APA is a defensive asset with a strong and proven ability to deliver growth in cash flows. Whilst APA’s pipelines are diversified by geography, customer, and supplier, 95% of APA’s earnings are currently exposed to fossil fuels, which introduces a layer of valuation risk given APA’s gas pipeline assets are likely to be stranded in the long term (i.e. 2-3 decades).
APA has embarked on a decarbonisation investment campaign to pivot the earnings away from gas transportation. This saw the $800m acquisition of the Basslink electricity power transmission line from Tasmania to Victoria in 2022. Whilst the desire to pivot away from fossil fuels is commendable, we do struggle with the return economics which suggests a 5-6% ROE on Basslink vs APA’s Group ROE of 17%.
We expect APA to make further acquisitions in the energy distribution, as it looks to strategically reposition its portfolio. Whilst the Group has ~$2bn of undrawn balance sheet capacity to deploy, there remains a clear risk that APA get involved in large-scale M&A potentially requiring fresh equity capital. We see this as keeping a handbrake on the share price.
New opportunities to grow the pipeline business look challenged in the short to medium term. The three most prospective new greenfield areas of gas field development; 1) Bowen Basin (QLD); 2) Narrabri (NSW), and Beetaloo (NT) all require additional drilling, approvals and the proving up of reserves and resources before they can be commercialised at scale and new gas pipelines can be considered. There remains a distinct prospect that only brownfield gas pipelines will be developed going forward.
Investment View
APA provides a relatively defensive yet low-growth investment prospect. The current share price is discounted due to 1) energy transition risk; 2) potential for large-scale M&A; and 3) rising bond yields. The first two issues are unlikely to go away in the short term.
We see APA as fairly priced against the risk/reward balance in front of the company. APA currently trades at a 15% discount to its long-term average, given ESG and near-term acquisition risks. The dividend is sustainable at 55cps and remains the key attraction to own APA. We rate APA a Hold.
Company Overview
APA Group is a leading Australian energy infrastructure business that owns, operates, and manages natural gas transmission and distribution assets across Australia. The company operates in three reportable segments: Energy Infrastructure, Asset Management and Energy Investments. APA Group owns and/or operates a robust portfolio of gas, electricity, solar and wind assets around Australia.
The asset base is split into 1) East Coast Gas (ECG) which includes NSW, QLD and VIC; 2) West Coast Gas (WCG) which includes WA; 3) NT Gas; and 4) Renewables and Electricity which includes Basslink (VIC to TAS).
The groups' energy investments include:
- Energy Infrastructure Investments (19.9%) – an unlisted energy infrastructure company that owns gas-fired power generation gas processing plants, electricity interconnectors and gas pipelines.
- EII2 (20.2%) – an unlisted energy infrastructure company that owns the North Brown Hill Wind Farm in South Australia.
- GDI (EII) Pty Ltd (20%) – an unlisted energy infrastructure company that owns the Allgas Gas Distribution Network serving South East Queensland and northern coastal New South Wales.
- South East Australia Gas (SEA Gas) (50%) – a partnership which owns the SEA Gas Pipeline built to transport natural gas from the Otway and Bass Basins to markets in Victoria and South Australia.
- SEA Gas (Mortlake) Partnership (50%) - owns the Mortlake Pipeline which supplies gas to the Mortlake Power Station in Victoria.
Figure 1: APA key assets – National exposure
Cornerstone Questions
1. WHERE IS THE NEXT GROWTH OPPORTUNITY FOR APA?
APA is limited via regulation in becoming more vertically integrated through the addition of gas processing plants or upstream gas development. Further large-scale pipeline acquisitions are off limits given competition concerns.
We see APA as having four options for growing its asset base and earnings within its core area of networked gas distribution.
- Organic expansion of the current base of APA-owned pipelines
- Develop new pipelines on behalf of new gas developments/markets
- Acquire existing domestic assets from other owners
- Adjacent non-gas distribution businesses. APA in 2022 acquired its first electricity distribution business.
OFFSHORE AMBITIONS IN THE US CANCELLED.
