Australia | May 21 2014
– Spark shakes up the utilities sector
– Taunts suitors to emerge, but brokers question the merit
– Duet sitting pretty
By Greg Peel
Some companies buy stakes in other companies simply by buying shares with cash. Spark Infrastructure ((SKI)) has entered into what must be one of the more complex stake-acquisition arrangements ever undertaken in order to effectively own 14.1% of network utilities peer DUET Group ((DUE)), formerly Diversified Utilities & Energy Trusts.
Instead of using cash to buy Duet shares, Spark has entered into a swap arrangement with Deutsche Bank’s proprietary operation that sees Deutsche taking Spark’s cash and then acting as the share buyer and risk-taker, albeit with certain incentives. The bottom line is Spark has initially acquired 4.6% of Duet at $2.087 and another 124.5m worth of shares at $2.20 on a three-year forward purchase with the potential to buy another 33m at $2.20 on Deutsche’s option. Spark has then written a seven-month “collar” option deal for Deutsche, which sees Spark assured of 124.5m shares at $2.20 and Deutsche protected above $2.30, but it is an “over-hedge”, thus incentivising Deutsche to acquire Duet at above $2.50. This potentially means SKI’s net entry price increasing from $2.16 to $2.36 and thus incentivises Spark to negotiate a merger within the seven month window.
Got it? Macquarie does, as the above outlines the analysts’ calculations. The rest of us might just take it as read. Spark will fund its cash obligation with debt and new equity, and has announced a $200m placement.
The deal has the potential to take Spark’s stake in Duet to 16.6% but the company has told the ASX it has no intention of launching a full takeover “in the current circumstances, particularly given the relative scale of the two entities”. Spark is the junior. So what exactly is Spark up to? As JP Morgan puts it, the emergence of another M&A move in the utilities sector is no surprise but the players involved in this one are indeed a surprise.
Spark was supposed to be just a passive yield investment, notes UBS, passing through cash flows from its minority positions in Victorian and South Australian electricity poles & wires. But management clearly has an agenda to do more, and having been outbid on acquiring the Sydney desal plant has now launched into this convoluted arrangement. CIMB notes, nevertheless, that the deal fulfills Spark’s long-stated objective of further investing in electricity and gas distribution and transmission.
Interestingly, there is not a lot in the way of synergies on offer given the two entities are themselves collections of unique standalone entities and while Duet crosses both electricity and gas, Spark has no gas exposure to date. Macquarie suggests the only gains on offer would be in a head office merger, although BA-Merrill Lynch speculates Spark may be looking at Duet for its break-up potential and thus the opportunity to marry up individual entities and achieve synergies that way, and sell others. Spark’s stake would at least mean the company is involved in any potential transactions, Merrills notes.
UBS agrees the deal at least ensures Spark has a “seat at the table” in what management believes is pending sector consolidation (albeit not a board seat). In making its $400m investment in Duet, Spark management has effectively advertised its belief, the broker suggests, that the deal “creates an opportunity to capture additional value in the future for security holders during a time when the Australian infrastructure sector is undergoing significant consolidation and change”.
In other words, Spark has seen the future and wants to be part of it. Spark is not big enough to fully takeover Duet by itself, so it has taken a strategic stake in a blaze of publicity which should ensure ears are pricked up around the infrastructure investment world. If someone does decide Duet’s worth having a swing at, Spark is there to reap the spoils. Spark’s 14% stake is a good place for a potential suitor to start.
Or, Spark is simply taunting Duet into a merger. Both are contenders to bid for NSW and Queensland poles & wires when privatised, and together they would make a formidable force to squeeze out any pretenders. And Spark would not miss out (as it did on the desal plant).
“As a ‘corporate raid’, this is not a bad transaction, and well executed,” says UBS.
Merrills thinks the deal has “some strategic merits”, and highlights Spark’s ambition to become a bigger company. The problem is Spark’s value lay in its low (55%) dividend payout ratio, which was set to rise after 2015 when debt was paid down. But now the company has gone for growth, and more debt.
JP Morgan is sceptical. The broker sees merit in Spark’s ambitions to diversify its asset base but believes the decision to gear up to acquire a stake in Duet “does little to improve the investment proposition”. A downgrade to Neutral from Overweight has followed.
Macquarie has downgraded to Underperform from Neutral. The raid may be well placed, the broker suggests, but the complex derivative arrangement means the bid is not firm, and strategic merit is compromised if Spark ends up paying the additional premium.
CIMB has downgraded to Hold from Add, suggesting “the strategic intention of this transaction is unclear to us”. Spark is trying to make itself more interesting to investors through its stake in Duet, when investors who wish to diversify their utility holdings can just go and buy Duet themselves, notes the broker.
And how might Duet respond?
Well basically Duet could take the bait and approach Spark for a merger, as senior partner, or scoff at Spark’s presumption and go for a reverse takeover. Or it could just sit back and enjoy the ride for the time being, waiting to see what might follow. One thing we do know is that Deutsche Bank has to go in and buy Duet shares. Duet’s stock price will thus be supported for a while.
On that basis, JP Morgan has lifted Duet to Neutral from Underweight and Macquarie has upgraded to Outperform from Neutral. Duet, says Macquarie, is “clearly in play”.
Australia’s utility sector is developing somewhat of a M&Ania.
Subsequent to the announcement, the consensus target price for Spark in the FNArena database has dropped only to $1.84 from $1.85. Duet’s target, on the other hand, has risen to $2.25 from $2.13. Macquarie, in particular, has lifted all the way to $2.50.
Spark now attracts only one Buy rating in the FNArena database, five Holds and one Sell (or equivalent). The Buy is nevertheless a previous rating from Deutsche Bank, and the broker will now be restricted on making a recommendation on both companies for some time. Hence, the Buy no longer counts.
If we similarly dismiss Deutsche’s Hold rating on Duet, that stock now attracts three Buys and three Holds.
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