The Stock

What to Buy: DUET Group Stapled Share (Australia: DUE, OTC: DUETF) @ USD1.70

Why Now? Perth, Australia-based DUET Group owns interests in essential energy infrastructure assets. Stapled shares entitle investors to earnings from four companies, DUET1, DUET2, DUET3 and DUET Investment Holdings Ltd. Fears about recapitalization efforts at certain of its affiliates have caused the stock to flat-line since plunging during the 2008-09 bear market.

That’s also triggered some worries about the safety of the twice-annual dividend of 10 cents Australian, though management affirmed its safety when it announced earnings late last week. The yield is 12.6 percent yield in Australian terms, which will rise for US investors if and when the Australian dollar appreciates against the US dollar.

The Story

As promised last Thursday, here’s another double-digit yielder.

Leave it to the Macquarie Group to concoct a financial structure that, despite holding the most solid of infrastructure assets, is complex enough to scare many investors away. Herein lays the opportunity. DUET shares basically comprise three energy infrastructure portfolios, with assets and investments that are tied to the rapid growth of Western Australia’s resource industries.

Over the past 10 years the region’s mineral and petroleum industries have achieved average annual growth rates in excess of 15 percent. Western Australia is the top exporting region, accounting for 39 percent of Australia’s total AUD196 billion worth of goods and services sent abroad in 2009. As of 2009 more than AUD70 billion had been either committed or spent to build out Western Australia’s energy infrastructure.

Essential-service assets covered by long-term contracts in regulated environments: That’s a formula for long-term wealth-building, provided at least the company’s complex structure doesn’t get in the way.

David: As you know I started reconnoitering for potential February targets early last week, and I kept circling back to Australia, again. As you know, my focus has been on this investment company that holds stakes in energy utility assets.

The exciting thing to me is that management announced on Friday that earnings covered distributions by 1.19-to-1 for the six months ended Dec. 31, 2010, in other words the payout ratio was about 84 percent. Overall results were in line with analysts’ expectations. The risk I see is an effort to recapitalize certain of the entities it owns may jeopardize the company’s S&P rating.

In a worst-case, that could tip it into junk from the current investment-grade BBB- with a “stable” outlook, which is always bad news for an infrastructure company.

Roger: This is DUET Group (Australia: DUE, OTC: DUETF), the Perth-based company that’s affiliated with Macquarie Group (Australia: MQG, OTC: MQBKY).

David: Right. Its assets include the only natural gas pipeline connecting the 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.

The Dampier-to-Bunbury Natural Gas Pipeline, of which DUET owns 60 percent, boosted earnings by 18 percent in the interim period, driven by completion of the Stage 5B expansion, which increased full-haul capacity by 112 terajoules per day. Stage 5B is the culmination of a three-stage, AUD1.8 billion expansion plan DUET put in motion when it acquired a controlling interest in 2004.

Assets operate under long-term contracts in regulated environments, making for stable cash flows that amply covered the distribution. Questions about debt levels at DUET’s affiliated companies have held the share price down, and rising interest costs ate into net income for the interim period. But the downside here is pretty well defined, and DUET will pay a generous distribution while we wait for the market to understand its virtues.

The 10-year closing low is around AUD1.37, which it hit on Mar. 6, 2009. That’s about 17 percent below its current level–about three distribution payments, or a holding period of about a year and a half. As for the top side, if this one hits AUD3.95 again, where it closed on Jun. 22, 2007, surging to that point on record volume, it would justify this product on its own.

If things go really sideways again, and we something like caused the Mar. 6, 2009, low, we’re down 17 percent. And we get it covered in three payments.

This one, to me, is all about well-understood downside risk.

Tell me if I’m oversimplifying.

Roger: I’ll answer you another way. There’s another piece to what you seem to be setting up as our “base case scenario”–which describes potential upside, potential downside and the rationale for buying now–and that’s the assumption that the biannual payout will survive.

As you point out, for the six months ended Dec. 31, 2010, earnings per stapled share covered the payout by almost 119 percent, or AUD0.119 versus the semi-annual payout of AUD0.10 per stapled share. Clearly, that’s a very solid number for an infrastructure company, as cash flows from things like pipelines generally don’t fluctuate all that much. I’m not really even that concerned about the increase in interest expenses, as it looks like something related to construction of a new asset that will boost cash flow even more.

After all, it’s pretty standard for companies to book these expenses first, and you can’t grow in the infrastructure business without first investing. I wish I could make more people understand that about utilities and energy infrastructure companies on this side of the Pacific. Then maybe they wouldn’t get so agitated every time one of my companies issues equity.

There are a couple of things that concern me about DUET, and that’s in addition to the fact that we need to make clear it’s a semi-annual dividend and not a monthly or quarterly one like everyone is used to. Item one is if we were employing our Canadian Edge Safety Rating System here, we couldn’t give DUET a point on at least one criterion: No dividend cuts during the trailing five years.

