Regulation is part of life in developed-world economies. Some industries are regulated more than others–utilities, for example, where in Australia, as in the US, a phalanx of local, state and federal officials scrutinize practically every move essential-service providers make.

Navigating a regulatory thicket where state-level demands often come in conflict with mandates from the federal government is one of the most important activities in which power and pipeline companies engage.

Good relations with elected and appointed official go a long way when it comes to making rate-request applications, seeking merger or acquisition approval and/or siting and constructing new facilities.

The broader regulatory outlook for Australian utilities has improved in recent weeks. South Australia has decided to deregulate electricity prices, the final result of a court challenge brought by merchant utility and AE Portfolio Favorite AGL Energy Ltd (ASX: AGK, OTC: AGLNF, ADR: AGLNY).

The retail businesses of AGL and Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY), an AE Portfolio Aggressive Holding due to its energy exploration and production exposure, had been threatened by less favorable rulings in South Australia as well as in Queensland, which had an adverse impact on those stocks’ performances in 2012.

Network utilities including Conservative Portfolio Holdings APA Group (ASX: APA, OTC: APAJF) and Envestra Ltd (ASX: ENV, OTC: EVSRF), although exposed to similarly difficult regulatory challenges, enjoyed a substantial “yield premium,” as investors hungry for consistent income amid an uncertain environment drove prices higher.

Looking forward, South Australia’s decision to deregulate establishes an important precedent for other states Down Under and bodes well for merchant utilities. And, with the Australian Energy Market Commission’s process of establishing new rules now drawn to a close, network utilities that will have to abide by these revised standards have some clarity.

There are rate resets yet to come and there have been requests for pass-through of capital expenses recently denied for specific companies. Yet in general regulatory risks for both merchant and network utilities appears to be waning.

There are opportunities, therefore, in utilities with no short-term rate-reset exposure as well as those trading at solid valuations.

Past Performance

The seven stocks that comprise the Utilities group in the AE How They Rate coverage universe–their number has increased by one since the January issue, as we’ve moved APA Group (ASX: APA, OTC: APAJF) in from Oil & Gas to better reflect the nature of its core business–have generated impressive results for investors in the aftermath of the Great Financial Crisis.

From Feb. 8, 2008, through Feb. 8, 2013, this magnificent seven produced an average total return in US dollar terms of 107.1 percent. The broader S&P/Australian Securities Exchange 200 Utilities Index returned 52.4 percent, the S&P/ASX 200 Index 27.2 percent. They also beat the S&P 500 Utilities Index, the S&P 500 and other global benchmarks.

Last year was another good one, as the group posted an average gain including dividends of 25.4 percent. That compares to a 24.1 percent for the S&P/ASX 200 Utilities Index and 21.8 percent for the S&P/ASX 200 and 1.3 percent for the S&P 500 Utilities Index and 16 percent for the S&P 500. It also beat global utility and broad-based benchmarks.

AE Portfolio Conservative Holding APA led the way for this tumultuous half-decade, posting a total return of 238.4 percent. Last year Australia’s biggest natural gas pipeline owner/operator put up an impressive gain of 33.4 percent. An original member of the Portfolio, the stock has posted a total return of 71.2 percent. And it continues to ride momentum this year.

On a strong run that now includes a price-only gain of 4.2 percent thus far in 2013, APA has zoomed past our recommended buy-under target of USD5.50, to USD5.94, or AUD5.77 on the Australian Securities Exchange (ASX). Based on the prevailing value of the Australian dollar-US dollar exchange rate the buy-under price on the ASX is AUD5.66.

Another member of our “Eight Wonders,” Envestra Ltd (ASX: ENV, OTC: EVSRF), also focused on natural gas infrastructure, is trading well above our recommended buy-under target. Envestra is up 81.5 percent since our initial recommendation after 2012’s 42.7 percent gain, best among the AE Utilities group. For the five years it’s up 117.4 percent, second only to APA.

