Ask the analyst: Why have markets shunned APA Group?
Australia's premier gas infrastructure firm used to be a market darling, but its shares have taken a severe de-rating in recent years.
Mentioned: APA Group (APA)
Ask the analyst is your chance to ask questions about the ASX companies and industries that our analysts cover. Please email your question to [email protected] and I will submit it to the analyst responsible. It may appear in a future edition of this series.
Today’s question
Today’s question comes from Jamie, a self-directed investor and Morningstar reader based in Queensland. Jamie wanted some insight on why APA Group (ASX: APA) has performed so poorly since 2022 and what might affect the company’s business going forward.
I put this question – and a few of my own – to Adrian Atkins, Morningstar’s APA Group analyst. We’ll hear from Adrian in a moment. But first, some context on APA and how it makes money.
How does APA Group make money?
APA owns a swathe of power generation, electricity transmission and gas infrastructure assets across Australia. These images from the company’s latest annual report from August 2024 makes the extent of this footprint clear.
APA has invested heavily in its power generation business in recent years, especially in the renewable power space. Yet natural gas pipelines, storage and distribution still speak for vast majority of underlying profits.
Figure 2: Underlying profit by asset type. Source: Author calculations, APA filings.
Net profits and P/E not overly useful
Something you have probably already picked up by now is that APA is an incredibly asset heavy business. This is reflected by the value of plant, property and equipment on APA’s balance sheet - some $12.5 billion as of their fiscal 2024 numbers - and huge annual depreciation charges.
Depreciation is a non-cash line in the accounts that spreads the cost of past investments in hard assets over the useful life of those assets. For APA, this charge was $687 million in fiscal 2024. Plus another $232 million in amortisation charges from past acquisitions and investments in intangibles.
These amounts are taken out of APA’s operating profits before it reports net profits. As you can imagine, this doesn’t leave much left over for reported profit. Small changes in revenue can lead to big swings in reported net profit figures.
Figure 3: APA Group net profit versus EBITDA. Source: Morningstar and Pitchbook data.
It is vital to remember, however, that depreciation and amortisation charges don’t actually represent a cash outflow. To understand how profitable an asset heavy infrastructure business like APA is, you are better focusing on other metrics like free cash flow per security.
This means that using a P/E ratio (which uses net profits as the denominator) to gauge APA’s valuation doesn’t make much sense either. Something like Enterprise Value to Earnings Before Interest, Tax, Depreciation and Amortisation might be more useful.
EV brings net debt into the equation to show how much, based on today’s stock price, it would cost to buy the whole company and all of its obligations. Meanwhile, EBITDA removes those hefty non-cash charges to the income statement that we mentioned earlier.
When you look at APA’s valuation through this lens, the stock market is clearly assigning a far lower multiple to APA than it has for several years. The chart below shows APA's EV to EBITDA multiple on January 9 for the past several years.
Figure 4: APA Group EV/EBITDA multiple over time. Source: Pitchbook
Why have APA shares fallen?
Our analyst Adrian Atkins thinks that several years of tepid growth in free cash flow per share is the main reason for this. He puts this down to higher interest costs on APA’s large debt load, higher costs amid the push into power generation and the dilutive acquisition of Alinta Pilbara.
Atkins thinks the market may be concerned that APA will take on more higher cost debt in order to fund further acquisitions and developments. This is a concern he shares in part, with his Capital Allocation rating of Poor for the company mentioning both APA’s debt load and “aggressive” growth of its renewable energy footprint. However, Atkins still sees plenty to like about APA’s competitively-advantaged gas infrastructure assets.
APA should have plenty of organic growth opportunities in its gas transmission network, which typically generate good risk-adjusted returns. . Meanwhile, Atkins thinks the up-front cost of replicating APA’s assets would stop rational upstarts from entering the market.
An unappreciated win?
Most of APA’s contracts in its key pipelines segment are unregulated. Pipeline capacity is sold on long term “take or pay” contracts that net APA a return one or two percentage points higher than regulated contracts to compensate for demand risk once the contracts end.
A lingering concern has been the potential for these pipelines to face more regulation and therefore earn the company lower returns. In a potential boon for APA shareholders, Atkins says, there are signs that this risk may have eased.
Atkins sees the recent draft decision not to regulate APA’s South West Queensland Pipeline as a case in point. Amid threats of regulation and likely lower returns, APA stopped capacity expansion on the route into Victoria. As this could possibly see winter gas shortages in the future, the regulator has seemingly backed down.
This decision looks important in a couple of ways. For one, the SWQP is a key asset having contributed almost 15% of APA’s underlying profits in recent years. More broadly, this could show that regulators are wary of deterring APA from making much-needed investments in Australia’s energy infrastructure.
Debt load may increase risk
Although the risk of gas market reform and greater regulation haven’t completely disappeared, Atkins does not think these pose the biggest downside risk to APA shareholders.
Instead, he sees this coming from the company’s heavy debt load. If bond yields and interest costs were to increase and worsen APA’s credit metrics, Atkins says an equity raise – which would dilute existing shareholders and weigh on cash flow per security – isn’t completely out of the question.
Atkins would ideally prefer to see more conservative leverage used at the company and a toning down of its acquisition and development drive.
Shares screen as undervalued
At a current price of around $6.90 per security, APA trades almost 25% below Atkins’ Fair Value estimate of $9.30. Based on Atkins’ forecasts for 2025, the shares also offer a prospective gross yield approaching 8%.
This is underpinned by Atkins’ forecast that APA can deliver roughly 6% per year growth in underlying profits thanks to the Alinta Energy Pilbara acquisition and the firm’s expansion projects.
Operating cash flow per security, a key determinant of dividends that can be expected from APA, looks likely to be held back by higher interest and tax costs. Yet Atkins expects APA to eventually grow this at a low to mid-single digit annual clip.
Looking out a bit further, APA’s biggest single contributor to underlying profits – the Wallumbilla Gladstone Pipeline – can be expected to deliver far less (if any) profit from 2035 onwards. APA’s 20-year contract to receive payments will have finished and the pipeline (which APA will still own) may or may not continue to be used by the customer.
APA will want to make up for that shortfall, likely explaining its active acquisition and development activity in recent years.
APA Group (APA)
- Moat: Narrow
- Fair Value estimate: $9.30 per security
- Price on January 9: $6.88
- Morningstar rating: 4 stars
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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.
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