APA has pulled back from ambitions to grow offshore earnings by closing the US APA office in 2022. We have long viewed any move by APA into a foreign jurisdiction has been a high-risk financial venture for APA. We doubt APA has any enduring operational competitive advantage in gas pipelines that is transferable outside of Australia. The US market is a particularly competitive market with over 50 major pipeline operators. Former CEO Robert Wheals departed as a consequence of this failed strategy.
NON-GAS PORTFOLIO ACQUISITIONS
The $800m acquisition of BassLink (TAS) was the first non-gas addition to the APA portfolio. Whilst APA claims the acquisition is earnings accretive, we question the strategic merit of moving away from APA's core business of gas distribution. Whilst gas or electricity distribution businesses are conceptually very similar, we question whether APA can bring a competitive advantage outside of the balance sheet, cost of capital and for some assets (and regulators) ‘Australian ownership’.
In our view, the current share ascribes little value for break-out-growth opportunities. Investors are rightly cautious about the incremental earnings uplift from pursuing adjacent industry development.
NEW PIPELINES
Australia has almost 40,000km of gas pipelines spanning all corners of the continent. There are proposals (not plans) to develop a further 12,000km of new pipelines at an estimated cost of ~$US20bn according to the Global Energy Monitor. Around 600km of pipelines are currently under construction. These proposals do not include capacity expansions of the existing pipelines.
Most of these pipeline proposals are not currently supported by Final Investment Decisions (FID)-approved gas developments. The Federal Government’s review of the gas market was less bullish around the requirement for additional pipelines, with only minor capacity additions likely to be required. The 2021 review found that domestic gas demand (ex-WA) is likely to fall by 20% into 2040, which implies a low-single-digit decline in per capita consumption. Link
Three new gas basins are currently in various stages of development, which would require additional pipeline assets if development was approved. The most prospective near-term development is the Bowen Basin (QLD). In NSW, the Narrabri basin has over >$1.5bn of development capital sunk into it only to be found hostage to anti-development and environmental campaigns. The Beetaloo Basin in NT covers an area the size of Texas (USA) with early-stage appraisal wells still ongoing.
It remains to be seen whether any of these three basins can be given commercial approvals, meaning that for pipeline developers, it's likely to be ~10 years under a fast-track scenario for any pipelines to be developed.
Figure 2: Proposed gas pipelines imply a 35% growth in existing pipelines
WHAT COULD APA ACQUIRE?
POTENTIAL ACQUISITIONS #1 ALINTA ENERGY
Alinta Energy, a WA-based energy generator/distributor owned by Chow Tai Fook Enterprises (Hong Kong) has placed its WA portfolio up for sale. The sale includes two power stations, a solar farm and the Goldfields gas transmission pipeline. In addition, there are several development projects which can be bought online. Press reports have suggested that APA has appointed advisors to assess the merits of a transaction. APA already owns most of Goldfield’s pipeline.
Pricing expectations are likely to be in the ~A$4-5bn range. Chow Tai Fook purchased Alinta in 2017 for just under $4bn from TPG Capital. The transaction was priced at 9.5x EV/EBITDA, with the business at the time generating $420m EBITDA. APA currently trades 12-13x EV/EBITDA, so prima facia, any potential transaction, even if heavily equity funded, would be earnings accretive for APA.
We think APA would not be interested in owning several of the assets. APA would likely bid as part of a consortium to either jointly own or split up the assets, which would have the added benefit of reducing the capital outlay and therefore potential requirement to raise additional equity. APA talks to $1.6bn of funding capacity available on the balance sheet, we estimate that it's closer to $2bn.
POTENTIAL ACQUISITIONS #2 SPARK INFRASTRUCTURE
KKR, Ontario Teachers and PSP Investors own Spark Infrastructure, which was purchased in 2021 for $5.1bn. Press reports have the consortium looking to sell the renewable energy business, which is viewed as non-core. The main assets include solar assets, windfarms, and battery storage which in FY20 produced <$10m of revenue. The asset would likely sit well within APA, helping transition the business away from gas distribution. Before being delisted, Spark Infrastructure had a development pipeline of >$6bn. This would be a key consideration for any acquirer.
