UPDatE

2012 InfratIl SEPtEMBEr GrOWtH InfraStrUCtUrE rEQUIrES CaPItal anD rEWarDS CaPItal PaGE 2 BUYInG GOOD BUSInESSES at faIr ValUE PaGE 4 InfratIlS tarGEt rEtUrn tO SHarEHOlDErS PaGE 8

Investment, earnings growth, shareholder returns

Over the last decade the Infratil group invested $3,060 million and its consolidated annual EBItDaf* (earnings before interest, tax, depreciation and value adjustments) rose from $35 million to $520 million. Over the same period Infratils compound aftertax return to shareholders was 13.7% per annum (since listing returns have been 16.7% per annum). Over 23,000 people own Infratil shares, presumably in expectation of earnings and value growth taking into account the risks associated with both Infratil and the financial market in general. Its likely that shareholders goals are medium-long term as by far the majority hold their shares for over five years. This Update addresses one key element of how Infratil goes about delivering to those earnings and value expectations; by investing. Investment is both a core part of how Infratil creates value and a distinctive feature of its activities (or from the other perspective, Infratil would look very different today had it ceased investing a few years ago). In the five years to 31 March 2012 consolidated investment was $1,592 million, over the last 10 years it was $3,060 million. The spend was in several sectors with approximately one third involving Infratil buying new holdings such as the 50% shareholding in Z Energy and two thirds applied by companies Infratil has invested in growing their own businesses. The upshot of this investment is earnings growth and good returns for Infratils shareholders. Infratils businesses continue to grow and Infratil continues to invest.

*EBITDAF is a useful non-GAAP financial measure as it shows the contribution to earnings prior to non-cash items such as depreciation and amortisation, fair value adjustments and the cost of financing and taxation. A reconciliation of Infratils EBITDAF to Net Surplus can be found on page 45 of the Infratils 2012 Annual Report.

InfratIl SEPTEMBER UPDATE 2012

Growth infrastructure requires capital and rewards capital

Someone who invested $1,000 when Infratil listed in March 1994 and who then purchased more shares with all dividends and the proceeds of all rights issued (ie. who following the initial investment neither put more money in nor took money out) would now have a shareholding with a market value of $17,460.
Infratil has achieved compound after tax return over eighteen and a half years of 16.7% per annum. Actual returns of individual shareholders will depend on when shares were purchased, whether dividends were taken as cash or shares, and whether the warrants and rights Infratil has issued were taken up or sold. For instance, someone who invested on 1 April 2007 immediately prior to the Global Financial Crisis would have had a subsequent return of almost exactly 0% per annum. Someone who purchased Infratil shares 2 years later would have earned 16.4% per annum. Historic returns are mainly interesting for what they say about future prospects. What were the ingredients of Infratils past success and will they bake the same cake over the next few years? ...The right method in investment is to put fairly large sums into enterprises which one knows something about and in management of which one thoroughly believes; John Maynard Keynes explanation of his investment approach, and it (with some additional features) also describes Infratils model. Keynes is worth quoting as he was an enormously successful and innovative investment manager of the Kings College Cambridge endowment fund. A detailed report on Keynes as an investment manager was released earlier this year and is summarised later in this Update. Infratils main businesses; Wellington Airport, TrustPower, Infratil Energy Australia, Z Energy, NZ Bus; are distinct and largely unconnected, but a common feature is capital intensive growth; that is growth which requires money; to finance terminal expansion, power stations, working capital and customer management systems, service stations, port facilities, fleet, and so on. The relationship between demand growth, investment and earnings growth is illustrated by Wellington Airport. Infratils 66% stake cost $96 million in 1998 at a time when the Airport catered to 3.5 million passengers and annual EBITDAF was $15 million. Over the subsequent 14 years the business has been expanded to accommodate 5.2 million passengers with over $300 million absorbed to finance runway extension, new terminals, land transport facilities, etc. Last year EBITDAF was $76 million. An attraction of this type of growth and investment is that it provides compound returns (as opposed to one-off gains) and it has optionality. More money will be put to work if the investments returns appear attractive, or allocated elsewhere if not. Additional capital will be available to Wellington Airport (and Infratils other businesses) so long as the prospective returns are suitable. If the Airport cant identify such opportunities then the funds can be allocated elsewhere. Effectively each of Infratils businesses is obliged to compete for capital which should mean only the better plans are progressed. Discipline is imposed on the management of Infratils subsidiaries and associates, and a range of investment options will be available to enable comparison of risk and return characteristics While the majority of Infratils allocation of growth capital has been (and is likely to continue to be) to internal projects, some is to the acquisition of new shareholdings. The most material recent example was the 2010 purchase of 50% of Z Energy. Infratils management are continually reviewing external opportunities, but despite several potential transactions since the Z Energy acquisition none has progressed. Good deals are hard to do but are worth looking and waiting for.

