Finding That Added Spark

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            [3] => ((SPN))
            [4] => ((HDF))
            [5] => ((DUE))
            [6] => ((CIF))
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    [1] => Array
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            [0] => SKI
            [1] => AIX
            [2] => MQA
            [3] => SPN
            [4] => HDF
            [5] => DUE
            [6] => CIF
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This story features SPARC TECHNOLOGIES LIMITED.
For more info SHARE ANALYSIS: SPN

By Greg Peel

There is little doubt that infrastructure funds covering the utility and resource sectors have become hot property in the search for yield and growth in the past few years, moving solidly into the space once dominated by real estate investment trusts. The GFC was a wake-up call for all listed funds with respect to gearing levels, but subsequent rationalisation has seen the survivors providing some excellent returns for investors.

Among the favourites, Spark Infrastructure Group ((SKI)) has always been a popular choice at the retail level yet outperformance has always alluded the fund, leading to unit holder disappointment. It was for this reason Spark management decided to conduct a strategic review, and a year later that review has led to a significant structural change.

Spark's first problem is that the listed entity owns only 49% of its two major assets – ETSA Utilities, the South Australian electricity distributor, and CHEDHA, which operates power distribution in Victoria. The majority 51% is owned by Cheung Kong Infrastructure (CKI), and unfortunately that has not changed.

Spark's second problem was that management of those assets had been controlled externally by CKI and Deutsche Bank's RREEF Infrastructure, which drew both base management fees and performance fees for the privilege, thus undermining earnings and rendering Spark's management a bit of a passenger. It is this arrangement which now has changed.

The market has always considered listed funds managed externally rather than internally to be of lesser value given control of the assets is out of the listed entity's hands. Such funds have always thus been undermined by a “structural discount” applied by investors. Spark was one of these, and those still in the externally managed club include Australian Infrastructure ((AIX)), Macquarie Atlas ((MQA)), SP Ausnet ((SPN)), Hastings Diversified Utilities ((HDF)), DUET Group ((DUE)) and Challenger Infrastructure ((CIF)).

The news on Friday was that Spark has now agreed terms with CKI and RREEF to take over, or “internalise”, the fund's management. In so doing Spark had to break a 25-year contract with the two parties, and for that there was a cost. That cost basically reflects the base and possible performance fees the two will lose out to 2030, and amounts to $49m.

All analysts agree that the internalisation move is a positive one, providing “option value” on the collection of performance fees in the future and unlocking value on the removal of some of that “structural discount”. However the benefit still needs to be weighed against the cost, which was hefty. Indeed, analysts largely agree the $49m cost, whichever measure you use, is slightly more than the cost of fees Spark will save over the period (bearing in mind performance fees have to be estimated). In other words, the deal itself is slightly dilutive to today's valuation.

The offset comes from the market now looking more favourably upon Spark, in analyst views, and easing off on the discount.

It also makes Spark a more viable takeover target from a structural point of view. Last September, Spark indicated it had received a sniff from a suitor at a “significant premium”, but at Friday's conference call management said it is not “actively engaged” in any such discussions. While internalisation might draw some interest, several analysts have pointed out that a 49% stake in electricity assets is not all that attractive for the usual suspects. CKI itself is nevertheless an obvious choice, but the fact CKI didn't move on the other 49% when Spark's funding profile had not been ascertained last year leads BA-Merrill Lynch to conclude the fund is not really interested.

Importantly, Spark will not be going to the market for fresh capital to cover the $49m cost. But it will “back door” a capital raising by reintroducing a dividend reinvestment plan on its next distribution. A 50% uptake of the DRP would equate to about $60m in funds, RBA Australia notes.

Prior to the internalisation announcement, Spark attracted five Buy ratings, two Holds and one Sell from the brokers in the FNArena database. Pointing to Spark's 8.3% dividend and low risk assets, Macquarie has today upgraded to Outperform.

JP Morgan's Underweight (Sell) rating has to be taken in the context of the JP Morgan rating system. Its recommendation relates to the sector only, rather than the market in general, and the broker sees better value elsewhere in the sector.

More than one broker this morning has suggested Spark's move will now put pressure on other externally managed funds to follow suit. High on the list are DUET, Hastings and SP Ausnet.

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