How the listed infrastructure sector is faring

Financial journalist
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As interest rates come down, the search for yield intensifies, and one of the sectors most interesting to income-oriented investors is infrastructure. The listed infrastructure sector can be a source of relatively strong and stable income flows, with generally predictable long-term cash flows and earnings.

In theory, infrastructure assets generate a long-term cash flow with a high yield and little volatility. Prior to the GFC the listed infrastructure sector was considered one of the best defensive sectors, but the sector has had to re-earn its stripes.

The credit crunch took an especially hard toll on listed infrastructure, as entities perceived to have high debt levels were hammered. For example, ports, road, rail and airports operator Asciano (AIO) fell 96% from peak to trough. The carnage was indiscriminate: Hastings Diversified Utilities Fund, now a part of pipeline operator APA Group (APA), lost 93%, even though it was regarded as one of the higher-quality members of the infrastructure sector, with assets including gas pipelines in Australia and water utilities in the UK, and a relatively high dividend yield funded from cash flow.

What investors might not have realised was that many infrastructure assets were geared beyond what their cash flows could support. When the credit crunch effectively closed the bank debt and bond markets – and sent credit spreads for infrastructure assets surging by 1% – the 70% gearing levels that were common in the sector proved too high, particularly for infrastructure stocks where the market saw short-term refinancing risk.

The sector learned a painful lesson – that if an asset is over-geared, it actually becomes a different kind of asset; and reliability of cash flow is paramount.

Defensive tag didn’t help

The listed infrastructure sector can throw up very competitive yields, but the yields have to be balanced against the reliability of the cash flows.

Even then, ‘listed’ is the operative word: investors can hardly expect infrastructure stocks to be immune to a market slump: in the GFC, even the stocks with most of their earnings regulated – such as electricity distributor Spark Infrastructure (SKI), electricity and gas transmission and distribution group SP AusNet (SPN) and gas pipeline operator APA Group (APA) – fell by more than 50%.

These were all considered to have very defensive earnings profiles, but it didn’t help when investors panicked.

Still, the predictable and stable earnings profiles of infrastructure stocks can come in very handy for SMSF investors in building an income portfolio, with the proviso that franking credits – so helpful to SMSFs in augmenting the after-tax yields on company dividend flows – are not usually available, because of the heavy depreciation and amortisation (D&A) requirements that render statutory profit close to zero.

Remember, a 5% fully franked dividend is worth 6.07% (5 x 1.215) to an SMSF in accumulation mode, because the fund (which is taxed at 15%) receives $215 worth of refunded franking credits on every $1,000 of dividend income; while the same dividend is effectively worth 7.14% (5 x 1.428) to the SMSF, because it receives the franking credits in full.

Good yields

That understood, there are some good yield situations available in the infrastructure space.

For example, market consensus projects SP AusNet (SPN) as offering a 7.4% yield in FY14. (This yield is expected to be 33% franked, which equates to a grossed-up yield of about 8.4%.) SPN manages a regulated network of electricity and gas distribution networks that serves more than one million customers in south-east Australia. Critically, almost 90% of SPN´s revenues are regulated.

Similarly, Spark Infrastructure (SKI) has about 80% of its revenues regulated. SKI owns 49% interests in three electricity distribution companies: Powercor and CitiPower in Victoria and ETSA in South Australia. It is trading on a 6.5% yield for FY 13, unfranked (some brokers reckon this is as high as 7.2%.)

SP AusNet and Spark Infrastructure both have revenue re-sets every five years. (SP Ausnet’s gas distribution assets come up for re-set this year, the electricity transmission asset in 2014 and the electricity distribution asset resets in 2016. Spark is up for re-set in 2015 and 2016.)

Market consensus has energy infrastructure owner DUET Group (DUE) on a distribution yield of 8.1%, unfranked, for FY14. DUET has more than 90% of its revenue regulated or under long-term contracts. It owns 80% of the Dampier to Bunbury gas Pipeline (DBP) in Western Australia, 100% of Victorian gas distributor Multinet Gas and 66% of Victorian electricity distributor United Energy. Multinet comes up for regulatory reset this month: United Energy and DBP are intact until January 2016.

The unfranked yield on DUET to a SMSF in accumulation mode is equivalent to a 6.7% fully franked yield; in pension mode, the fund needs to be earning 5.7% fully franked to beat the DUET yield.

Less regulation, more growth

While ‘regulated earnings’ sounds reassuring, where there is less regulation, there is greater scope for distributions to grow. For example, toll road operator Transurban (TCL) is able to benefit both from rising traffic volumes on its roads, and rising tolls, which grow at CPI (the inflation rate), or 3.5% – 4%, whichever is higher.

TCL owns Melbourne’s CityLink and Sydney’s Hills M2, and owns 75% of the M1 Eastern Distributor (Sydney) and 50% of the M5 and M7 (also Sydney). It also owns three roads in the USA.

Market consensus puts Transurban on a 5.6% yield, 25% franked, in FY 14. While this is not as attractive at first sight as some of the other infrastructure yields, Transurban should be able to grow its distribution by 10% a year until at least 2025 (its CityLink concession expires in 2034.) With this scope for growth, Transurban looks very much like the pick of the infrastructure stocks on yield grounds.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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