InfratIlS EBItDaf & nEt OPEratInG CaSH flOW (aftEr IntErESt anD tax)
$ Million

600

500

400

300

200

100

1995

1996

1997

1998

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Earnings before interest, tax, depreciation and values changes

2011

2012

Net Operating Cashow

Note: A reconciliation of Infratils EBITDAF to Net Surplus can be found on page 45 of the Infratils 2012 Annual Report.

InfratIl InVEStMEnt (BUSInESS aCQUISItIOn & IntErnal CaPItal SPEnDInG)

$ Million

900 800 700 600 500 400 300 200 100 0

1995

1996

1997

1998

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Business Acquisition

2011

2012

Internal Capital Spending

InfratIl SEPTEMBER UPDATE 2012

Buying good businesses at fair value, then supporting disciplined internal growth
Over the last decade Infratil has allocated $3,060 million either to business acquisitions or internal capital spending. The increase in earnings and shareholder value over that period indicates that average returns on this capital has been good, however the average includes positives and negatives. Four brief case studies are outlined below.
InfratIl InVEStMEnt (BY COMPanY)
$ Million

Infratil airports Europe; right ingredients wrong outcome In the 1990s Australia and New Zealand were amongst the first countries to sell state-owned airports and to allow their commercial operation. The resulting value uplift encouraged Australasian investors to look at markets where similar developments were occurring, which led to Europe. Infratil invested in Prestwick, Kent and Lbeck airports and purchased an option over

900 800 700 600 500 400 300 200 100 0

1996

1998

2000

2002

2004

2006

2008

2010

2012

an airport near Berlin. These airports were acquired at well below replacement cost as rapid growth in European air travel made it likely that their capacity would soon become needed and valuable. Kent for instance cost less than 20 million and the next London runway will cost over 2 billion (Mayor Boris Johnsons preferred site in the Thames Estuary is likely to cost over 20 billion). Notwithstanding this enormous potential, Infratil has now called it quits. European air traffic growth has slowed so that the need for additional airfield capacity is postponed, and Infratils assessment of the relative benefits of waiting (and continuing to meet operating cost) versus refocussing elsewhere have favoured exit.

Other TrustPower
an industry undergoing profound change created the opportunity to purchase the Z Energy shareholding at an exceptional price and to then drive earnings growth by changing managements focus In March 2010 Infratil acquired a 50% shareholding in Z Energy at a cost of $210 million. Since then the holding has provided cash returns (interest and dividends) to Infratil of $61 million and now has an average broker analyst valuation of $405 million. In addition, Z Energy has initiated a programme of internal investment to create further growth in throughput and returns. The recipe for a low purchase price and a great deal of subsequent value-add? Among the dozens of ingredients the salient one was a decade of uncertainty and change surrounding the New Zealand liquid fuel industry. That, along with poor financial returns, would have influenced Shells decision to exit, discouraged other

