Selling Spark Infrastructure

Twelve months ago on April Fool’s Day we welcomed Spark Infrastructure’s decision to internalise its management. Rather than pay external managers asset and performance fees, an in-house management team would earn salaries and performance-based bonuses.

It should have been a good thing (and there’s a small chance it may yet be). Too often external managers seek reward by increasing assets under management instead of generating outsize returns from existing assets. Performance-based bonuses theoretically address this empire-building problem.

But not always. An internalised management can feel the same need to stamp its authority on a business and seek out ways to increase remuneration. Enter the ‘company-transforming’ acquisition.

You can almost hear the argument at the annual general meeting following the purchase: ‘Managing a larger and more complex business requires more skill and talent so we need to pay ourselves more’. Unfortunately, the evidence is mounting that Spark Infrastructure is about to embark on this path.

New strategy

On 1 Mar 12 (Long Term Buy – $1.36) we lamented management’s new strategy of diversifying away from its electricity business. With press reports this week suggesting the company could bid for Sydney’s $2bn desalination plant, either independently or as part of a consortium, those plans are gathering pace.

Spark doesn’t need to do this. The company’s electricity networks transmit plenty of reliable cashflow that, following an expensive upgrade and expansion already approved by regulators (which also happens to explain why your electricity bills are increasing), will grow substantially over the next four years. That’s why we originally recommended it in Spark's WACCed up returns on 1 Jul 09 (Buy for Yield – $1.085).

Revenue growth was certain and Spark had raised enough capital to meet its share of the network expansion payments. There was no need to raise further capital until around 2015.

Despite its high debt levels—essential infrastructure owners need large licks of debt to produce decent returns on capital while paying for large growth and maintenance expenditure programs—Spark offered a mixture of growth and income, making it suitable for many members.

Now it is becoming far less so. There are three principal reasons why we’ve decided to sell now and ask questions later.

First, we can’t see why the company would want to dilute its electricity assets at a time when they’re about to generate growing and reliable cashflow. Unlike a desalination plant, management knows these assets inside out.

Equity raising?

Second, Spark would probably need to raise a large amount of equity and debt to acquire an expensive asset. Its balance sheet already has enough debt for our liking.  Should the financial burden be shared amongst a consortium, then Spark would have a minority interest in an unfamiliar asset. Conflicts often arise when management doesn’t have full control.

Finally, and most importantly, such an acquisition is likely to be a classic case of ‘diworsification’. Just look at a few examples; Foster’s blew up billions buying wine assets; Insurance Australia Group made an ill-judged expansion in the UK; GPT Group embarked on a failed overseas funds management strategy; and Rio’s purchase of Alcan transformed this company for the worse.

These are just a tiny sample of ‘company transforming’ events. This is a mistake made over and over again, too often an example of management over-confidence and self-belief.

One shouldn’t discount the possibility that Spark will pick up a bargain and execute the management of a new asset perfectly. The security price may even rise rapidly on news of an ‘earnings accretive’ acquisition that offers plenty of growth.

Maybe securityholders will have a wonderful opportunity to buy more securities at an attractive price in a rights offer or security purchase plan, or the company will receive a takeover offer. Spark, after all, is the perfect asset for a sovereign wealth fund or even our own Future Fund.

Risk on the downside

Yet history is against such an outcome. Large acquisitions tend to produce wonderful returns for the owners of the business being acquired but blow up vast amounts of capital invested by securityholders of the acquirer. At the current security price, this risk outweighs any potential upside.

If you’re more optimistic about an acquisition such as this, you may opt to ignore our advice and hang on. We, though, are regrettably selling Spark Infrastructure from both the model Growth and Income portfolios and will wait to see what unfolds.

Should another opportunity to purchase Spark at a cheap price arise, we’ll take another look. Despite the security price falling 7% since 3 Apr 12 (Hold – $1.52), we’re downgrading to SELL.

Note: The model Income portfolio will sell 7,000 securities at $1.42 netting proceeds of $9,940.00.

The model Growth portfolio will sell 6,493 securities at $1.42 netting proceeds of $9,220.06.