I should increase my bet in this stock. Who knows what is the...

I should increase my bet in this stock. Who knows what is the target but small caps look brighter.

Takeover target update: Mid-cap Australian utilities

By Tony Featherstone9 June | 2016
Financial Journalist

Spark Infrastructure leads list of attractive acquisitions.

The utilities sector could be an unlikely source of takeovers this year as predators capitalise on cheap borrowing costs to snap up undervalued Australian electricity providers.

Spark Infrastructure Group, DUET Group and APA Group have been mentioned in market chatter this year as takeover targets, even though regulatory issues usually complicate hostile acquisitions of monopoly or duopoly infrastructure assets.

Defensive Australian utilities with predictable yield must look more attractive to cashed-up domestic or foreign raiders. With the yield on the 10-year Australian government bond hitting an all-time low of 2.14% this week, the hurdle rate to justify acquisitions is falling.

Persistent low inflation and interest rates are also driving higher prices for defensive assets with reliable yield, and possibly justifying higher valuation multiples for some.

Of the three utilities, DUET Group, an investor in energy assets, has been touted most as a takeover target. Spark’s 10.6% economic interest in DUET made it a potential suitor as part of a consortium. But Spark divested 8% of its DUET interest in late May and will exit its full stake in time.

DUET’s high debt position and acquisition of Energy Developments in 2015, seen by some as a ‘poison pill’ to deter Spark, cloud its takeover appeal. DUET has performed well for shareholders over the past five years and should benefit from recent favourable regulatory outcomes on electricity pricing. But it looks fully valued for now.

I cannot get my head around APA Group as takeover target. It operates Australia’s premier gas infrastructure business and looks more like an acquirer than a target. APA has been a terrific performer: the five-year annualised average return is 24 %.

Spark Infrastructure is a different proposition. It has a 49% stake in two regulated electricity businesses in Victoria Power Networks (Powercor and CitiPower) and a 49% holding in South Australia’s electricity distribution business through SA Power Networks. A Spark-led consortium late last year won the bid to lease Transgrid, New South Wales’s high-voltage electricity network.

Spark too has rewarded shareholders, although some activist shareholders argue it should be worth much more than its current valuation. The one-year return (including distributions) is 27% and over five years Spark has returned an average 20% annualised.

I like Spark’s decision to divest its interest in DUET. The stake was held via financial derivatives and DUET is highly geared: potentially a risky proposition for Spark in the event of another financial crisis. The divestment reduces Spark’s balance-sheet risk. Also, there were limited synergies between the two utilities given their asset differences.

Like DUET, Spark will benefit from the Australian Energy Regulator’s decision (AER) in May for Victoria Power Networks’ regulated revenue. The decision produced a small rally in Spark as brokers upgraded their earnings and distributions forecasts after the slightly better-than-expected decision. A dividend increase from Spark looks a fair bet.

As important, the decision reduces regulatory risk for Spark, although uncertainty on some smaller pricing issues remain. Combined with the DUET divestment, Spark should have a lower risk profile from a predator’s perspective. With global infrastructure assets in high demand, and a reasonably open share register, Spark has elements of a takeover target.

Spark also looks the best value of the three utilities mentioned. This column’s starting point is to identify companies that are undervalued and a reasonable investment, at the prevailing price, with or without a takeover. Buying stocks on the basis of takeover alone is rarely a good idea.

Seven of 10 broking firms that cover Spark have a buy recommendation according to consensus analyst forecasts. Macquarie Equities Research’s 12-month target, at the high end of broker forecasts, is $2.66. If Macquarie is right, Spark is about 17% undervalued, before dividends.

An expected yield of about 6%, unfranked, is another attraction for income investors and a sweetener for those are prepared to wait longer for any takeover battle.

CYBG stars
CYBG’s CHESS Depositary Interests (CDIs) on ASX have rallied from $3.69 in February to $5.53 – a remarkable rally that shows how much latent value existed in the National Australian Bank spin-off.

I nominated CYBG for the Super Switzer Report in February 2016 as one of the market’s three top de-mergers; included it as one of six turnaround ideas for this report in March; and added it to the takeover target portfolio in April. Hopefully, readers took note.

CBYG’s maiden first-half result as a standalone company showed that it is delivering on its turnaround faster than the market expected through significant efficiency gains.

CYBG looks like a neat acquisition for a larger European bank that wants a foothold in the attractive United Kingdom banking sector that, like Australia, is dominated by a few gorillas. UK banks arguably have better growth prospects and valuations than their Australian peers.

Potential predators will be watching CBYG’s share price rally and its management capturing value in the business at quick pace. Perhaps that will prompt predators to move sooner rather than later on CYBG, which looks like a sound long-term investment regardless of takeover. CYBG is due for a price pullback or pause after recent strong gains.