Envestra closed at AUD1.02 on the ASX on Feb. 15, or USD1.05 based on the aussie-buck exchange rate, while we rate the stock a buy under USD0.80. That’s a level the stock hasn’t traded below since mid-July 2012. We haven’t boosted our buy-under target because Envestra hasn’t boosted its dividend since August 2011.

Actionable Utilities

Fortunately, there are two similarly solid companies in the AE Portfolio that are trading under our recommended buy targets, Conservative Holding AGL Energy and Aggressive Holding Origin Energy.

Both stocks outperformed major benchmarks for the five-year period, AGL returning 93.2 percent and Origin 91.5 percent. Last year, however, the stocks were fair to middling, in AGL’s case, and outright underperforming, in Origin’s. Both are in the black thus far in 2013, though they also still look like compelling values.

AGL operates retail, merchant energy and upstream gas businesses and has over three million customer accounts. AGL is also Australia’s leading renewable energy company and the country’s largest private owner, operator and developer of renewable generation assets.

The company has major investments in hydro and wind as well as ongoing developments in key renewable areas including solar, geothermal, biomass, bagasse (juice extracted from residue of sugarcane or sorghum stalks and used as a biofuel) and landfill gas.

The commanding feature of AGL Energy as an investment is that it continues to add assets and build scale on favorable terms. Management expects underlying profit for the year ending June 30, 2013, to be in the range of AUD590 million to AUD640 million, compared with AUD482 million in fiscal 2012.

One of the main reasons for the expected increase in earnings is the contribution from the Loy Yang A power station acquired June 29, 2012.

Earnings are forecast to skew to the second half fiscal 2013, with approximately 55 percent of the full-year profit being recognized in the period from Jan. 1 to June 30. This is largely due to the imposition of a carbon tax by the Australian federal government as of July 1, 2012, but recovery of that cost from retail customers not commencing until after that date.

Guidance also includes the anticipated effects of the adverse regulatory pricing decision of the Queensland Competition Authority in Queensland. It also takes account of electricity price decreases for South Australian customers as of Feb. 1, 2013. The South Australian government deregulated the retail electricity market effective on that date.

AGL added 180,000 customers during fiscal 2012, with new signups in all Australian states in which it operates. The company’s organic growth strategy resulted in a net increase of 32.5 percent in New South Wales customers. These additions came at a lower average cost than was incurred during the privatization process in the state.

The company boosted its final distribution for fiscal 2012 by 6.6 percent to AUD0.032 per share, bringing the full-year payout, including the AUD0.28076 interim dividend, to AUD0.60076 per share.

AGL will report results for the first half of fiscal 2013 on Feb. 27.

AGL Energy, which continues to add assets and customers terms favorable to consistent dividend growth, is a buy under USD16 on the Australian Securities Exchange (ASX).

AGL also trades as an American Depositary Receipt (ADR) on the US over-the-counter (OTC) market; it represents one ASX-listed share. AGL’s ADR is a buy under USD16.

Origin Energy, an integrated energy company with oil and gas exploration and production as well as power generation and energy retailing operations, was the subject of a January 2013 Sector Spotlight.

Since hitting a four-year low in late 2012 the stock has posted a strong rally, rising from AUD9.84 per share on the ASX to as high as AUD12.50 on Feb. 1, 2013. The stock has retraced some of this gain over the past two weeks, settling at AUD12.16 on Feb. 15 Down Under. That’s still a 23.6 percent price-only, local-terms rally off the low.

Management most recently guided for flat to 5 percent growth in fiscal 2013 earnings, before interest, taxation, depreciation and amortization (EBITDA). This is a downward revision from a prior forecast of 5 percent to 10 percent growth. Origin expects a 5 percent to 10 percent decline for net profit after tax (NPAT) after previously predicting a “flat” fiscal 2013 compared to 2012.

