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Equity Bottom-Up

Narrow moat-rated APA Group's share price has recovered strongly, providing investors with another good opportunity to reduce exposure. While still a good-quality company with astute management, its best days are likely behind it. At the current price of AUD 9.83, APA Group screens as expensive, trading 16% above our unchanged AUD 8.50 per share fair value estimate and offering a 4.5% mostly unfranked distribution yield. The stock is up more than 30% since November 2016 when we had a positive recommendation on it.As previously flagged, APA Group will buy the Orbost gas processing plant from Cooper Energy for AUD 20 million and upgrade it for AUD 250 million. The processing plant is located on Victoria's east coast and will process gas from Cooper Energy's offshore Sole gas field, and potentially its Manta gas field down the track. APA will also be able to process gas for other gas producers. We like acquisitions and developments like this, as they tie in to APA's core gas transmission network and drive cost efficiencies and additional revenue opportunities. These synergies mean the assets are worth more to APA than others, explaining why it can outbid other investors and still expect good returns.We believe these value-accretive acquisitions and developments are what has made APA a great investment over the past two decades. Unfortunately, fewer opportunities now remain to add meaningfully to the gas network given its large size and competition concerns. Other opportunities for growth remain, including investment in wind and solar farms, but these are much less attractive in our opinion as they lack the synergies of gas network additions. Our conclusion is that while APA will continue to invest large sums each year, the quality and value created from these investments will not be as good as in prior years.Major headwinds are also likely from reform of the gas industry, which is likely to force APA's returns down on new contracts. Reform will force greater transparency on pricing from APA, and give customers easier access to binding arbitration if they aren't happy. APA was relieved full regulatory oversight was ruled out, but, depending on how much transparency is forced on it, the impact on returns could be similar. This too suggests the future won't be as rosy for APA as the past, though long-term contracts ensure the impact will be minimal in the near term.The third major headwind for APA is that interest rates are likely to rise in coming years. This would hurt earnings and make its dividend yield less attractive compared with rising yields on bonds. If rates rise, the most impacted will be companies with high financial leverage, such as APA. APA has around AUD 10 billion in debt, and interest expense is by far its largest cash cost at over AUD 500 million per year. A 1% increase in the firm's average borrowing costs would increase interest expense and reduce free cash flows by AUD 100 million. Fortunately, the firm has substantial interest rate hedging in place, limiting the increase in interest expense to AUD 12 million (pro forma fiscal 2016). But as hedges mature over time, APA would face the full impact of rising rates. Regardless, we expect APA's average interest rate to fall further in the near term as expensive debt locked in during the global financial crisis matures.If credit markets become skittish in the years ahead, APA may find it harder to secure financing given it runs high financial leverage. Fiscal 2017 forecast net debt/EBITDA of over 6.5 times is aggressive in our opinion. We gain comfort from APA having had similar financial leverage going into the global financial crisis, and it survived without a dilutive equity raise. However, with risks to earnings from gas industry reform, the firm may not perform as well next time.Adding all this up, we think APA's expensive share price is at odds with its more subdued outlook as investors remain focused on the rearview mirror.Analyst: Adrian Atkins

Narrow moat-rated APA Group's share price has recovered strongly, providing investors with another good opportunity to reduce exposure. While still a good-quality company with astute management, its best days are likely behind it. At the current price of AUD 9.83, APA Group screens as expensive, trading 16% above our unchanged AUD 8.50 per share fair value estimate and offering a 4.5% mostly unfranked distribution yield. The stock is up more than 30% since November 2016 when we had a positive recommendation on it.As previously flagged, APA Group will buy the Orbost gas processing plant from Cooper Energy for AUD 20 million and upgrade it for AUD 250 million. The processing plant is located on Victoria's east coast and will process gas from Cooper Energy's offshore Sole gas field, and potentially its Manta gas field down the track. APA will also be able to process gas for other gas producers. We like acquisitions and developments like this, as they tie in to APA's core gas transmission network and drive cost efficiencies and additional revenue opportunities. These synergies mean the assets are worth more to APA than others, explaining why it can outbid other investors and still expect good returns.We believe these value-accretive acquisitions and developments are what has made APA a great investment over the past two decades. Unfortunately, fewer opportunities now remain to add meaningfully to the gas network given its large size and competition concerns. Other opportunities for growth remain, including investment in wind and solar farms, but these are much less attractive in our opinion as they lack the synergies of gas network additions. Our conclusion is that while APA will continue to invest large sums each year, the quality and value created from these investments will not be as good as in prior years.Major headwinds are also likely from reform of the gas industry, which is likely to force APA's returns down on new contracts. Reform will force greater transparency on pricing from APA, and give customers easier access to binding arbitration if they aren't happy. APA was relieved full regulatory oversight was ruled out, but, depending on how much transparency is forced on it, the impact on returns could be similar. This too suggests the future won't be as rosy for APA as the past, though long-term contracts ensure the impact will be minimal in the near term.The third major headwind for APA is that interest rates are likely to rise in coming years. This would hurt earnings and make its dividend yield less attractive compared with rising yields on bonds. If rates rise, the most impacted will be companies with high financial leverage, such as APA. APA has around AUD 10 billion in debt, and interest expense is by far its largest cash cost at over AUD 500 million per year. A 1% increase in the firm's average borrowing costs would increase interest expense and reduce free cash flows by AUD 100 million. Fortunately, the firm has substantial interest rate hedging in place, limiting the increase in interest expense to AUD 12 million (pro forma fiscal 2016). But as hedges mature over time, APA would face the full impact of rising rates. Regardless, we expect APA's average interest rate to fall further in the near term as expensive debt locked in during the global financial crisis matures.If credit markets become skittish in the years ahead, APA may find it harder to secure financing given it runs high financial leverage. Fiscal 2017 forecast net debt/EBITDA of over 6.5 times is aggressive in our opinion. We gain comfort from APA having had similar financial leverage going into the global financial crisis, and it survived without a dilutive equity raise. However, with risks to earnings from gas industry reform, the firm may not perform as well next time.Adding all this up, we think APA's expensive share price is at odds with its more subdued outlook as investors remain focused on the rearview mirror.Analyst: Adrian Atkins

APAグループは最近の株価上昇により割高に見える