Wellington Airport Infratil Energy Australia

NZ Bus Z Energy

buyers, and created opportunities for a local as opposed to multinational management focus. The fuel processing and distribution industry is changing from the historic model of an oil major, such as Shell, finding and extracting oil (upstream activities) and also processing, distributing and marketing the oil and fuels (downstream). For some years it has been difficult, or just not possible, to be consistently successful at all the stages. Shell and other integrated oil companies are now selling out of refining and distribution to free up capital for upstream and exploration activities. In New Zealand the industry had poor returns and shareholders have maximised cash extraction through under-investment or in the case of Shell, sale of its downstream operations. The success of Infratils Z Energy investment reflects a low entry price and a new management team taking advantage of the opportunities created by a restructuring industry.

trUStPOWEr CaPEx anD EBItDaf

$ Million

Infratil Energy australia group, low cost entry New Zealands electricity industry was deregulated in the 1990s and over the next decade it became vigorously competitive and mergers and acquisitions were common. A decade or so later the Victorian electricity market was the first in Australia to follow New Zealand and it created an opportunity for New Zealand experience to be applied building a business across the Tasman.

400 350 300 250 200 150 100 50 0

1996

1998

2000

2002

2004

2006

2008

2010

2012

The Infratil Energy Australia group (retailing and peaker-generation in the south and eastern states, and generation and energy sales to wholesale customers in the west) was started from nothing by applying New Zealand electricity market expertise to the deregulated and restructuring Australian electricity and gas markets. It was a window of opportunity which is now less open as re-regulation makes startups more difficult and raises the costs of acquiring customers. The industry is also changing as it consolidates into a small number of large and medium sized companies. Strategy Infratils investment strategy is to look for lowcost entry into businesses which are well understood by management and to then build capacity and value as demand expands. The approach has mainly delivered, but not always. European airports were not successful for Infratil. They fitted the strategy, but the European economic crisis stifled air traffic growth raising the holding cost and extending the period before underutilised airfields would be needed. At t i m e s eve n ex t re m e l y s u cce ss f u l businesses will face a lack of demand in their

Capital Spend

EBITDAF

Note: A reconciliation of TrustPowers EBITDAF to Profit before Income Tax can be found on page 50 of TrustPowers 2012 Annual Report.

trustPowers recent investment focus has shifted from building generation in new Zealand to wind farms in australia and irrigation in Canterbury. this is a result of capital discipline and an ability to use expertise outside of core functions TrustPower owns 21 power schemes around New Zealand and retails energy to approximately 210,000 customers. Since 2000 TrustPower has increased its New Zealand generation capacity by approximately 40%, however the recent investment focus has been on irrigation in Canterbury and wind farms in Australia, especially the latter. TrustPower is expanding its Snowtown wind farm at a cost of $550 million and has over $1 billion of other projects in Australia. This shift in investment focus reflects discipline and a willingness to look outside of the usual while still taking advantage of inhouse expertise. At present New Zealand does

not need more electricity generation capacity, the economy has not grown for five years and nor has electricity consumption. Companies which have recently invested in New Zealand generation are likely to have inadequate returns for several years on that capital. TrustPower however is able to undertake attractive largescale investment by applying its capital and expertise to construct wind farms in Australia which benefit from that countys policy target of 20% renewable generation by 2020. The table below compares the disclosed economics of TrustPowers Snowtown project a n d a re ce n t l y i n i t i a te d w i n d fa r m i n New Zealand. It gives some indication of why TrustPower is building in South Australia and why it is able to create value with its investment. Recognising that different sites will have different output prices and operating costs so cost per unit of expected generation will explain only part of a projects economics.

Company TrustPower Meridian

total Capital Cost $550 million $169 million

Projected annual Output 985GWh 235GWh

Cost/Output Unit $560,000 $720,000

core markets and a pause in growth unless investment in adjacent fields can be developed, which for TrustPower has meant wind farms in Australia. However, sometimes good investments will not be found and Infratil is prepared to defer capital spending or cancel projects if that is the best option.