Origin identified the costs of complying with the Australian government’s Small-Scale Renewable Energy Scheme (SRES) as the main driver of its guidance revision, noting that an increase from 8 percent to 19 percent its liabilities under the scheme will boost costs by AUD40 million.

The downward revision led to the mid-November slump. Recent news from the company has been more upbeat.

Origin’s exploration and production unit reported output of 29 petajoules equivalent (PJe) and sales revenue of AUD200 million for the three months ended Dec. 31, 2012.

Production was up 1 percent compared to the second quarter of fiscal 2012, as increased output from work in the Otway Basin more than offset the suspension of gas operations at Kincora in the Surat Basin and a lower share of Australia Pacific LNG production due to the dilution of Origin’s ownership interest.

Sales revenue also improved by 1 percent due to higher average commodity prices.

Production for the half year was down 5 percent because of the AP LNG dilution, lower production from BassGas as a result of the Mid Life Enhancement project, the suspension of gas operations at the Kincora gas plant and lower customer nominations and plant availability at Kupe. Sales revenues for the half were AUD5 million lower at AUD425 million.

Management noted “significant progress” at the key AP LNG project, with the upstream component 29 percent complete.

Origin has no dividend cuts over the past five years, though dividend growth has been only very modest. For fiscal 2012 the company paid AUD0.50 per share, split evenly between interim and final payments, after it paid AUD0.49 per share for fiscal 2011 and AUD0.48 for fiscal 2010.

The payout ratio for fiscal 2012 was 55.5 percent, well within reason for a company with Origin’s cash-generation capabilities. Debt-to-assets is just 21 percent, and the company has no major maturities until an AUD1.8 billion revolving loan facility comes up for rollover in April 2015.

With a price-to-book value of 1.01 and a price-to-earnings multiple of 15.88 the stock represents a compelling bargain.

Origin trades on the ASX under the symbol ORG and on the US over-the-counter (OTC) market under the symbol OGFGF.  It also trades on the US OTC market as an American Depositary Receipt (ADR) under the symbol OGFGY. The ADR is worth one ordinary, ASX-listed share.

Origin Energy is a buy on the ASX using the symbol ORG and on the US OTC market using the symbol OGFGF under USD15. Origin’s ADR, which represents one ordinary, ASX-listed share, is also a buy under USD15.

Origin Energy will report full financial and operating results for the first half of fiscal 2013 on Feb. 21.

Spark Infrastructure Group (ASX: SKI, OTC: SFDPF), which is the subject of one of this month’s Sector Spotlights and is a new addition to the AE Portfolio, holds 49 percent interests in two entities that control three power companies: SA Power Networks, which was formerly known as ETSA Utilities, and Victoria Power Networks, the holding company for CitiPower and Powercor Australia that recently changed its name from CHEDHA Holdings Ltd.

Please note that ownership of Spark by US investors is limited to “qualified purchasers,” which the Securities and Exchange Commission defines, in relevant part, as individuals “who own not less than USD5,000,000 in investments.”

The “qualified purchaser” standard is more exacting than the SEC’s “accredited investor” standard, which includes, in relevant part, those with “individual net worth, or joint net worth with the person’s spouse, that exceeds USD1 million at the time of the purchase” as well as those “with income exceeding USD200,000 in each of the two most recent years or joint income with a spouse exceeding USD300,000 for those years and a reasonable expectation of the same income level in the current year.”

Because Spark has advised that it “may require an investor to compete a statutory declaration as to whether they are an ‘Excluded US person’” we are going to add the stock to the Aggressive Holdings rather than the Conservative Holdings.

We’ve decided to make the addition because, though the great majority of AE subscribers are US-based investors, we do have a number of readers in foreign jurisdictions that don’t have similarly onerous burdens on cross-border investing.