David: That’s true, and I’m glad you mentioned the CE Safety Rating System. Did you see the in-house comments following last month’s issue? Our publisher would like more than just a passing reference to the System.

With that in mind, DUET does earn a point because its 84 percent payout ratio is below what’s considered “at risk” for Electric Power and for Gas/Propane companies. And should we credit it another point for the nature of its business? Would you say that the late 2008 cut (for payment in early 2009) obviates its status as a “recession-resistant” business?

Roger: To an extent yes. But let’s keep in mind the flipside of these businesses. They’re almost always regulated to some degree. In fact, in some countries it’s impossible for investors–particularly foreigners–to make a return on investment. We cited this risk with an earlier high-yield recommendation in this service, Telstra (Australia: TLS, OTC: TLSYY). That company seems to have worked out its problems with the government over the National Broadband Network and first half fiscal 2011 results were in line with guidance. Management has even projected it will hold the current rate out through 2012, which I also like.

But Telstra’s regulatory struggles when we bought it were very real and are shared by every other regulated infrastructure company in Australia. That’s a risk every investor needs to be aware of. These assets also produce good cash flows when the government lets them. That’s usually the case as everyone realizes you have to allow a fair return to attract investment, and that Western Australia needs it.

In fact, the whole country needs it after those floods. But it’s always tempting for officials to lean a bit on these companies, who are otherwise profitable even in hard times. It’s something I’m concerned about in the US and Canada, too, by the way.

David: I wouldn’t argue with that. It seems like a low payout gives management some leeway here, though, if a government edict makes one of their assets less profitable for whatever reason.

I’m a little more troubled by the rather high debt this company seems to have: That’s debt as a share of assets; “gearing,” to use the Australian English was 67.7 percent as of Dec. 31, not exactly “Very Safe,” not exactly “At Risk.” What’s the situation as far as maturing debt in the short and medium term?

Roger: OK, now I’m going to be a little more direct: You did indeed oversimplify this one.

DUET’s debt situation is maybe a little more complicated than our readers are used to, but let me try to break it down. In 2011, they have roughly AU511 million in maturing bonds. There are three issues. One has a “floating” rate and two others are at 4.7 and 6.375 percent, respectively. Refinancing these as well as the AU1.26 billion in six outstanding loans is why it’s so important for the company’s credit rating not to implode this year.

Next year there’s another AU275 million in bonds coming due, this one also at a floating rate. And there are four loans coming due as well, totaling AU573 million. After that, maturing obligations drop off to much lower levels. It’s important to recognize, however, that these loans and bonds together add up to more than the AU1.5 billion market capitalization of DUET as a whole.

Refinancing or even paying some of this off–and at better interest rates than DUET is now paying–is by no means an insurmountable challenge. In fact, I would say it’s probable they’ll do it. However, I wouldn’t give DUET any rating points for debt.

On the plus side, credit rater Standard & Poor’s did comment this week that the company’s earnings were “broadly in line” with their expectations. At the same time, it warned that if the plan to deleverage the company’s asset companies isn’t balanced with an appropriate capital structure and liquidity plan, it may “weaken the group’s credit profile.” That’s rater-speak for we may cut the rating, and if so it would not be favorable for refinancing all that debt the next two years. So, again, no points for debt here.

David: Management’s strategic focus is to build a diverse portfolio based on energy mix, geographic considerations and regulatory regimes. The latter consideration is huge, particularly in Oceania. Is DUET exposed to crazy statists, the way utility companies in New Zealand are?

Roger: Again, I think the Telstra experience is enough reason for caution. But looking at this industry United Energy, DUET’s affiliate that distributes electricity to a 1,472 square kilometer network in Southeast Melbourne and the Mornington Peninsula, is, with Dampier-to-Bunbury pipeline, the company’s principal growth driver.

In October 2010 the Australia Energy Regulator granted 93 percent of the revenue requested as part of the Victorian Electricity Distribution Price Review. Although United has questioned minor aspects of the determination, there are no “clawbacks” in the AER decision. This suggests regulatory relations in Australia are much better than in New Zealand. Affiliates have also enjoyed favorable tariff increases in recent months. That’s really good news for the company. Better, those rate hikes have surely been noticed by banks and other institutions, and that’s who’s going to have to carry most of the water on the refinancing.

David: One regulatory event did cause me some agita. That’s this talk of halting installation of smart meters in Victoria. We saw that play out with one of our recommendations in Canada, the former Consumers’ Waterheater Income Fund–now EnerCare Inc (TSX: ECI, OTC: CSUWF) in Ontario–which won a reversal. This is nonsense, yes?