InfratIl SEPTEMBER UPDATE 2012

The Crash, The Depression, WWII 1924 to 1946

A recent study of a highly successful funds manager operating from 1924 to 1946 illustrates the consistency of what works. Most of that managers rules would fit Infratil today
John Maynard Keynes fame is based on his roles in economics and history, but as the bursar of Kings College Cambridge he was also an exceptionally successful fund manager of the Colleges endowment fund. Over the 22 years between 1924 and 1946 the discretionary fund managed by Keynes returned a compound 13.7% per annum. The period included the 29 Crash, the Great Depression and World War II. Earlier this year Professors David Chambers of Cambridge and Elroy Dimson of the London Business School produced an extensive review of Keynes fund management performance in which they note His portfolios were idiosyncratic and his approach unconventional. He was a leader among institutional investors Keynes experiences in managing the endowment remain of great relevance to investors today. Although Keynes succinctly summarised his approach as ...the right method in investment is to put fairly large sums into enterprises which one knows something about and in management of which one thoroughly believes the academics study identitfied several factors which contributed to the outperformance of Keynes as a fund manager. Knowledge Keynes knew a lot of people and was well abreast of the news. His stock-picking was the product of fundamental security analysis... and on a judicious reading of the financial press, on the one hand, and the use of his personal network of City and industry contacts, on the other. Manager/fund mutual interest His interests and those of the College were closely aligned. 75% of his personal shareholdings were in the same companies as the College funds. Good timing (surprising given the period) Keynes was highly committed to investing in equities, and on average 74% of the managed funds were in shares. His timing in this regard was good. From 1900 to 1923 the UK equity risk premium over UK government bonds was 1.3%. Over the period of Keynes management, 1924 to 1946, the premium rose to 4.5% (from 1946, when Keynes died, to 2000 it rose further to 6.8%). Although Keynes was investing at a time when shares did relatively better than government bonds, competition for good shares was muted as UK insurance companies had only 3% of their funds in equities in 1920 and had not reached 10% by 1937. Smaller companies and focus Funds were mainly invested in smaller and mid-sized firms and the portfolio was not diversified, for instance Keynes avoided shares in banks and financial companies. there is little in Keynes approach with which Infratils management would disagree, although naturally there are significant differences between how Kings College and Infratil implement their strategies. the former was an active trader of listed shares while Infratils approach is buy and hold and the majority of its holdings are unlisted. Value investment Initially Keynes was a top down investor who used a credit cycle theory of investment to structure his investments in accordance with his view of the economy and financial markets as a whole. But by the early 1930s, having not foreseen the 29 Crash, he had concluded that this approach was unsatisfactory and moved to concentrating on a few core holdings, considered cheap relative to their intrinsic value and held for several years. He also shifted from buying shares which had recently risen in value, to largely buying shares out of favour with the market, ie he had adopted a contrarian approach.

rEtUrnS UK
index

The graphs show the relative performance of the funds managed by Keynes over 22 years and by Infratil for the eighteen and a half years
Kings Col Annual Return

2000 1600 1200 800 400 0 1924 1926 1928 1930 1932 1934 1936 1938

13.7 6.8
1946

since listing. To provide a third reference Warren Buffetts last 22 years of performance is also shown. In each case the fund performance is compared against the relevant share and g ove r n m e nt b o n d m a r ket ret u r n s . Th e comparisons are not entirely level playing field as the individual circumstances of tax paying investors would mean that net returns are likely to differ from those shown. Both the Infratil and Keynes returns are after tax in the hands of Infratils shareholders and Kings College. All the bond returns do not deduct tax

UK Shares Annual Return

1940

1942

1944

Kings Col Cumulative

UK Shares Cumulative

UK Bonds Cumulative

rEtUrnS US
Index

and Buffetts returns are gross of shareholder tax on capital gains.

