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Treasure Chest: AGL Mired In Uncertainty

Treasure Chest | Sep 11 2019

FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. An earnings contraction may hold AGL Energy back in FY21, as the electricity generation market remains mired in uncertainty.

-Risks from regulation, pricing pressures and ageing power plants weigh
-Electricity sector amassing a growing list of unknowns
-Cash generation likely to support buybacks, unless a telco opportunity presents


By Eva Brocklehurst

Are expectations for AGL Energy ((AGL)) still too high? The company has outlined several issues prevailing over FY20, including the outage at Loy Yang 2. However, Citi believes this explains just 10% of the reduced net profit guidance, which at $822m is -21% below the prior year.

Citi suspects earnings contraction might still hold the company back in FY21, expecting net profit of $717m, around -12% below consensus forecasts. The difference is likely because Citi is not forecasting an entire reversal of the impact of the Loy Yang 2 outage, when the plant comes back on line in FY21, stemming from lower electricity prices and the expenditure associated with repairs.

AGL has also quantified higher depreciation in FY20, which emphasises the age of the assets in its portfolio, Macquarie points out. Morgans agrees, assessing fundamentals are bleak for the longer term and becoming harder to ignore. Risks from re-regulation, pricing pressures and the ageing of the power plants – AGL's coal generation fleet is 38 years old – are expected to weigh on the stock regardless of any short-term support from the current share buyback.

UBS is more positive, believing the $650m on-market buyback in FY20 should support the share price, although acknowledges the headwinds from regulation and lower long-term wholesale electricity prices. The challenges are considered priced in and, in the wake of the FY19 results, UBS upgraded to Neutral.

Citi calculates the fair multiple for AGL, at a 13.2x PE (price/earnings), is well below that implied by the current share price. Hence, the broker reiterates a Sell rating, suspecting investors for growth are unlikely to be compelled by what is on offer. As AGL pays dividends as a 75% pay-out of earnings per share in income, Citi suspects funds may be better off seeking value in stocks where dividends are not backtracking.

Moreover, value investors may not be getting enough margin of safety. The company's ability to generate cash is not the issue and the balance sheet may be able to afford acquisitions of scale. Rather, Citi believes investors are simply treading carefully in the current environment.

In retail electricity the broker is positive about the longer-term benefits to earnings if competition is reduced in a semi-regulated environment, but still expects some pressure. This stems from heightened competition in Queensland and Victoria, which may lead to either continued loss of market share or margin contraction, although not to the extent of recent years.

UBS suspects electricity prices will remain elevated through the 2019-20 summer and this should support AGL's share price. Nevertheless, there are concerns that prevailing market and policy settings will limit the company's ability to source and execute on attractive growth projects.

Ord Minnett takes a similar approach, assessing that, with earnings re-based lower, there are reasons to be positive. The stock is offering a 5-5.5% dividend yield and there is some evidence of market share gains in terms of electricity retail customer numbers. Moreover, the slump in earnings could ease political scrutiny of the company.

Morgans asserts there is a growing list of unknowns for the electricity sector. Regulation will become topical in FY20 as the government renews an attempt to pass legislation in order to wield a "big stick" over electricity providers. While unlikely to be triggered, Morgans points out this would have a huge negative impact on the sector if it were ever used.

The company has identified around $1.5bn in projects to provide flexible capacity, although the majority will not be developed before 2022. AGL Energy has also emphasised a long-term need for the Newcastle gas plant as the market transitions to renewables but, clouding the outlook, is the issue of when that need emerges.

Macquarie notes, making this even harder, is additional transmission capacity and Snowy Hydro 2.0 on the 2025-2030 horizon. Moreover, the company's gas portfolio could struggle as legacy contracts roll off and margins come under pressure.

The company generates strong cash flow, yet the broker points out there are limited opportunities for expenditure as projects are still 2-3 years away from final investment decisions (FID) and near-term FID will suffer from uncertainty over government policy, which is undermining any projected economics.

Hence, cash generation will support buybacks, unless management finds a significant telco opportunity. In the meantime, the valuation is yet to become compelling for the broker.

FNArena's database has three Hold and four Sell ratings. The consensus target is $18.16, suggesting -4.3% downside to the last share price. Targets range from $16.28 (Citi) to $19.50 (Macquarie). The dividend yield on FY20 and FY21 forecasts is 5.3% and 5.2% respectively.

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