POTENTIAL ACQUISITIONS #3 UNSUCCESSFUL ACQUISITIONS
APA has been in several auction processes over the last two years. We know of at least four that have been unsuccessful.
We think this reflects APA’s changing strategy, financial discipline, and higher risk appetite. Below are examples of these acquisitions in adjacent industries:
- Ausnet $10bn – Sold to Brookfield in 2021 – APA was known to have bid.
- Central-West Orana (NSW) Renewable Energy Zone – APA did not meet the final round in April 2023.
- Tilt Renewables was sold to AGL/Mercury Energy JV in 2021 for ~$A3bn
- APA’s US expansion was formally called off in 2022, which had not delivered any acquisitions.
POTENTIAL ACQUISITIONS #4 APA COMPETITIVE ADVANTAGE
In our view, the environment for acquisitions is tricky for APA, particularly as it looks to step outside of its core area of gas distribution. APA has traditionally derived competitive advantage from; 1) the lowest cost of capital; 2) operational expertise in gas distribution; 3) the ability to extract operational synergies, and 4) Australian ownership. In our view, many of these competitive advantages are reduced (in some cases removed altogether) for new energy or transition assets.
APA is facing global competition for Australian assets. In many cases, these players have access to both cheaper and larger pools of capital.
Financial sponsors have also been active in the Australian infrastructure market. The AUDUSD at 0.68 gives offshore players a stronger footing vs when the currency is at >0.75.
As APA moves outside of gas distribution, the operational enterprise becomes a less powerful competitive advantage, whilst synergy benefits with APA’s existing assets are reduced substantially.
We see APA’s competitive advantage today (ex-gas markets) as limited to; 1) ability to access Australian public funding markets; 2) local knowledge and Australian management team; and 3) low-cost (Australian) capital (industry super funds may have even lower cost of capital); 4) debt capacity of ~$2bn.
POTENTIAL ACQUISITIONS #5 ESG CONSIDERATIONS
A key driver of APA’s acquisition agenda is ESG considerations, and the desire to pivot the business away from gas distribution. Whilst APA’s Scope 1 and 2 carbon emissions are relatively low, Scope 3 emissions (the consumption of the gas by APA’s end customers) are very high. There is little APA can do to reduce that.
If APA were to be successful in either acquiring Alinta or Spark, there would not be a step change in APA’s CO2 footprint. This is likely to continue to frustrate both existing and potential new shareholders.
The key challenge for APA is to deliver lower CO2 intensity distribution growth, whilst not pushing the company into highly competitive auction processes where the risk of overpaying for assets is highest. Increasingly APA is facing global competition for domestic assets. This level of competition is much higher than what APA has traditionally faced in its gas pipeline business. Global players also have access to lower costs of capital vs APA, with competition coming in many forms from industry players, financial sponsors, investment funds and JVs combining resources of multiple groups.
POTENTIAL ACQUISITIONS #6 SHARE PRICES AHEAD OF MAJOR TRANSITIONS
Transitions of business strategy, particularly those that result in acquisitions and/or equity raisings can have negative influences on a company’s share price. In some cases, the impact can be profound and last several years. If the market is debating whether the company overpaid for acquisition, even if the acquired assert is within the company’s operational domain and sector, the share price performance can often be quite negative.
In our view, the APA share price is at risk of a number of these influences playing out;
- Pending a large-scale (decarbonisation) acquisition – potentially outside APA core gas business,
- Debate on price is almost a given - not least given size, but more importantly it’s likely to be a highly contested asset
- Potential for equity raise or at least available balance sheet capacity being used up,
- Large-scale acquisition under new CEO Adam Watson after missing out on serval transactions will likely raise questions around both fit and financial accretion.
Companies that are experiencing transition pain
- Aurizon (AZJ) – the QLD-based rail operator has found itself in a similar position to APA, needing to pivot away from the core coal-based transport business. The acquisition of One Rail in 2021, debt-funded, used up most of the company’s debt capacity and was poorly received by investors. AZJ's share price has yet to recover.