Bu ett Annual Return

2500 2000 1500 1000 500 0 1989 1991 1993 1995 1997 1999

15.4 8.1
2011

What stands out is that investment in the equity of good companies can provide attractive returns, even over periods famous for their economic and financial upheaval. 1924 to 1946 included several worst of market crashes, depressions and wars, but well informed investment in good companies by Keynes was still able to post a compound return of 13.7% per annum. Perhaps more surprisingly the average UK market return for the period was 6.8% per annum. It is galling to note that the UK sharemarkets compound rate of return between 1924 and 1946 was better than the New Zealand markets

US Shares Annual Return

2001 2003 2005 2007 2009

Bu ett Cumulative

S&P 500 Cumulative

US Bonds Cumulative

rEtUrnS nZ
Index

since March 1994. Also, since March 1994 the NZ sharemarket

Infratil Annual Return

2000 1600 1200 800 400 0 1994 1996 1998 2000 2002 2004 2006

16.7

index have provided a lower return than the government bond index. Leaving aside tax, $100 invested in shares in March 1994 would have compounded to now be worth $313, while $100 invested in government bonds would have compounded to $378 over the same period.

NZ Shares Annual Return

6.4
2012

2008

2010

Infratil Cumulative

NZX Cumulative

NZ Bonds Cumulative

InfratIl SEPTEMBER UPDATE 2012

Infratils target return to shareholders. What should they be?

a number of years ago Infratil began publishing an aspirational target for its shareholder returns of 20% per annum after-tax over the long-term. In reality, no company can be precise about equity returns, especially a company with a relatively diverse portfolio of businesses which will usually be at different stages of their business cycles. Even when operating and financial targets are met, no one can secondguess how the share market will respond. The aspirational target is not however meaningless and it is used within Infratil to judge investment projects and also to benchmark whether businesses and assets should be retained or sold. 20% is a high return target and it precludes Infratil investing in or retaining very low risk/return businesses. However, it is also not a must meet goal and targets change as market circumstances shift. The graphs on the facing page show the long-term trend for a number of interest rates in four markets and illustrate the current uniquely low cost of money. There is no direct relationship between Infratils own return objectives and international interest rates, but major changes in the financial markets are likely to have wider connotations. Even if return targets havent changed, means to their delivery can. Since the 2007 Global Financial Crisis Infratil has placed greater priority on the cash generation of its businesses which has flowed through to a higher dividend to shareholders. Five years of financial market and economic uncertainty, even with interest rates seemingly lower for longer, continue to encourage investors to place a premium on cash earnings and dividends.

DEBt anD EQUItY rEtUrn COMParISOnS (all fIGUrES arE COMPOUnD annUal rEtUrnS)
Period US Equity US Bonds Infratil nZ Equity nZ Bonds aust Equity aust Bonds Japan Equity Japan Bonds UK Equity UK Bonds

Nominal 5 years 10 years 25 years Real 5 years 10 years 25 years In US$ 5 years 10 years 25 years 0.8 6.6 9.5 7.4 5.7 8.0 3.1 19.4 18.6* 0.9 10.7 8.3 9.7 13.5 9.0* (0.2) 14.9 10.9 14.4 14.0 12.0 (4.8) 4.4 (0.6) 10.0 5.7 5.9 (3.6) 7.7 8.0 1.1 5.0 6.9 (0.8) 4.2 6.6 5.7 3.3 5.0 (1.1) 11.3 14.3* (3.3) 2.6 4.0 5.5 5.2 4.7* (6.0) 5.2 6.0 7.7 4.3 7.1 (11.1) 0.2 (2.7) 2.7 1.5 3.6 (1.8) 5.4 5.7 3.0 2.8 4.6 0.8 6.6 9.5 7.4 5.7 8.0 1.6 13.7 16.7* (0.6) 5.0 6.4 8.2 7.8 7.1* (3.8) 7.9 9.2 10.3 7.1 10.3 (11.3) 0.2 (2.3) 2.4 1.4 4.1 1.1 8.0 8.8 6.0 5.3 7.7

* 18.5 years for NZ, from the time Infratil was listed in March 1994.

