Investors need to discard history and believe in several improbabilities to buy DUET at current levels. Most importantly, investors need to believe the oxygen supply from DUET’s promised distributions will deny the forces of fundamental valuation’s gravity. Dividends can be solid indicators of company health, but equally can mask chronic issues. We know the pitfalls of the yield bait set by sellers of spivvy property investments, but we rightly expect to be able to rely on yield guidance provided by top 50 ASX companies. DUET has issued equity (excluding equity issued to fund acquisitions) equivalent to more than 100% of its cash distributions to shareholders over the last five years. The lack of free cash flow to fund DUET’s distributions has been demonstrably chronic; issuing equity to fund increasing distributions reinforces the chronicity of the lack of cash flow, makes no economic sense if we put to one side a desire to maintain a certain stock price and, most importantly, will ultimately be cut.

Questions regarding DUET’s disclosure obligations in this regard have been put to the regulators to ensure investors are kept aware of the information they are entitled to receive. (VIEW LINK)

Investors whose disposition is to believe in DUET’s distributions as a solid basis to value the stock should consider the following questions:

- What is stock XYZ Limited worth if it has a forward dividend of 10 cents per share and has consistently grown dividends at 5% p.a for the last 10 years?
- How much is stock XYZ Limited worth if 100% of the last 10 years of distributions have been funded by issuing equity?
- What is the true forward yield if the shareholders will be required to fund 4 cents (40%) of the dividend by subscribing for new shares?

If your answers reasonably were:

- Don’t know because we don’t have enough information
- Don’t know because the answer is not zero and we need to know the asset values
- Less than 6 cents (with the amount below 6 cents due to capital being turned into taxable income)

you are on the right track as you are looking for fundamental or intrinsic asset values to determine the value of the stock. If you reasonably believe in examining comparable company valuations using comparable statistics, if Spark Infrastructure followed the exact approach followed by DUET to determine “distributable cash flow” (a term to watch out for by the way because it is a term of art and doesn’t have the meaning we expect), then this would be the comparison:

- DUET plans to distribute 18.5 cps – a yield of 7.3%
- Spark would distribute 21.3 cps – a yield of 8.9%
- DUET’s yield would equal Spark’s yield at a DUET share price of $2.08.

While Spark appears to have capacity to pay higher distributions from free cash flow, its approach is conservative and sustainable while DUET’s is aggressive and not sustainable. The yield comparison simply points to a large valuation discrepancy which needs explanation.

Around half of DUET’s equity value is derived from its 100% ownership interests in the Dampier to Bunbury (DBP) pipeline and Energy Developments. DBP has almost no growth and its regulated asset base (RAB) will decline as will its cash flow. This is an asset where valuation on the basis of yield, in particular by using the perpetuity growth method, can assist materially as the answer will be close to a 50 year DCF model’s output. Even excluding all taxes, a reasonable valuation approximation is derived by dividing DBP’s EBITDA less an estimate of 5% for maintenance capex by the required rate of return. The denominator *(r-g*) includes a factor for the expected long term rate of decline in cash flow (consistent with declining RAB). The equation becomes $265mm/6.5% - the calculated equity value of $1.4 billion calculated using this method represents a 38% premium to the valuation at which Alcoa sold its 20% stake to DUET. By this latter reference point, the value of $1.4 billion appears aggressively high, but well south of some analysts’ calculations – if one applies a positive growth assumption to a declining growth asset, this will happen and these analysts are willing to believe a sophisticated company such as Alcoa sold its interest at DBP at an approximate 60% discount to its true equity value.

Energy Developments (EDL) is very different – it has materially higher growth, capital intensity and risk than DBP. DUET acquired EDL in late 2015 for 8.2x forward EBITDA. If the acquisition multiple is applied to FY 2017 earnings estimates, the equity value today is $1.55 billion. We therefore have the two largest assets, which account for a little more than half of economic EBITDA, valued at a blended EBITDA multiple of around 11.0x. To believe these assets are worth a higher multiple than this, investors need to believe either or both Alcoa or the highly-experienced and skilled Chairman of EDL sold their assets on the cheap.