- Atlas Arteria Group (ALX) – the large acquisition of Chicago Skyway (US) in 2022, was accompanied by a large capital raising and saw the stock underperform, partly due to investors viewing the equity raising to push away corporate interest.
- Worley (WOR) – through 2021 the company had underperformed the market by >20%, on concerns around fossil fuel exposure. Over the last 12 months, these perceptions have changed as WOR has increasingly demonstrated an ability to win new business in the clean energy/transmission.
- Transurban Group (TCL) – in 2021 the company purchased WestConnex (WCX) in Sydney (NSW), the pricing was perceived as full whilst additional equity was needed. TCL underperformed whilst investors got comfortable with financials and equity dilution.
Figure 3: Share prices don’t like companies transitioning business strategy
2. CLIMATE CHANGE AND ECONOMIC RETURNS ON PIPELINES
Climate challenges for pipelines
The transition towards renewable energy poses a potential threat to APA's growth and asset values, which unashamedly provide fossil fuel for customers to burn. Whilst we consider gas to be a transition fuel, with roughly half the CO2 intensity of coal in the generation of electricity, there is limited appetite to develop new gas-powered generation assets.
This is in part given by the effective gas development moratorium in both NSW and VIC which prohibits the development of new gas fields. This in turn limits the opportunity for new gas pipelines to be developed. For the most part, APA is not in control of its future growth – reliant on the development of new gas fields and new distribution paths to market.
APA’s Annual Report 2022 mentions climate change as a risk but concludes at this point there is no risk of APA being left with stranded assets. We think this is right over the next 15-20 years, but it remains unclear how significant the use case and economic value for pipeline assets will be post-2035.
Whilst the concept of “economic life” might be new for pipeline investors, toll road investors on the other hand are adept at pricing toll road concession life into the cash-flows and valuation of roads. TCL for example has average concession life of 28 years. There is a positive correlation between valuation multiples and concession life. We would expect the same to apply to pipelines.
Figure 4: Renewables are continuing to take market share in Australian energy production.
Figure 5: Gas has a role as transition fuel, with half the carbon intensity of coal when consumed.
Over the past 20 years, APA has grown its EBITDA at a CAGR of ~13%. This has largely been driven by an increased utilisation rate of gas and pipeline acquisitions. This growth rate has begun to slow greatly, with the 3yr forward CAGR falling to ~5% due to the limited ability of APA to partake in acquisitions and the focus on moving away from its core gas operations. Without a clearer operational pathway, it’s difficult to see how APA move back to its historic growth rate.
Figure 6: APA has historically grown earnings at CAGR ~13%. The market is assuming just ~5% CAGR over the next three years.
WHAT DOES THE HIGHER INTEREST RATE ENVIRONMENT MEAN FOR REVENUE GROWTH?
The large majority of APA’s asset base has CPI-linked revenue escalations with more than half of the escalations being updated quarterly. As a result of this, APA has been a significant beneficiary of the higher inflation environment. Revenue outperformance over 1H23 was specifically attributed to inflation-linked tariffs.
As inflation normalises, we see the risk of group revenue growth slowing given revenue linkage to the CPI. APA does not benefit from the direct revenue linkage to CPI in the same way toll road assets do. To offset the likely slowing inflation linkage, APA has some ability to reprice commercial gas contracts (which decline in real terms over time). Recent expansion and enhancements to APA’s pipeline infrastructure will help with repricing.
Figure 7: Dividends have historically grown at 5%. Higher interest rates, and a lack of recent acquisitions is likely to result in slower growth in coming years.
3. HOW CAN GROWTH BE FUNDED?
Balance sheet gearing (ND/EBITDA) currently sits at ~5.5x, close to APA’s long-term average. The maintenance of investment grade credit rating is the key financial metric for APA, allowing the company to keep costs of debt reasonable, whilst providing financial comfort to clients and regulators.
APA is fully hedged with an average debt maturity of 6.2 years, leaving the company in a strong position when refinancing in a higher interest rate environment.
