Australia | Sep 03 2013
-Growth opportunity with new pipeline
-Spotlight on use of equity for funding
-Better returns than regulated base
-Provides some de-gearing capability
By Eva Brocklehurst
DUET Group ((DUE)) has raised new equity and will fund and build a pipeline that it will operate on behalf of Chevron's Wheatstone project. The gas pipeline will link Wheatstone's domestic gas plant to the Dampier to Bunbury (DBP) natural gas pipeline in Western Australia.
Construction should be completed by December 2014 at a total cost of $95m, and generate $13m of cash flow for distribution in 2015. Project cash flow will only add around 5% to FY16's total but it highlights DUET's ability to find accretive growth opportunities outside expanding DBP. Moreover, post commissioning, the pipeline will have a forward haul gas transmission capacity of 337TJ/day so there's growth potential should the capacity of the Wheatstone project increase. While this deal won't improve earnings growth significantly, for CIMB it highlights the fact the development division can secure accretive projects and establishes a foundation for development to become a meaningful contributor over coming years.
DUET raised $100m via a placement to fund the project at a minimum issue price of $2.03, a 2.4% discount to the last trade. Of the raising, $95m is for construction costs, while the balance will meet working capital requirements and transaction costs. With gearing currently towards the top end of its targeted range, management elected to fully fund the pipeline via equity. BA-Merrill Lynch finds the notion attractive. The placement is 4% dilutive to FY14/15 earnings forecasts but the deal is considered 1.5% free cash flow accretive from January 2015. The broker also thinks the deal is well aligned with unit holder investment criteria.
The company's debt/regulated asset base (RAB) ratio of 78.7% is at the top of the 75-80% target range. The distribution investment plan, along with around $20m/year of excess cash, means DUET has enough to fund its $150-200m of annual growth capex and 3% distribution growth through to FY16. What is obvious to brokers is that this leaves limited room to fund new projects. The deal is only small and not sufficient to lift distribution forecasts but Merrills still thinks it is a solid first project for the development business.
In Deutsche Bank's opinion too, the plan to construct the Wheatstone pipeline, and simultaneously raise $100m in equity, underlines conflicting forces within the company. Future growth opportunities may be attractive but high gearing levels and very high cash pay-out ratios dictate that a disproportionate level of new equity is required. This is is effectively a form of de-gearing. Deutsche Bank believes the decision to fund the entire development using new equity underlines the limited capacity of the balance sheet and, hence, there are downside risks from funding constraints and potential dilution from future equity raisings.
The transaction is still a low-risk one in Credit Suisse's view as it provides an internal rate of return of 13%, much stronger than sub-8% returns available in recent regulatory (RAB) decisions. The broker thinks the stock is one of the cleanest and lowest risk sources of yield in the regulated utilities sector. At another level, Credit Suisse think the transaction is a positive signal that management is actively seeking organic growth opportunities.
Macquarie sees the transaction revealing the option value in the assets, albeit small in the scheme of the $5.3bn RAB. With RAB facing a slowing growth outlook and a tightening regulatory environment, Macquarie expects these features will continue to dominate the stock's performance. DUET is trading at a discount to its net present value but, like its peers in the sector, will remain that way until bond yields decline or the distribution outlook is upgraded. Neither is imminent in the broker's opinion.
One unusual element Macquarie has observed is the flat $13m fixed cash flow plus operating costs. Typically all DUET contracts have an inflation component, thus the cash flow stays real. With a flat price, the up front cash flows are likely to be better but there is a risk of inflation over time. So, being funded with equity, if DUET's distribution can grow at the rate of inflation over time, the contribution from this asset will shrink over time.
Another aspect that was a little surprising for the broker was the choice to fully fund with equity, although admitting a combination of issues favour equity. DUET does not cross guarantee any of its assets and the development company itself is a single contract company, with no income until the asset is established. This is, potentially, a riskier proposition for the banks. Given the size of the venture, DUET's yield of 8.3% is not dramatically different to the possible funding costs. What it implicitly provides is some de-gearing capability in FY16 once the asset revenue stream is established. This would reduce the reliance on external funding at a time of regulatory re-setting.
On the FNArena database there is one Buy rating – BA-Merrill Lynch. The seven others are Hold ratings. The consensus target price is $2.16, suggesting 0.5% upside to the last share price. The distribution yield on FY14 consensus forecasts is 7.9% and on FY15 it is 8.2%.
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