Roger: Yes; management noted in its conference call that there is no halt to installations. There is an ongoing review of time-of-use pricing. The smart-meter rollout actually contributed to 6 percent earnings growth; as of Dec. 31 approximately 89,000 were installed in a project that will eventually encompass more than 650,000 electricity meters, deploying a new communications network, installing new supporting IT systems and redesigning business processes to accommodate the new meters.

This is the kind of thing I like. Companies invest and the return flows right on to earnings. Moreover, smart meters make a utility’s system more efficient and therefore less expensive and more reliable.

David: I guess we ought to run over a few more of the numbers for our readers. These are for the six months from Jul. 1, 2010, to Dec. 31, 2010. A 7.6 percent increase in revenue, 6.7 percent growth in cash flow–both pro forma numbers–and an 11 percent drop in earnings per stapled security stand out, though those earnings as we said do provide nice dividend coverage.

Breaking it down by division, Multinet, the Victoria gas distribution company, posted a 3.2 percent boost in cash flow, thanks to weather and a nice 9.1 percent rate increase. DUET holds a 79.9 percent interest in Multinet. Western Australia Gas Networks holds four distribution system licenses in metropolitan Perth, Geraldton, Bunbury, Busselton and Kalgoorlie-Boulder. It provides liquefied petroleum gas to Albany. DUET holds a 25.9 percent interest.

DUET is selling a 29 percent in Duquesne, another gas distributor, to the Government of Singapore Investment Corp (GIC) for USD360 million, with which it plans to reduce debt. Disposal of Duquesne will make DUET’s an all-Australia portfolio.

Roger: These are all great numbers that I’m very comfortable with, provided DUET is able to manage its debt maturities in 2011 and 2012. But that brings me back to my second reservation about this pick. What about the division into three parts?

David: I was getting to that. DUET Group comprises Diversified Utility and Energy Trust No. 1 (DUET1), Diversified Utility and Energy Trust No. 2 (DUET2), Diversified Utility and Energy Trust No. 3 (DUET3) as well as DUET Investment Holdings Ltd (DIHL). DUET essentially “staples” all of these interests together into one security, DUET Group, on the Australian Securities Exchange.

The combined interest of DUET1 and DUET2 in the Dampier Bunbury Natural Gas Pipeline Trust, United Energy Distribution Holdings Ltd and Multinet Group Holdings Ltd is treated as a controlling interest for accounting purposes. DUET holds non-controlling interests in WA Network Holdings Pty Ltd and DQE Holdings LLC, the formal name for Duquesne.

Roger: Could you possibly have found something a little more complicated?

David: Hey, finding real 10 percent-plus yielders is tough these days.

Roger: Just yanking your chain. I find there are really only two types of companies yielding more than 10 percent these days. The first is made up of companies that are almost certainly paying above their means and are going to cut.

I think DUET falls well into the second: Companies that have hemmed themselves into a structure so complex that no matter how solid they are it keeps them undervalued. What makes me hopeful about this one is the experience of another Macquarie Group affiliate, Macquarie Power & Infrastructure (TSX: MPT, OTC: MCQPF) in Canada.

They, too, own energy assets and have been undervalued for a long time. But they’re really making up for lost time now. DUET, it seems to me, is going to have to do its refinancing, recapitalization or whatever you want to call it and become a simpler, more understandable structure. If they can do that–and three of the nine analysts covering it think they can–we’re going to have a huge winner here.

On the other hand, I think you pretty much laid out the worst-case at the outset here. That’s a return to the old low and, though management is adamant otherwise, some sort of dividend reduction. I note though that Macquarie P&I in Canada is very much dedicated to paying a high dividend. In fact, for all their alleged faults, that seems to be a common thread for all affiliates of the Macquarie Group.

David: I think you’re right. In fact, the outgoing CEO Peter Barry had this to say when DUET released earnings: “The proportionate earnings of the business outlines the free cash that the assets generate.” And his replacement David Bartholomew apparently shares that pro-dividend view–that these assets are to generate cash flow to pay dividends. And again don’t forget that this stock trades at just 1.13 times book value. That’s very cheap.

Roger: It is, provided they can refinance that debt at a cost that doesn’t undermine profitability. But again, what we’re providing in this service is high-return vehicles with big yields, which means everyone’s got to take on some risk.

I think the big one with DUET is complexity, and I urge all of our readers to make sure of what they’re getting into. For one thing, the website (www.duet.net.au) has a lot of information, including the webcast of the conference call. That’s a hallmark of anything related to Macquarie Group.

Meanwhile, we have a new pick every month for anyone who’s turned off by the structure; see Open Positions, below, for previous recommendations and current advice.

David: Thanks, Rog. And thanks for straightening out the complex structure and debt situation. That’s clearly an important the issue.

DUET Group’s (Australia: DUE, OTC: DUETF) stapled share– is a buy up to USD1.70 for those who understand the potential pitfalls and have risk capital to allocate.

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