APA is currently rated BBB stable by S&P (re-confirmed January 2023). Major debt refinancing is not required on this side of FY25. Debt coverage currently sits at ~11.6% OCF/ND which is comfortably within range for a BBB S&P credit rating (minimum for the rating being ~9%).
APA has A$2.3bn of cash and undrawn debt to fund its growth opportunities. This includes A$1.4bn for organic pipeline opportunities over the next 3 years with ~A$840m (60% of the A$1.4bn) being allocated in FY23. FY23 projects include the East Coast gas (ECG) pipeline expansion and Western Outer Ring Main (WORM), which are being implemented to meet increased winter demand and a return of migration into Australia post-pandemic.
If APA was to deploy ~A$2.0bn of debt to fund an acquisition, we estimate debt coverage would bottom at ~10%. Assuming the new assets can generate a ROA of 4.0% (APA ROA currently 4.6%), then OCF coverage would return through 11% in FY25E.
Our view is that the ability to debt fund both capex and acquisitions up to ~A$2.0bn puts APA in a good position to increase its assets base. The key issue for APA is in the ability to find large-scale accretive opportunities.
The Group’s current expansion of the ECG and WORM for ~$840m reflects incremental growth opportunities that remain across the APA network remain. These two project expansions, spread over 3 years, add ~2% to the asset base each year – which is only just ahead of population growth.
Figure 8: APA Balance sheet has A$2.3bn of cash and undrawn facilities. A$1.4bn of which is expected to fund organic capex opportunities FY23-25E.
EARNING ACCRETION SCENARIO
We expect that if APA was to use up to ~A$2bn (we look at debt capacity on forward basis, excluding the A$1.4bn of current organic CAPEX spend) of debt to fund an acquisition, it would be earnings accretive without creating an issue for the balance sheet or credit rating. In our view, anything above A$2bn would require an equity raise, and therefore diluting accretion.
We estimate that the debt cover would only fall to 10% (before you add in benefit of new earnings), keeping it well above the ~9% minimum needed for the BBB credit rating. Earnings accretion should lift the debt cover back to +11% within 2 years, even with a lower assumed earnings yield (less productive assets from an EBITDA perspective).
Figure 9: Acquisition scenario: $A2bn would add ~6% to earnings.
Figure 10: A lack of recent acquisition activity sees APA balance sheet deleveraging. We see >$2bn of debt capacity available through FY24-25.
APA Share Register– Largest Shareholder Remains a Seller
UniSuper is the largest shareholder on the APA register, currently owning 9.97%. In recent months UniSuper has been selling down its stake on-market. UniSuper’s stake peaked at 16.1% in 2020.
In 2019, UniSuper appointed Lou Caparelli to head up the super giants' ESG push. Caparelli is on the record as stating that UniSuper continues to push companies to have stated goals for decarbonisation, and clear action paths.
Since Caparelli’s appointment, UniSuper has been increasingly asking the companies it owns to increase their commitment to climate action. For more see Link.
In UniSuper’s latest climate report (March 2023), APA is the Fund’s lowest scoring holding on climate change grounds across UniSuper’s Materials and Utilities exposure. APA is also the Fund’s largest fossil fuel exposure.
In our view, it’s not clear how APA fits into UniSuper’s ESG framework.
Having your largest shareholder continuing to drip feedstock into the market remains far from ideal, particularly when UniSuper has effectively mandated fossil fuel exposures out of their Funds. UniSuper is effectively behaving like a forced seller, suppressing the share price in our view
How does this situation resolve? One scenario is via capital raising. If APA were to make a large acquisition that needs to be funded via equity, APA could over raise so UniSuper can exit the register. With new CEO Adam Watson now in the driver’s seat, we suspect cleaning up the APA share register is a high priority to fix.
CEO and Incentives
Current CEO, Adam Watson has been in the role since December 2022, and prior as CFO since 2020. Former APA CEO Robert Wheals – 14 years at APA, left the Group in August Results in 2022 as the Board called time on the US ambitions.