DUET’s securities are trading at 12.4 x FY 2017 EBITDA. If you see a lower number than this in analysts’ reports, the calculations are likely in error (with more than one analyst failing to include the United Energy minority interest in the calculation – a basic corporate finance error). The implied >14X EBITDA multiple this implies for DUET’s other assets (other than DBP and ENE) borders on the absurd. The implied EV/RAB multiples for the two regulated businesses in the portfolio (which have immaterial contributions from unregulated businesses) is 1.9x, well above the nose-bleed stratosphere. Investors can only survive at this level for so long as the oxygen from the promised distributions keeps them alive. Analysts reports show lower EV/RAB multiples but these are driven by their excessive valuations of DBP, in particular.

By contrast, one can buy Spark at less than 12x proportionate or “look-through” EBITDA. Spark’s portfolio includes unregulated businesses conducted by the entities which produce very material, recurring EBITDA. Spark does not help its market valuation by failing to disclose its earnings from its unregulated business - a lazy application of similar RAB multiples to Spark’s portfolio companies and DUET’s produces misguided and thoughtless valuation answers because they fail to account for the significant value in Spark’s unregulated businesses.

If we put to one side DUET’s distributions on the basis they may be a false indicator, an investor has to believe in a majority of the following improbabilities to buy DUET:

- DUET is worth 12.4 x EBITDA when SPARK is trading at less than 12x despite Spark not having a low multiple Energy Developments equivalent in its portfolio
- Alcoa and the Board of Energy Developments sold to DUET at bargain prices despite being under no compulsion to sell at all
- DUET’s regulated assets can be worth premium RAB multiples to assets in Spark’s portfolio despite the massive cash flow and valuation uplift from the unregulated earnings in Spark’s two major assets
- credit markets will remain benign and allow DUET to refinance ~$4.5 billion of debt during the next two years on attractive terms despite the weighted BBB- credit ratings and key debt metrics (FFO/debt) below the level which SPARK management regards as prudent for the sector (based upon their comments on the last results call)
- Australian bond rates and equity discount rates will remain at near record lows for the foreseeable future
- The regulators will not insist DUET makes the necessary disclosures to ensure its distribution guidance does not omit material, price-sensitive information such as how the distributions will be funded.

There is debate at least on a weekly basis about the outlook for long term bond rates. Regulated assets have benefitted from their positioning as bond surrogates, but they are more complicated than this due to the 5 yearly regulatory reviews which reset key inputs into the regulator’s pricing model. This makes the regulated asset owners the economic equivalent of owners of a long term set of predictable cash flows which are bond-like but which are reset every 5 years by reference to prevailing bond rates and other key CAPM inputs.

There is a short cut way to estimate the likely impact on the value of regulated assets once bond rates revert towards historical averages. If we assume the market today is, on average, valuing growing, leveraged regulated assets at 1.4x RAB, we can divide the value into two parts:

- A core value of 1.0x RAB where the owner’s return on equity is equal to the regulator’s determined return on equity. Because the 5 yearly resets change the cash returns over the following 5 years using CAPM and there is an exactly equal change in the forward discount rate, the value of this core part remains equal to 1.0x RAB
- The incremental value derived from the combined effects of financial leverage, tax benefits and growth which, in our estimation of current market value has an ascribed value today of 0.4x RAB (1.4 – 1.0 of core value). The value of this part of the cash flow will decrease with an increase in bond rates and equity discount rates.

If risk-free rates increase by 2%, equity discount rates should increase by the same amount. The NPV of the second or incremental value of the cash flows over a period of 50 years can be expected to reduce by ~20%. A change in value of 20% of 0.4 x RAB = 0.08x RAB. For an asset leveraged at 80% debt /RAB, the change in equity value is 0.08/0.60 = 13%. This is a proxy for how investors can expect the value of DUET’s equity to change in a rising interest rate scenario.

Investors strapped in to an expectation that DUET’s distributions will be both stable and growing should stay alert to the risks in this regard and to seeing the shares trade below $2.00.

For more detailed analysis, visit (VIEW LINK) and read the attached letter.

James Dunphy

8 September 2016