AGL Confronts Higher Costs And Competition

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AGL Energy's wholesale electricity division was the beneficiary of higher gas and electricity prices in the first half but this was was marred by a sharp decline in consumer segment earnings.

-Will the shift in mix to wholesale from retail drag on AGL's valuation?
-Attractive dividend and potential capital management a key positive
-Reduction in gross margins likely amid increased retail competition
 

By Eva Brocklehurst

The wholesale business drove a strong result for AGL Energy ((AGL)) in the first half, as the company leveraged higher prices. This was offset by a lower margins across the consumer-facing business with operating earnings in that division below broker expectations.

Full year guidance has been reiterated, which implies earnings growth in the June half and retail price increases in Victoria, that will be offset by higher marketing costs and the impact of discounting.

The wholesale business has experienced both gas and electricity re-pricing flowing through and remains the sole driver of earnings growth, but what surprised Macquarie was the degree to which the customer segment suffered, with a -30% decline in operating earnings (EBIT) in the first half.

The company notes structural changes are occurring at the customer base, which reflect a desire to avoid government intervention amid renewed competition. As the value attached to retail earnings is more than for wholesale, in Macquarie's view the central issue for investors becomes whether the mix-shift to wholesale drags on valuation.

The stock has de-rated towards longer-term multiples which signals to Morgan Stanley that the peak of the pool price tailwind is now factored into the share price. Morgan Stanley believes policy risk has plateaued, with most initiatives to date aimed at increasing competition and protecting vulnerable customers.

In the near term the broker anticipates negative news flow will continue regarding rising end-user prices and remains wary of the unintended consequences from the proposed National Energy Guarantee.

The market is placing too much emphasis on declining electricity futures prices as a predictor of earnings, UBS asserts, as well as risks from increased retail competition. The broker highlights strong earnings growth, attractive dividend and the potential for capital management.

UBS attributes recent share price weakness to concerns regarding returns from the $1.3bn in proposed growth expenditure, the outlook for wholesale electricity prices and increased retail competition.

Yet, the broker believes the company's approved investments screen well and the market is underestimating the impact of rising gas prices and the NEG on wholesale electricity prices.

The increased competition is expected to take time to affect AGL. UBS retains a Buy rating but decreases its valuation based on higher interest rates and increased long-term competition in retail.

Citi estimates a -2-3% reduction in electricity gross margins from increased competition, based on a review of historical effects from deregulation and the level of profitability in generation that could be used to subsidise retail.

The broker believes, even if it turns out to be wrong about margin compression, the upside value to shareholders is not compelling. Citi now only forecasts a 2% compound growth rate in earnings per share from FY18-23 and downgrades its rating to Sell from Neutral.

Domestic growth is also likely to become harder, following scrutiny of the company's concentration by the regulators. Moreover, organic growth options are becoming more costly.

Deutsche Bank suggests competition is only likely to accelerate in the retail customer segment and come the full year the company will also be cycling around 1.1m customers that have taken up its fixed price scheme.

Costs

AGL has acknowledged there is a structural increase in costs which needs to be addressed via a re-engineering of the business. Morgan Stanley notes the focus is now back to cost reductions, while cash flow momentum and the defensive positioning of the business provide the relative appeal.

Downside risks to estimates notwithstanding the broker suspects the market may be surprised on the upside, should AGL announce a materially larger self-help program.The company intends to outline its cost reduction targets at the full year result in August.

Second half earnings are likely to be affected by increased marketing costs while new renewable capacity may put downward pressure on wholesale prices over the medium term, Ord Minnett suggests. Despite the emerging risks the broker believes the stock remains attractive on valuation and sticks by an Accumulate rating.

Earnings growth expectations are based on another round of cost cuts and Citi considers this a difficult task. Citi does not believe a second round of cost reductions will be as large as the initial $191m, recently completed, and forecasts around $60m over 18 months.

There is also risk the cost reductions could lead to a deterioration in customer service quality and a portion of the reductions competed away.

Wholesale Electricity

Wholesale electricity prices have increased materially in recent years driven by the closure of baseload capacity. Yet there is now significant new renewable supply coming on board and the next baseload closure is likely to be several years away.

This suggests to Ord Minnett average prices are likely to decline, but it also could mean elevated volatility as much of the new capacity is not despatchable. The broker suggests the company is re-positioning for this new market dynamic by investing in fast response generation such as the Barker Inlet gas plant as well as a feasibility study for a new gas peaker in Newcastle.

Macquarie notes the company is advocating for further policy certainty around despatchable supply, which creates a new revenue stream for coal-fired plants.

The re-investment cycle is still to commence, and with technology shifting quickly, the broker suspects the company's investment plans will change significantly in the coming years, although the ability to re-invest to replace existing earnings will be challenging.

FNArena's database shows four Buy, two Hold and one Sell (Citi). The consensus target is $25.29, signalling 17.7% upside to the last share price. This compares with $26.97 ahead of the results. Targets range from $20.54 (Citi) to $27.70 (Deutsche Bank). The dividend yield on FY18 and FY19 forecasts is 5.3% and 6.0% respectively.

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