Watson is yet to make his mark on the company. APA is at an inflection point concerning its future strategy, driven by rising ESG demands from investors, and largest shareholder UniSuper pivoting its investments away from fossil fuel. UniSuper continues to sell down its ownership in APA, which makes Watson’s role in overseeing future growth options critical at this juncture.
From an incentive perspective, Watson’s base pay of $1.7m, is supplemented with an STI of up to 90% of base. APA is yet to disclose what factors drive the calculation of STI and LTI.
The former CEO’s incentives contained no ROIC control on short-term remuneration, which in our view exposes shareholders to potential dilutive acquisitions. APA does attempt to control dilution, through the LTI incentive, where 50% are based on ROIC measures.
We would like to see greater ROIC focus within Watson’s incentive package, along with a clearer picture of how remuneration is tied to APA’s ESG strategy.
In our view, there are only modest remuneration controls and incentives for the CEO to avoid a dilutionary large-scale dilutionary equity funded acquisition. It will be up to investors to enforce financial discipline.
Figure 11: APA CEO base remuneration in-line with listed peers
Valuation Considerations
EV/EBITDA multiple is the most common way equity investors assess valuation of gas pipeline assets. APA has typically traded on a forward multiple of 13x, within a reasonably tight range of 12-14x. Through much of 2022 and 2023 CYTD the multiple has been falling as interest rates rise, ESG issues weigh, and acquisition risks increase. Over the last decade, APA has typically paid 12-13x for pipeline assets in Australia.
The current share price trading at a 15% discount to long term EV/EBITDA would normally be seen as the signal to go positive on APA. With heightened risk of near-term large-scale acquisition risk, combined with UniSuper still selling down their position in APA, we resist the valuation temptation to have more positive call on APA.
CK Infrastructure in 2018 attempted to take APA private with a recommended transaction at 15x EV/EBITDA FY1. This implied a full control premium of 25-30%. The deal was eventually knocked back by the FIRB. APA has never traded anywhere near 15x multiple since.
Cross boarder valuation multiples for gas pipeline assets are fraught with danger given different levels of competition, regulation, and market structures. In May 2023, US pipeline operator Oneok (OKE.US) proposed a $US14bn takeover of Magellan Midstream Partners (MMP.US). The implied transaction multiple (including control premium) is 12x EV/EBITDA FY1. US pipelines typically trade in the 8-9x range.
Figure 12: APA NTM EV/EBITDA multiple typically trades in a tight 12-13x range
Figure 13: APA peer comps. APA is without a listed peer on the ASX.
Risks to Investment View
Investment Thesis
APA is fairly priced against the risk/reward balance in front of the company. APA currently trades a 15% discount to its long-term average, given ESG discount and acquisition risks. We see the dividend as sustainable at current levels, whilst the balance sheet has ~$2bn of headroom within its BBB investment grade rating framework. Fully deployed, this has the potential to increase APA’s asset base by ~10% and would be accretive to earnings.
Strategic and ESG risks surround the company, weighing on the valuation multiple. Outside of large-scale lower carbon intensity acquisitions, there is nothing the company can do to step change and lower the associated carbon intensity associated gas consumption.
New management are focused on making large-scale acquisitions to lower the carbon intensity of distributions. Clean energy assets are likely to be well-contested. There is a clear risk that APA will be perceived as overpaying for any new assets. Acquisitions also increase execution risks, which APA has limited operating experience outside of gas distribution assets.
Medium-term, we remain unconvinced that new assets can return APA closer to its historical distribution growth rate which averaged 5% over the last 20 years. The market has a 3yr DPS CAGR estimate of ~4%.
APA has a low risk of being taken over in our view, given the carbon intensity of earnings. Foreign interest is unlikely following the FIRB rejection in 2018 from CK Infrastructure. Australian-based financial sponsors or a consortium may be possible but for APA's carbon footprint. We rate APA a Hold.
Figure 14: APA EV/EBITDA typically trades in tight 12-14x band.
Figure 15: APA leverage ratio remains comfortably with BBB investment grade credit band.
Figure 16: Spread between APA and 10yr government bond yields has collapsed.
Figure 17: APA dividend yield is 5.5%, 1% point higher than the S&P/ASX 200.