As we note in this month’s Sector Spotlight, the power companies in which Spark holds interests are all stable from a regulatory perspective, with no resets until 2015; growing, with the overall “regulated asset base” (RAB) expanding 4 percent in the first half of 2012 and 9.3 percent for the 12 months to June 30, 2012; and building wealth, with the interim distribution for 2012 up 10.5 percent and management guiding to 3 percent to 5 percent annual growth through 2015.

Spark recently internalized the management of its assets, achieving significant cost savings in the process. And there are no debt refinancing requirements until September 2014.

Net debt-to-RAB at the asset-company level was 81.8 percent as of the mid-year 2012 report and is on track to reach approximately 75 percent by year-end 2015. Spark Infrastructure in its own right has very little debt, with standalone net gearing of 2.1 percent and a “look through” rate of 58.5 percent.

Moody’s rates Spark Infrastructure Baa1 with a “stable” outlook. S&P rates SA Power, CitiPower and Powercor A- with “stable” outlooks.

Standalone operating cash flow per security of AUD0.06 per share for the first half of 2012 (Spark reports financial and operating results according to a calendar-year schedule) fully covered the distribution of AUD0.0525.

Management has established a target payout ratio of approximately 80 percent of standalone operating cash flows across the current regulatory period to 2015, with a forecast annual distribution growth rate of 3 percent to 5 percent.

The Australian Energy Regulator (AER) has approved capital expenditure over the current five-year regulatory periods, which will drive growth in the RAB of the respective companies at 8 percent per year.

Along with its first-half earnings announcement Spark reaffirmed its previous full-year distribution guidance for 2012 of AUD0.105 per security. The interim distribution of AUD0.0525 per security for the six months to Jun. 30, 2012, represents a 10.5 percent increase from the AUD0.0475 paid as an interim dividend in 2011.

Spark Infrastucture trades on the ASX under the symbol SKI and on the US over-the-counter (OTC) market under the symbol SFDPF.

Spark Infrastructure, a new addition to the AE Portfolio Aggressive Holdings, is a buy on the ASX using the symbol SKI and on the US OTC market using the symbol SFDPF under USD1.80.

Non-Portfolio Network Utes

Duet Group (ASX: DUE, OTC: DUETF) has investment interests in three major Australian gas and electric assets.

The Dampier Bunbury Natural Gas Pipeline, in which Duet holds an 80 percent interest, is Western Australia’s principal gas transmission pipeline. It’s the only pipeline connecting the natural gas reserves of the Carnarvon and Browse basins on Western Australia’s North West Shelf with industrial, commercial and residential customers in Perth and the surrounding regions. Natural gas supplies approximately 50 percent of total primary energy consumption in Western Australia.

Almost all of Dampier-Dunbury’s revenue is derived from contracted gas transportation tariffs, charged to wholesale customers for shipping gas along the pipeline. Cash flows are backed by long-term contracts with the major shippers using the pipeline.

More than 80 percent of the tariff is paid on a capacity reservation (or “take-or-pay”) basis, with the remaining 20 percent depending on the shipper’s actual throughput. Contracts are in place until at least 2019 with all of the shippers on the pipeline, ensuring stable and predictable revenues.

The Dampier-Bunbury is essential infrastructure, with no direct competition from other pipelines or a material risk of bypass by other pipelines, and substantial barriers to entry for a competing pipeline to be built. It has an expected remaining useful operating life of over 50 years and has a strong track record of 26 years of reliable operation.

Though Dampier-Bunbury is basically under contract with private shippers until at least 2019, it’s a requirement under the Western Australian gas regulatory regime that proposed access arrangement revisions are lodged with the Economic Regulatory Authority (ERA) for its approval at least every five years.

On Jan. 17, 2012, application was made to the Australian Competition Tribunal (ACT) for a merits review of the ERA of Western Australia’s decision for the 2011 to 2015 regulatory period. This process is still ongoing, though it’s important to note that the tariffs under existing shipper contracts are set under commercially negotiated agreements and won’t be affected by the access arrangement until 2016.

