Stock Review

Pipelines pump out the cash


  • Company: APA Group (APA)
  • Recommendation: Sell
  • Price at Review: $3.75
  • Current Price: $6.78
  • Fundamental risk: 1.5
  • Share price risk: 3.5

They may be boring and predictable, but the cash keeps coming and that's what you want from an income stock.

Company ASX Current Share
Fundamental Risk Share Price Risk Our
Australian Pipeline Trust APA $3.85 1.5 3.5 Sell
Envestra Limited ENV $1.14 2.5 2.5 Hold for Yield
GasNet Australia Group GAS $2.45 2.0 2.0 Hold for Yield

Valuing gas pipeline stocks is a cinch. In fact, if you’ve got your head around our education article from November 04, titled Valuing a bond, then you’re about 80% of the way there. Both bonds and gas pipeline stocks tend to be delightfully predictable in nature. Whereas a bond pays a stream of cash flows backed by a government or corporate promise, gas pipeline stocks offer a stream of cash backed, you’ll not be surprised to hear, by working gas pipelines.

The main difference in valuation lies in estimating the future cash flows, since they’re a little more variable for pipeline stocks than they are for bonds (although they’re nowhere near as variable as most other stocks). So a little digging needs to be done to ascertain the structure of the pricing regime. Usually, regulators determine the rates—and they don’t have a reputation for being overly generous to pipeline owners. Also, returns may be reliant on the throughput of gas or they may be fixed around the cost of constructing the pipelines. If based on the former, you’ll also need to estimate whether customers are likely to be using more or less gas from the pipeline down the track.

Once those questions have been answered as best as possible, valuing the stock is simply a process of discounting your anticipated future cash flows back into today’s money, as we discussed with valuing a bond. We start with the current distribution, make educated guesses as to how it might grow or shrink, and then work out what price we’re willing to pay for that future flow of cash. The price we’re willing to pay, which should also take into account risk factors like debt, geographical diversity and customer concentration, then determines the return we’re looking for from the stock.

Golden rule

But there’s one further rule to follow: never, ever overpay. While overpaying for any stock is not a smart idea, it’s particularly irrational with these stocks. If someone offered to sell you their bank term deposit with a $10,000 balance for ‘just’ $15,000, you’d laugh, right? But overpaying for a pipeline stock is essentially the same. Like term deposits and bonds, gas pipelines are all about income, as distributions are unlikely to grow significantly enough to justify higher stock prices anytime soon.

Just look at the history of the first listed pipeline stock, Envestra, which is up 7% since we last mentioned it in issue 156/Jul 04 (Hold for Yield—$1.07). In the year to 30 June 2000, it paid distributions totalling 9 cents. Four years later, the total distributions were 9.5 cents—up, on average, less than 1.5% a year. With that sort of growth, capital gains should be scarce to say the least. But if the yield is high enough, that shouldn’t worry you. On a yield of 8.3%, which we feel is about right for a stock which has predictable cash flows but also lots of debt, we’re still happy to call this stock a HOLD FOR YIELD.

Envestra makes its living through a 20,000km-long, spaghetti-like distribution network that allows its customers, mainly big gas retailers, to deliver gas to homes and industry. But GasNet and Australian Pipeline Trust are somewhat different beasts. They own gas transmission pipelines which carry great volumes of gas longer distances, from source or gas treatment plant to the cities where the gas is passed over to distribution networks like Envestra’s in Victoria and South Australia, and AGL’s in NSW. The transmission pipelines are the highways or, more specifically, the tollways, of the gas delivery system.

Attractive attributes

GasNet’s smallish, mostly Victorian, network of around 2,000 kilometres is a good, simple business that’s pretty hard to stuff up. And, like the others, it’s a borderline monopoly—talk about attractive attributes. Over the past year, it has returned 20 cents in distributions to stockholders, made up of 10 cents in tax-deferred capital returns and 10 cents in unfranked distributions. So it’s currently selling on a yield of 8.2%. To anticipate a bunch of queries from subscribers, that’s probably higher than the yield reported in your newspaper. The figures in the press tend to miss some of the capital returns, thereby short-changing the real yield received by investors. We’ve traditionally recommended GasNet as a buy for Most Bankings whenever it offers a yield of 10% or better but, with the stock up 7% since issue 156/Jul 04 (Hold for Yield—$2.29), we’re sticking with HOLD FOR YIELD.

Spot the odd one out
Stock Distribution (cents) Current yield
Australian Pipeline Trust 22.5 5.8%
Envestra 9.5 8.3%
GasNet 20 8.2%

The similar, but much larger, Australian Pipeline Trust owns pipelines running through numerous states, although its biggest asset is the Moomba to Sydney pipeline which delivers gas from South Australia’s plentiful outback to the energy-hungry Sydney market. Like the other two, Australian Pipeline Trust has quite consistent cash flows—its last four quarterly distributions totalled 22.5 cents, of which 5 cents was fully taxable and 17.5 was 40% franked. This stock has risen an impressive 45% since issue 156/Jul 04 (Hold for Yield—$2.66) and, quite frankly, we’re flabbergasted by that movement. Remember, never ever overpay for a pipeline stock.

That brings us to what we’ll call the income stock predicament. When an income stock, with little prospect of meaningful long-term capital gain, rises significantly in price, it usually signifies one of two things. Either the stock is very overpriced or management is doing something risky to get some growth, like changing its business or structure and almost certainly taking away the safety and predictability that Most Bankings crave. Either way, selling is the conservative option. From what we can see, it looks like Australian Pipeline Trust falls into the former, simply overpriced, camp. It hasn’t grown distributions much in the past and, if our forecasts are correct, it won’t grow them too much in the near future. The current price offers a yield of 5.8%. We simply don’t think that’s enough return from a highly geared trust and, at these prices, there’s every prospect of future capital losses. We’re changing our recommendation to SELL.

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