AGL Energy Wins Customers

This story features AGL ENERGY LIMITED. For more info SHARE ANALYSIS: AGL

Despite downward pressure on electricity and gas prices, AGL Energy still has several positives in its outlook. None the least being customer retention.

-AGL Energy's customer gains/retention signal the benefits of incumbency
-Lower electricity pricing hampers development of new generation
-Current buyback program underpinning share price

By Eva Brocklehurst

AGL Energy ((AGL)) provided a pleasant surprise to brokers, delivering a first half result that was ahead of most expectations, despite underlying profit falling -20%. An outage at Loy Yang A unit 2 did not have the impact that was feared and costs are expected to be recouped in FY21 from insurance.

The company's Macquarie Generation (MacGen) coal supply chain provided better access to cheaper contracts, which should lift FY20 earnings. MacGen also offset the prolonged outage of Loy Yang A unit 2. Renewable generation was also higher which allowed AGL Energy to use less gas. FY20 earnings (EBIT) guidance has been reiterated at $780-860m, with a bias to the top end.

The company has acknowledged falling wholesale electricity prices and the re-pricing of legacy gas contracts will create headwinds. Renewables and cheap gas are putting downward pressure on electricity futures which in turn will put downward pressure on consumer electricity prices.

Wholesale electricity prices were ahead of Macquarie's estimates in the first half, reflecting additional generation at MacGen, a reduced need for gas and better spot prices. Yet, while these gains mitigate the impact of the outage at Loy Yang A unit 2 they do not prevent the impact of falling prices on overall profitability, the broker asserts.

As wholesale electricity prices are in backwardation (where the current price is higher than the forward price) and growth projects are uncertain, UBS expects earnings to decline by -8% over the next three years as the generation fleet realises lower pool revenue. Ord Minnett agrees backwardation has negative implications for future earnings while current wholesale electricity prices are unsustainably low.

Morgan Stanley estimates normalised underlying FY21 earnings per share could fall -5-12%. This is predicated on the non-recurring insurance recovery for Loy Yang A unit 2, which investors won't capitalise on, and the higher MacGen production rate, which investors shouldn't capitalise in view of potential displacement by wind and the closure of Liddell over FY22-23.

Customer Retention

The company is also making progress on customer retention, although margin pressure continues. Macquarie points out the company is bucking the historical trend by winning customers as a fall in wholesale prices makes it harder for lower-tier operators that take on inventory to sell it.

Citi agrees the strength of incumbency is on show at AGL Energy and upgrades to Neutral from Sell. The company was able to build its customer base by taking share from smaller operators that are disadvantaged in a semi-regulated retail environment.

The cost to acquire and retain customers was reduced as churn declined to 15.7% from 17.6%. This suggests to UBS market competition may have eased. The increases in regulated pricing in Victoria and the draft decision in NSW suggest downside risk from regulated prices may be contained.

However, Macquarie suspects, with electricity prices coming off their highs, and volatility dropping with more supply, efforts by management to develop its strategy in new generation and gas imports are somewhat thwarted.

A lower gas price is the result of a current oversupply the east coast gas market. While AGL is typically short gas, Macquarie points out larger volumes were taken on when prices were close to $10/gigajoule, thus the risk is for an earnings squeeze in FY21 as commercial contracts roll.

Morgans assesses, beyond FY21, AGL will struggle to maintain earnings as the coal fleet is retired, and the current investment program does not replace the capacity lost when Liddell eventually shuts. Unplanned outages during the current quarter at Liddell and Bayswater will affect second half earnings and the fleet is likely to become more unreliable and expensive to maintain.

UBS remains supportive of the company's strategy to secure battery capacity at strategic locations within the National Electricity Market, although the impact to earnings remains immaterial at the current scale. The proposed LNG import terminal in Victoria at Crib Point has not progressed, with management highlighting the complexity in the approvals process.

Buybacks

While the long-term outlook is challenging, Morgans believes the dividend and resumption of the buyback program will support the share price and upgrades to Hold from Reduce. The buyback is having a positive influence on the share price, Citi agrees, and the downside is reasonably well contained.

Macquarie also suggests scope for further share buybacks will likely be constrained in FY23/24 when Liddell is no longer contributing. What counts against expansion of the buyback is the capital- intensive projects in hand, such as the Newcastle gas storage, Liddell batteries and Crib Point import terminal.

The broker calculates these will use at least the next 1-2 years of surplus cash flow. Nevertheless, capital expenditure demands remain modest for the next 12 months, as at least two of these projects will not have an impact in 2020.

FNArena's database has three Hold ratings and four Sell. The consensus target is $18.90, signalling -8.7% downside to the last share price. The dividend yield on FY20 and FY21 forecasts is 4.8% and 5.0% respectively.

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