The document summarizes an investment thesis for Spark Infrastructure Group. The key points missed by the market were: 1) the potential impact of a tax dispute was overplayed and limited, 2) regulatory growth would drive significant cash flow growth, and 3) detailed modeling showed underappreciated free cash flow potential. The thesis identified catalysts like earnings releases and potential tax resolution. Extensive research and modeling was conducted to support the thesis and mitigate cognitive biases.

1. Market perception of the stock
 An unresolved tax dispute dominated the market debate for SKI in late 2013. The dispute related primarily to the capital structure of the asset companies where interest tax deductibility on shareholder loans was being challenged by the tax office
 Notwithstanding the dispute, consensus was positive on the stock, underpinned by the high cash covered dividend yield and growth profile. Investors were reportedly staying on the sideline however
 SKI was priced on ~7.2x EV/EBITDA (cons) and a 7.2% dividend yield that relative to 'quality & yield' defensive peers offered attractive prima facie value
Where the market was wrong
1. The materiality of the tax issue was significantly overplayed in the market: Detailed modelling a reasonable ‘worst case’ outcome indicated a 9 cps (5% of market price) impact. This appeared to be more than discounted in the price after deduction from valuation
2. Regulatory growth trajectory underappreciated: Regulatory tariff increases of ~9% p.a. over the next 2.5 years would drive EBITDA growth of 11% p.a. High quality growth where defensive peers were more limited
3. Latent value from significant cash-flow generation: A proportionate operating cash-flow multiple of just ~5x underscored an improving FCF yield of 10%+ as capex peaked in FY14. The improving FCF profile provided positive dividend surprise potential that consensus was missing entirely
4. Market valuation approaches missing the material FCF growth profile: EV/EBITDA multiples failed to appreciate the confluence of strong OCF growth over the medium-term coupled with peaking capital intensity that was better captured by detailed DCF analysis. Given FCF at the asset co’s was swept for distributions, this method was credible
Long idea: Spark Infrastructure Group (SKI.ASX)
Significant latent cash flow profile underappreciated by the market
Fundamental idea case study
Mark Cox, CFA
Spark Infrastructure (SKI.ASX) is a mid-cap infrastructure vehicle that retained 49% interests in two regulated electricity distribution assets: SA Power Networks and Victoria Power Networks. Distributors are the ‘poles and wires’ piece of the supply chain converting high voltage transmission into lower voltage current for residential, commercial and industrial end users. Critical factors for the stock are: regulatory developments, volumes, regulated tariffs, funding and capital expenditure.
Pulling it all together
Forecast - strong cash-flow outlook: A modelled proportionate cash-flow multiple ~5x over the medium-term driven by regulatory mandated growth provided a significant and underappreciated ‘cash-cow’ profile particularly with capital intensity peaking
Valuation – Asset level DCF analysis provided a more granular appreciation of free-cash flow to investors than market EV/EBITDA multiple approaches: Undervalued with 21% upside on conservative DCF methodology and 22% on EV/EBITDA basis vs. comparables
Sentiment - tax issue overhang dominated market the debate but materiality limited: Estimate of reasonable worst-case 9cps impact more than priced in - excessive margin of safety
Catalyst - full year earnings to highlight significant cash-flow growth: Market underplaying generous regulatory growth trajectory and upside to distributions
Outcome
From the average entry price SKI produced a total return of 30%, exceeding the ASX200 total return by 22%. SKI also outperformed the funding stock (WES) by 24%
Spark Infrastructure Group

2. 1. What was the idea’s ‘edge’? What was new or unique the market was missing?
 Asset co tax disputes were significantly overplayed - impact likely limited to 9cps in a reasonable bear case (subsequently development was in line with forecasts) > market myopic on improbable tax ‘bear’ case
 A comprehensive forecast revealed the market was missing the upside potential for distributions: SKI had significant latent capacity to increase yield > beat on DPS guidance probable given yield mandate
 Consensus typically applied simplistic ‘sum of the parts’ approaches to valuing the stock using nebulous EV/EBITDA multiples > more detailed modelling of the asset companies provided a more granular and cash-flow centric approach
2. Identifiable future catalysts to move the market towards the investment thesis:
 Growing cash pile – In FY14 SKI would need to explain to investors what it is doing with a payout ratio below 80% (note acquisition risk), or, increase DPS (it subsequently invested a portion in another listed vehicle). A DPS increase above guidance should drive a rerating
 Potential conclusion of the tax issue during FY14 removing disproportionate sentiment overhang
3. Research backed by sound analysis – mitigate heuristic and cognitive error probability:
 Consulted with two external experts on key industry debates – A discussion with the AER Chairman particularly insightful given regulatory risks factors at the time (Better Regulation review)
 Met with management multiple times yielding significant insights on ownership, motivations and risk profile
 Work shopped idea with sell-side panel and internal peers (PM, investment committee expert, CIO) for reasonableness of assumptions
 Conducted discovery and decomposition on 20+ major documents from co, regulator, industry submissions, and peer stocks
 Built highly detailed models on both asset co's and hold-co to support financial forecasts. Considered ~72 input factors when building forecasting framework
 Wrote a detailed initiation report with accompanying pitch book exploring investment thesis, critical factor forecasts, tail scenarios, valuation and risk factors
4. Expose and consider risk factors. Acknowledge an idea conviction level:
 Explicitly considered and commented on where the thesis could be wrong on each key critical investment issue
 Considered scenarios (tail risk scenario model) to understand dispersion of potential outcomes. SWOT analysis of investment thesis. Listed key downside risk factors
Long idea: Spark Infrastructure Group (SKI.ASX)
Internal testing: Quality of investment thesis
Fundamental idea case study
Mark Cox, CFA