas many of APA’s transmission lines are unregulated and rely on long term contracts, distribution pipelines are heavily regulated. Over 90% of group revenue is regulated and 70% derives from predictable residential users. To say this is a stable business is like saying Black Caviar is rather swift.

That stability has encouraged a lot of debt (see Table 1 again). A capital raising in 2009 was used to pay down debt and management insists it will slow distribution growth for the same reason.

Despite that, Envestra may still require further debt or equity to meet future capital expenditures, as it has done for the past five years. Although today’s yield of 5% is stable and reasonable, it’s unlikely to grow immediately. Envestra ticks some boxes but we’re not recommending jumping in yet. HOLD.

Duet Group

Duet Group’s prime asset is 80% of the Dampier to Bunbury Pipelines (DBP), which links the 175 trillion cubic feet (tcf) of WA offshore gas to the WA market. The attractiveness of the asset is aided by the WA state government, which forces offshore producers to set aside 15% of their gas for domestic use, much of which travels the length of the DBP.

Duet’s other assets are substantial, but less interesting. It owns 66% of United Energy Distribution, which distributes electricity throughout south east Melbourne, and Multinet Gas Holdings, which distributes gas to some Melbourne suburbs.

The group has a bewildering structure. Each asset has its own security as well as a management contract stapled into a six-security entity. Simple, right? Fees paid are downright usurious. Duet pays 1% of its market capitalisation and 20% of any excess returns it enjoys over the index to a consortium of banks each year.

Fortunately that mess, and those fees, will be abolished later this year, replaced by internal management and a simpler, triple-stapled structure.

After years of disaster, Duet is on the mend. It has sold a bewildering array of overseas assets, raised substantial equity to reduce debt and the simplified structure relieves a key concern, although annoyingly, Duet continues to refer to free cashflow that excludes interest payments.

Funny that. Interest is the company’s largest expense and adding that cost back to operating cashflow reveals there is little headway for future cash calls. Duet is worth watching as improvements take shape but, for now, there are better prizes to chase. AVOID.