Spark Infrastructure reported a solid first-half 2013, with earnings before interest, tax, depreciation and amortisation, or EBITDA, increasing 11% to AUD 340 million on a proportional basis. Growth was driven by substantial tariff increases to recover increased investment, partly offset by lower volumes. Regulated asset base (RAB) grew 9% in the past year and will continue growing robustly in coming years as investment continues.

Spark is tracking slightly ahead of our expectations, leading to modest upgrades to our forecasts and our fair value estimate, which increases from AUD 1.60 to AUD 1.70 per security. We believe Spark looks roughly fairly valued at present, and is better value than some regulated peers, such as Envestra (ASX:ENV) and DUET (ASX:DUE). We continue to believe the firm has no moat as returns are reset to costs of capital every five years, and the negative regulatory environment presents substantial risks to returns at upcoming resets in 2015 and 2016.

Much uncertainty remains around the audit by the Australian Tax Office. While Sydney Airport got away relatively unscathed, Spark might not be so lucky. The main tax issue is the deductibility of interest payments on the shareholder loan notes in the Victorian assets. Amendments for the 2007 tax year totalled AUD 296 million, which were covered with a small cash payment and carried forward losses. Similarly adverse amendments are expected from 2008 to now. Total tax adjustments could wipe out tax losses, require substantial cash payments for past years and bring forward future cash tax payments.

While the market focuses on tax issues, our main concern remains the adverse regulatory environment. Harsh new settings will impact following the next regulatory resets in 2015/2016. The regulator is cutting the cost of equity allowance and looking at other ways of reducing returns in an effort to limit quickly rising household energy bills. Utility bills are rising on higher energy fuel costs, government policies promoting green energy and substantial investment to modernise networks.

The South Australia network was softest in first-half 2013, with EBITDA increasing just 2% to AUD 357.5 million as sagging residential electricity volumes offset solid tariff increases. We expect performance to improve in the second half following a 10% tariff increase in July 2013. The Victorian networks EBITDA increased 21% to AUD 345.3 million, driven by large tariff increases and a jump in unregulated revenue from increased network services for third parties. Volumes are also soft in Victoria.

Analysts view increasing use of solar panels, increased energy efficiency of appliances and high electricity tariffs as long term headwinds to electricity volumes. Theoretically, this shouldn’t impact earnings as the regulator increases tariffs to compensate for weak volumes to ensure the networks earn a fair return. However, with tariffs reset only every five years, there is scope for errors.

Volumes are currently tracking below the regulator’s forecasts, suggesting Spark is earnings less than it should be, all else being equal. Spark’s financial position is reasonably good. While net debt/regulated asset base is high at 80% on a look-through basis, Spark can carry more debt than some peers due to substantial unregulated revenues. Further, leverage is falling over time due to retained earnings. Net debt/RAB should ease lower to 75% by 2015. Financial leverage measured as net debt/EBITDA is forecast to be 5.4 times in 2013, in line with peers. Spark has only minor debt at the corporate level, which we view as prudent.