The table copied above shows the average returns investors have gained from bonds and shares in a number of markets, both in real and nominal terms. The returns are also calculated for a US$ investor to remove the impact of currency changes. All but the New Zealand figures came from a Deutsche Bank report.

In all these markets bonds have outperformed shares over the last five years. An anomalous outcome which hints at the difficulty in forecasting future returns and help explain why investors will be conservative now.

nEW ZEalanD MOrtGaGE ratES SInCE 1900

% pa

25 20 15 10 5 0

1900

1908

1916

1924

1932

1940

1948

1956

1964

1972

1980

1988

1996

2004

2012

Nominal Mortgage Rate

UK BaSE ratE SInCE 1694

% pa

20 16 12 8 4 0

1694

1714

1734

1754

1774

1794

1814

1834

1854

1874

1894

1914

1934

1954

1974

1994

UK Base Rate

nEtHErlanDS 10 YEar GOVErnMEnt BOnD YIElD SInCE 1517

% pa

25 20 15 10 5 0

1517

1547

1577

1607

1637

1667

1697

1727

1757

1787

1817

1847

1877

1907

1937

1967

1997

Netherlands 10yr Yield

US 10 YEar trEaSUrY YIElD SInCE 1790

% pa

20 16 12 8 4 0

1790

1810

1830

1850

1870

1890

1910

1930

1950

1970

1990

2010

US 10yr Yield

InfratIl SEPTEMBER UPDATE 2012

Infratils investment projects now underway

Company TrustPower TrustPower: Snowtown Infratil Australia Wellington Airport NZ Bus Z Energy Other Total Capital Budget range $40-50 million $550 million $40-45 million $20-30 million $50-55 million $85-90 million $5-10 million $790-830 million

the Infratil group has approximately $800 million of capital projects now underway and total spend this financial year is likely to be in the order of $500 million. the spread of the investment is set out in the table. This does not include NZ Refinings $365 million continuous catalytic converter project which Z Energy supported. The largest investment project now under construction by the Infratil group is TrustPowers $550 million. This is not expected to be fully commissioned until mid-2014 and is projected to provide annual earnings before interest, tax and depreciation of $99 million and free cash flows after operating costs, interest and tax of $53 million.

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funding and partnerships $300 million a year is the average investment outlay of the the Infratil group over the last decade. The money has come from operating cash flows, borrowings, equity issues and asset sales. What it doesnt include is the use of co-investors in new ventures. The most salient example of this was the $210 million contributed by the NZ Superannuation Fund to acquire 50% of Z Energy. Infratil has a long track record of investment partnerships; Wellington City in Wellington Airport, Alliant Energy in TrustPower, management in Infratil Energy Australia, and Utilities Trust in Glasgow Prestwick Airport. The partnerships have allowed Infratil to participate in larger acquisitions than it could otherwise accommodate, to share risk, and to gain expertise and support. They are likely to to be a feature of Infratils future acquisitions, especially if the scale of transactions increases or they are made in sectors or locations where Infratil would benefit from local knowledge.

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InfratIl SEPTEMBER UPDATE 2012

Details of the data sourced from infratil, used in constructing the graphs and tables in this Update are available from Infratil (info@infratil.com). further data and information was sourced from the following: *US returns data from the Federal Reserve of St Louis *Long term interest rates and return data ex-NZ from Deutsche Banks LT Asset Return Study by Jim Reid, Nick Burns and Stephen Stakhiv, September 2012 *NZ share, bond and mortgage rates and returns from Bloomberg, ANZ and the Department of Statistics and the National Library archive *Warren Buffett investment record from Buffetts Alpha by Andrea Frazzini, David Kabiller, Lasse Pedersen August 2012 *John Maynard Keynes investment record from Keynes the Stock Market Investor by David Chambers

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