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This article appeared in the October 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Why reliable, higher-yielding utility stocks appeal in volatile markets.

Photo of Nathan Bell By Nathan Bell, Intelligent Investor

Europe, we are told, is on the brink of financial disaster. The brink happens to be a crowded place right now, with America and Japan nestled comfortably on the same precipice. With markets swinging wildly, utility and essential infrastructure investments have seldom been more attractive.

Whether its gas pipelines, electricity networks, toll roads, airports, or power stations, a combination of monopolistic assets, regulated returns and stable cash flows are supposed to offer conservatism and stability. An antidote, in other words, to the chaos. However, like most conventional wisdom, those truths need to be tested.

The good and the bad

Because of deregulation, a distinction has emerged between what constitutes a utility, such as energy giants AGL and Origin Energy, and what are more accurately termed essential infrastructure businesses, such as Spark Infrastructure and SP AusNet. But what you really need to know is that both categories have attractive characteristics; many assets are natural monopolies so they face limited competition. It only makes sense, for example, to build one set of pipelines and power grids. Cash flows are predictable, too.

These companies own a mix of regulated and unregulated assets. Spark Infrastructure and SP AusNet operate the "poles and wires" of the electricity grid - a natural monopoly. Because their prices are regulated and there is no competitive pressure, returns are predictable and stable. A large lick of debt in such instances is bearable. Origin Energy and AGL, however, are retailers of electricity, an unregulated activity subject to fierce competition. Too much debt in this scenario could be dangerous.

In the past, Intelligent Investor has been wary of the utility sector because of its excessive debt and unsustainable dividends. These remain key areas of concern, although predictable cash flows mean infrastructure assets can often carry higher-than-average levels of debt. Investors need to be judicious in deciding when debt is OK and when it's not.

Dividends also deserve attention; higher is not necessarily better. It is important to measure dividends paid against cash the business generates. Energy and infrastructure assets have a habit of generating profits without generating cash. This neat trick is done by revaluing assets as a profit, an activity that does not add to the business cash pile. Be sure to check cash flow and profits to see if one is turning into the other.

A dividend that is too high could also signal a future capital raising. Take Spark and SP AusNet as an example. Both need to reinvest in their distribution networks to increase regulated returns, so require heavy doses of cash. Spark pays only about half its cash flow as dividends, leaving cash to reinvest. Spark's dividends may be lower than SP AusNet's, but they are also more sustainable and will grow, in Intelligent Investor's opinion.

Three of the best

(Editor's note: Do not read the following ideas as share recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article.)

Selecting the business in which to invest is the next step. Predictable cash flows and high yields have traditionally attracted income investors to infrastructure companies. There are, however, some utility and infrastructure businesses that can potentially grow, too. Spark Infrastructure, MAp Group and Origin Energy fall into this category, according to Intelligent Investor's research.

1. Origin Energy

Origin operates in the non-regulated parts of the electricity sector. Although retail prices are regulated, there is a twist. Regulatory bodies, such as IPART in NSW, set the maximum price that retailers such as Origin and AGL can charge customers. But in urban markets, for example, where the cost of supply is low, price competition means Origin can fight for customers and charge less than the regulated tariff, yet earn higher returns than most regulated businesses.

Origin's real competitive advantage, though, lies in an area where there is no regulation at all: power generation. Under the intelligent stewardship of chief executive Grant King, who realised early that energy assets would become more valuable; Origin assembled some of the biggest and best gas and electricity generation assets in the industry at a fraction of what they would cost today. With a massive pool of cheap production and generation capacity, price regulation is not a big deal. Origin's growth has come not from the largely regulated price at which it sells energy, but from the low costs of producing it. As a low-cost producer of power, it is well placed to compete aggressively.

Although the largest portion of profits comes from retailing energy, Origin also has a significant oil and gas production business that it intends to grow. A large coal seam gas-to-LNG project in Queensland could well transform the company, making the production side of the business far more important. Although Origin is morphing into more than a simple utility, its prospects are attractive.

2. Spark Infrastructure

Spark owns essential infrastructure and charges other companies a fee to access it. The business model appears simple enough but understanding what fees the companies are allowed to charge is more complicated.

Spark owns stakes in energy distributors ETSA, Powercor and Citipower, which have monopoly control over the electricity network in their respective geographic regions. As a result, the government-sanctioned Australian Energy Regulator (AER) controls how much they can charge their customers. Crucially, the return Spark is allowed to earn depends on how valuable its asset base is, which is determined by the value of its assets in the prior year, less depreciation plus fresh capital expenditures. The more money Spark spends on capital expenditure, the more the regulator allows it to earn.

Because Spark is in the midst of a major expenditure cycle (which, incidentally, is the reason everyone's electricity bills are rising), returns from the three underlying assets are forecast to grow 8 per cent a year over the next four years. And thanks to the diligent use of debt, Spark's interest in those assets will increase by 14 per cent a year over that time. A reasonable yield of more than 7 per cent (unfranked) will continue to be paid, but with plenty of cash to fund expenditure, Spark is one infrastructure business with genuine growth prospects.

3. MAp Group

MAp Group is not an energy utility, but it will own 85 per cent of Sydney Airport and, if you have used it, you will instantly understand why airports make wonderful businesses. Park your car in the one of the most expensive airport parking lots in the world, and then venture into the terminal itself and you notice that Sydney Airport has been transformed into a mini-Westfield, complete with captive shoppers and lucrative rents. From parking charges to rents and aircraft charges, Sydney Airport is a fee-fest. As a customer, it's annoying. As an investor, it's a goldmine; the closest thing to an unregulated monopoly.

MAp is in the happy position of being able to charge what it likes for most of its services and not having to worry about competition. But having so much power also brings risk. If MAp gouges profits too fiercely, the risk of government intervention and reregulation is ever present. The company runs a fine balance between maximising returns without putting off regulators.

The company will soon pay a special distribution of 80¢ per security, and generally offers a distribution yield of about 6 per cent. Although MAp is an attractive business, it is exposed to some specific risks; any event that would severely cut travel volumes through Sydney Airport, such as industrial action, or a weather or health scare, would have a big impact. Keep this in mind when allocating capital.

Utility and essential infrastructure companies such as these may seem a little boring but many investors will happily welcome a little less excitement right now.

About the author

Nathan Bell is research director of Intelligent Investor. Access a free trial.

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