This ASX share is a buy after it dodged a MASSIVE bullet: analyst

How does a failed business deal cause a stock to rise more than 17% in a month? Here’s how.

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In an odd turn of events, a particular ASX share has been upgraded from “hold” to “add” by one investment house because of a failed business deal.

Shares for energy infrastructure firm APA Group (ASX: APA) have not lit the world on fire of late. They closed Friday at $9.64, which is pretty much where they were at the trough of the COVID-19 crash in March 2020.

In an attempt to diversify its business, APA in September submitted a takeover bid for electricity company Ausnet Services Ltd (ASX: AST).

Eventually the Ausnet board went with another suitor, Brookfield Asset Management Inc (TSE: BAM.A), in a bitter blow for APA.

APA’s proposal reeked of desperation

But Morgans senior analyst Nathan Lead has no doubt APA’s takeover bid was terrible and investors were absolutely relieved the proposal was not accepted.

“We estimated APA needed to bridge a more than $3 billion gap in order for the acquisition to have zero value per share impact,” he wrote in a Morgans memo.

“This willingness to pay overs to diversify into electrification may signal that APA is concerned about the long-term prospects for its existing business.”

The market certainly agreed with Lead, pushing APA shares up more than 17% in less than a month since Ausnet killed the takeover offer.

Morgans analysis shows APA’s 2049 “terminal value” now assuming “mildly declining perpetuity cash flows”.

“Alternatively, APA’s penchant for M&A could see its cost-of-equity rise as it is viewed by the market as cum-capital raising.”

But now macroeconomic conditions could trigger revenue upgrades

So why is a loser who missed out on a business deal now so attractive to the Morgans team?

Inflation, pure and simple.

Lead explained that APA’s revenue changes are correlated to the consumer price index via “contracted price escalations”.

“The low inflation environment has reduced APA’s earnings growth in recent years,” he said.

“However, APA should benefit from a CPI surge in 2022. Circa 32% of EBITDA is sourced from the Wallumbilla-Gladstone Pipeline, whose US$ revenues escalate annually on 1 January based on November CPI in the USA.”

The November CPI figure is expected to be reasonably high, following October’s year-on-year 6.2% increase.

“Furthermore, we understand domestic CPI for the December quarter drives annual escalation of a mass of AU$ contract revenues in 2022 (and the September quarter CPI was a solid 3%),” Lead said.

“Long-term we assume Australian and USA CPI averages 2.4% and 3% per annum through to 2030 respectively, as per market implied expectations in yield curves.”

The Morgans team is therefore upgrading APA shares from “hold” to “add”.

“At current prices, we estimate a 12-month and 5-year potential return of circa 11% and 7.6% per annum, respectively.”

Should you invest $1,000 in APA Group right now?

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*Returns as of January 13th 2022

Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended APA Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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