Should you have APA Group in your portfolio?

APA Group (ASX: APA) is the largest gas pipeline owner and operator by market capitalisation at $4.9 billion, and transports more than 50% of all natural gas used in Australia. It is a major shareholder in other pipeline related companies, and is seeking further exposure to the LNG pipelines in Queensland involved in the separate BG Group and Origin Energy (ASX: ORG) LNG gas development projects.

In July it approached Envestra (ASX: ENV), the $1.9 billion pipeline company, with a merger proposal that offered a scrip exchange valuing Envestra at $1.10 a share at the time of the announcement.

Its gross gearing is at 172%, but because the investment costs of building or buying pipelines are very large, its debt is abnormally big compared to a regular company. With scale, though, the monopolistic-like nature of owning a gas pipeline has long-term cash flows that can maintain the company as well as pay down the debt steadily.

Once the pipeline is set up, then apart from regular maintenance, capital expenditure is lower, allowing more gross profit to go towards debt payment. Its earnings before interest, tax, depreciation and amortisation (EBITDA) margin is 54.4%, giving it that earnings buffer. Net profit margin is 14.8% by the time everything is paid for.

Recently, the company’s share price hit a high of $6.97 in May, but has come back down to $5.89 for a price-earnings (PE) ratio of 25.45.  Its earnings per share (EPS) growth has been around a five-year average of 5%, which doesn’t immediately match the current PE, but this is because of the share issues it has every year, cutting the per share ratio down accordingly. The market is pricing in the expansion of its networks if the merger goes through and for the QLD pipeline potential.

Envestra itself has extensive gas distribution networks that service major population centres in QLD, Victoria and South Australia, and has exposure to the New South Wales and Northern Territory markets. The company is a regulated monopoly in those areas, and it gets its income from the gas retailers that use its pipeline for the product delivery. Thus, its ability to charge for service is set by regulators, but it can periodically apply for a cost increase to keep with inflation and assure a decent profit to maintain its business.

APA holds a 33% share ownership in the company, and just this month the ACCC announced that it will not oppose the merger if the two companies can reach an agreement. Envestra’s share price sits at about $1.10, the per share value of the proposed merger.

Envestra’s EBITDA is an even higher 71%, and net profit margin ends up at 21%. It raised its net profit 45.8% from $73. 9 million to $107.8 million in 2013. Its gross gearing sits at 240%, so it has heavy interest expenses to pay off. It has been conducting share issues since 2007 to keep equity flowing in and offset investments.

Foolish takeaway

Should APA be successful with the merger, it will be a $6.7 billion company with control over the majority of networks covering central and eastern Australia, and with the LNG gas development in SA and QLD going full steam ahead, they will be carriers for all that extra gas planned to be sold overseas.

Investors can look towards steady income through dividends and the combined company would have a protective “moat” around its business, ensuring future earnings and growth.

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned. 

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