This is a bit technical, so feel free to skip it if technical isn’t your thing. Despite generating a total return of 31% last year, Spark Infrastructure owners could be in for an even better year in 2012.
Whilst Spark owns electricity distribution networks, its financial characteristics are more like a five-year bond than a normal operating business. It owns assets that are monopolies and, to prevent abuse of those monopoly powers, it is regulated by the Australian Energy Regulator (AER).
Every five years, the AER sets the prices that Spark’s businesses are allowed to charge and locks them in for the following five years. It does this by determining an appropriate weighted average cost of capital (WACC) for the business and applying it to the relevant asset base.
The regulator is effectively allowing Spark to earn a fixed rate of return on its assets over the five year period.
The good news for Spark owners is that when the rates were determined about two years ago, the timing couldn’t have been better.
The formula for WACC looks like this:
WACC = wdkd + weke
wd = debt weighting
kd = cost of debt
we = equity weighting
ke = cost of equity
If you’re Spark, you want the assumptions used to be as high as possible when the AER is determining your revenue. You want the assumed cost of debt to be high, the assumed cost of equity to be high and the assuming equity weighting to be high (equity always costs more than debt, so the higher the proportion of funding you assume is equity, the higher the overall WACC).
In 2009 and 2010 when the AER was gathering its assumptions, financial markets were in a state of disarray. Implied debt margins were high and finance was hard to come by, which meant the AER assumed a higher proportion of equity than it otherwise would have. All up, Victorian distribution companies CitiPower and Power Corp ended up with a WACC of 9.4% and the South Australian company ETSA was granted 9.76%. I estimate both would have been 1.5% lower in more ‘normal’ financial markets.
You can see the assumptions used by the AER in the table below, complete with an interesting comparison from the prior five year period.
Risk Free Rate
Debt risk premium (DRP)
Market risk premium (MRP)
Nominal vanilla WACC
Nominal post tax return on equity
Net capex over 5 years ($June 2010)
Opex over 5 years ($June 2010)
As an example of the benefits Spark is deriving, ETSA obtained real-world 5-year financing last year at a margin of 1.35%. The regulator assumed 2.98% when it determined ETSA's allowable revenue.Of course, once the rate has been set, you want reality over the five year period to be much more benign than the regulator has assumed. That’s exactly what has happened.
Even better, the risk free rate has plummeted. Five-year government bonds were yielding 5.89% when the WACC was determined; today the four year rate is about 3.4% (this regulatory period has four years left to run).
It’s not an exact analogy, but owning Spark is like owning a four-year bond throwing off a 9% interest rate when the market rate is closer to 6%. It should be trading at a hefty premium to its face value, which in Spark’s case is the regulatory asset base used to calculate its returns.
If interest rates continue to fall, expect the Spark stock price to continue rising.
Note: SKI stock price at time of posting was $1.36
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.