Tariffs to apply under contracts from January 2016 will be determined after the next decision of the ERA, expected during 2015.

Duet also owns 100 percent of Multinet Gas, which distributes in Victoria over a network covering 1,860 square kilometers of the eastern and southeastern suburbs of Melbourne and the Yarra Ranges.

Approximately 96 percent of Multinet’s total revenue is regulated and is primarily from distribution tariffs charged to customers for connection to and use of Multinet’s distribution system.

Growth in distribution revenue is driven by regulated tariff charges and volume growth. Multinet’s top 250 gas users collectively account for only around 1 percent of total distribution revenue. As a result, the potential for a negative impact on revenue from the loss of a major user is very low.

In March 2012 Multinet filed its Gas Access Arrangement Review (GAAR) submission for the period 2013 to 2017 with the AER. This process is ongoing, with a rate reset due sometime in 2013. 

Finally, Duet holds a 66 percent interest in United Energy Distribution, which provides electricity to about 25 percent of Victoria’s population. The distribution network transports electricity from the high voltage transmission network to residential, commercial and industrial electricity users.

Approximately 91 percent of UED’s total revenue is regulated and includes network tariffs charged for the use of UED’s distribution network and metering revenue. The tariffs are levied on electricity retailers, who pass these costs on to their customers. Growth in network tariff revenue is driven by volume growth and regulated network tariff charges.

Other revenue comes from services that UED provides to its customers, such as relocating assets at the request of our customers, extending existing distribution networks, providing public lighting to local council areas, and access charges for the use of electricity distribution poles to telecommunication companies.

The next regulatory reset date for UED’s access arrangement is Jan. 1, 2016.

Management reported statutory consolidated revenue for the first half of fiscal 2013 grew by 9 percent, while earnings before interest, taxation, depreciation and amortization (EBITDA) were up 7 percent.

Duet reported a statutory loss of AUDD45.9 million due AUD98.1 million in expenses related to the internalization of its management.

Cash coverage of the interim distribution of AUD0.0825 per stapled security was 104 percent. Management reaffirmed full-year distribution guidance of AUD0.165. Duet Group is a buy under USD2.20.

SP AusNet (ASX: SPN, OTC: SAUNF) owns and operates electricity transmission and electricity and gas distribution networks in Victoria. It’s one of Australia’s largest energy delivery businesses, managing AUD6.3 billion worth of electricity and gas networks and servicing more than 1 million customers in southeast Australia.

The electricity transmission network transports electricity from power stations to electricity distributors across all of Victoria via 12,800 towers and on approximately 6,500 kilometers of transmission lines.

The electricity distribution network moves electricity from the transmission grid to approximately 620,000 customers across eastern Victoria. This network spans approximately 46,500 kilometers across an area of 80,000 square kilometers.

SP AusNet’s gas distribution network transports gas to approximately 570,000 customers across central and western Victoria. This network spans approximately 9,700 kilometers across an area of 60,000 square kilometers.

The company recently suffered an adverse ruling by the AER regarding smartmeter costs and charges for the period from 2012 to 2015. The AER increased SP AusNet’s allowed cost recovery budget for the period by AUD17.5 million against a request of AUD73.9 million.

Management of SP AusNet noted that it “will carefully review the AER’s decision and determine whether it is appropriate to take any further action.”

For the first half of its fiscal 2013, which ended Sept. 30, 2012, SP AusNet reported that net profit after tax increased by 15.6 percent to AUD169 million. EBITDA was up 6.5 percent to AUD525 million, as revenue rose by 6.5 percent to AUD884.5 million on solid contributions from all of its businesses.

SP AusNet paid an interim distribution of AUD0.041 per stapled security on Dec. 21, 2012. Management forecast a full-year distribution of AUD0.082 per share, a 2.5 percent increase over fiscal 2012. The fiscal 2014 distribution is expected to be 2 percent higher compared to fiscal 2013.