Australian utilities are unlikely to be materially affected by US tariffs. The Reserve Bank of Australia modelling suggests US tariffs have the potential to wipe 1% from the level of Australian gross domestic product over the next few years, but the actual damage will depend on monetary and fiscal stimulus both domestically and in major trading partners.

Why it matters: We expect Australian and New Zealand economies to slow marginally, but electricity demand and prices are unlikely to be materially affected. At this stage, electricity futures prices remain rock solid in Australia and New Zealand.

  • We maintain our earnings forecasts for Australian and New Zealand utilities. While Origin and Genesis are hurt by lower oil prices, the impact on earnings forecasts and valuation is largely offset by weaker currencies and cheaper coal purchases. Oil price hedging also helps in the near term.
  • Australian gas demand is also unlikely to be hurt by US tariffs and our forecasts for APA Group are unchanged. APA’s gas pipelines and other assets typically operate on long-term Consumer Price Index-linked contracts, with limited exposure to commodity prices.

The bottom line: We leave our fair value estimates unchanged for all ANZ utilities. Narrow-moat-rated APA Group and Manawa Energy are undervalued. No-moat-rated AGL Energy and Origin Energy, and narrow-moat-rated Mercury NZ, Meridian Energy, Contact Energy, and Genesis Energy are fairly valued.

  • Despite a strong showing since the release of its interim results in February, APA securities trade at a 15% discount to fair value. Its defensive earnings and big yield of over 7% are attractive.
  • Manawa is a small New Zealand hydroelectric power producer. There is significant upside if Contact’s takeover offer for Manawa gains regulatory approval or, failing that, over the medium term as contracted electricity prices rise toward futures prices. Shares trade 24% below fair value.

Our top ASX pick: APA group (ASX: APA)

APA Group is Australia’s premier gas infrastructure company. Limited regulation, scale, and a superior skills base help it capitalize on gas demand growth and generate competitive advantages that warrant a narrow economic moat. However, gas market reform and potential regulation of pipelines could weaken its competitive advantages. Fair value uncertainty is medium, as secure revenue is balanced by high gearing and limited transparency over customer contracts.

APA Group is Australia’s premier gas infrastructure company. Gas transmission and distribution is the core business, generating more than 80% of group EBITDA. Power generation—wind farms, solar farms and gas power stations—contribute about 11% and electricity transmission, asset management and investments contribute the balance. The investments division owns stakes in small energy infrastructure companies and the asset management division provides management, operating, and maintenance services to third parties and part-owned companies, leveraging APA’s skills base.

APA’s long-distance gas transmission pipelines and power generation assets typically operate under long-term, CPI-linked contracts with energy retailers, LNG exporters, and major industrial/mining companies. Returns are traditionally 100 to 200 basis points above regulatory returns to compensate for higher demand risk. Electricity transmission and gas distribution networks are regulated, with returns set by the Australian Energy Regulator to provide fair profits after covering reasonable costs.

APA Group’s core strategy during the past decade has been to create an integrated east-coast gas transmission grid connecting multiple gas sources to multiple markets. This is now complete following numerous acquisitions and the firm is progressing a similar strategy in Western Australia, connecting to remote mine sites and towns. Expansion creates economies of scale and synergies from linking pipes together into a network with one manager. Further acquisitions of transmission pipelines are unlikely given competition concerns, but organic expansion is ongoing.

APA Group’s narrow economic moat stems from its unparalleled gas pipeline network, which benefits from efficient scale.

Domestic gas markets are served by a handful of pipeline firms, with APA by far the largest. New entrants are deterred by high capital costs and inelastic demand, which would ensure poor returns from entering the market and competing with incumbent operators. Incremental demand growth can be met most cost-effectively by upgrading existing pipelines with, for example, higher compression. A wide moat is precluded, as we lack sufficient confidence that slim excess returns can be maintained over the long term, given regulatory threats, the softening outlook for domestic gas use, and the powerful and concentrated customer base.

APA Group’s main attraction is a portfolio of unregulated gas infrastructure assets, which contributes the vast majority of revenue. Unregulated assets are unprotected from risks such as falling demand, but long-term contracts, a diversified portfolio, and a reasonable outlook for gas demand provide comfort. Contracts average nearly 10 years in length and are mostly take-or-pay. The firm’s core strategy during the past decade has been to create an integrated east-coast gas transmission grid connecting multiple gas sources to multiple markets. Expansion creates economies of scale and synergies from linking pipes together into a network with one manager. This approach improves flexibility, simplifies transport, increases the range of services available to customers, and greatly improves security of supply in the event of disruptions to gas sources. Economies of scale help create cost synergies, while an ability to offer a wider range of services leads to additional revenue, underpinning superior returns.

Returns are usually attractive for organic expansion that increases use of existing assets. Commonly, the best returns come from adding compressors to a pipeline to boost throughput and storage capacity in a cost-effective manner. However, these strong returns are most at risk from gas market rule changes and potential regulation. Rules introduced in 2018 force gas pipeline owners to disclose a high level of financial information on each pipeline and service to help customers determine fair prices. This is backed up by giving customers the ability to demand binding arbitration if negotiations fail. These rule changes haven’t had much impact on gas transmission pricing because of subjective variables in negotiating tariffs, so the government is considering full regulation whereby tariffs for individual pipelines will be determined by the Australian Energy Regulator. We don’t expect much impact in the medium term given the time required to investigate which pipelines should be regulated before providing a regulatory determination. Additionally, regulated returns, which are linked to government bond yields, have risen sharply in recent years. Over the longer term though, APA’s ability to extract excess returns will likely diminish.

APA Group’s regulated assets, including gas distribution pipelines and electricity transmission lines, contribute less than 10% of revenue. These assets lack moats because of the regulatory cap on returns. Nonetheless, they are decent assets that should earn returns broadly in line with their cost of capital. Regulated revenue is determined under a building-block approach, with returns and cost allowances set by the regulator. We consider the regulatory process to be broadly fair and transparent, balancing sufficient returns for investors against acceptable utility costs for consumers. High and rising energy utility bills will keep the regulator focused on minimizing returns. Regulatory resets generally occur every five years and are evenly spread for APA Group’s major regulated assets with, on average, one reset per year.

The firm’s asset management division, which provides management, operating, and maintenance services to part-owned subsidiaries and other infrastructure owners, leverages the firm’s skills base to generate solid returns, unaffected by regulatory rule changes.

Electricity generation is a small but fast-growing part of the business. APA provides electricity from wind and solar farms with backup from batteries and gas-fired power stations to remote locations, such as mines in Western Australia and Queensland. We see a long runway of growth as miners decarbonize operations over coming decades. While returns are superior to those from some other APA assets, they are limited by powerful customers capable of building in-house generation. We think higher returns are commensurate with the additional risk that comes from servicing remote locations, albeit relatively long-term CPI-linked contracts help.

APA Group’s ESG risk is too small to affect its moat rating.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.