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Cheap Power Very Expensive For AGL, Origin

Australia | Feb 08 2021

This story features AGL ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: AGL

Both AGL Energy and Origin Energy issued a profit warning last week. Clearly, the industry is feeling the pain from lower-for-longer electricity prices in Australia

-Government intervention to further reduce industry returns
-Questions asked about the future of old-style electricity generators
-AGL and Origin’s generation assets currently valued at less than zero
-Electricity prices expected to recover to long-run average of $70/MWh
-Ongoing recovery in APLNG to support Origins earnings growth

By Mark Story

Recent surprise announcements by two energy majors in Australia, AGL Energy ((AGL)) and Origin Energy ((ORG)), reveals just how severe the impact of surging renewables is on their business models.

In response to weaker wholesale energy prices, AGL Energy booked a shock write-down, while its peer Origin Energy warned of a two-year profit hit.

Australia’s largest electricity generator and retailer, AGL announced it would take -$2.7bn in impairments at its interim financial result to be released next week.

Provisions include -$1.9bn relating to onerous contracts to wind farm PPAs (power purchase agreement), -$1.1bn in increases to environmental restoration provisions, and generation asset impairments of -$532m against a positive tax offset of $878m.

AGL reiterated underlying guidance of $500-580m for FY21 and flagged FY22 will actually improve by $50-80m post tax due to the unwind.

Markets weren’t entirely surprised

Given AGL has been trading below book value since January 21, UBS suspects the market had already factored in the possibility of an impairment. But what these recent announcements bring clearer into view, adds UBS, is that AGL's earnings will decline year on year.

The broker also flags downside risk in the medium term, especially should government policies underwrite new generation.

While these charges do not impact AGL's near-term net debt position, UBS expects higher charges to lower future cash flow when the onerous contracts are settled or when rehabilitation cash costs are incurred from 2023.

UBS also expects FY21 gearing to increase to 36% (from 26%) which reduces the likelihood of further capital management in the near term.

While AGL is trading at an FY21 dividend yield of 7.6%, UBS expect the yield to drop materially year on year.

The broker maintains a Sell on the stock as increasing renewable penetration, supported by government underwriting, pushes the outlook for wholesale electricity prices lower.

Quick on the heels of AGL’s bombshell came Origin’s missive that in response to lower wholesale prices flowing into retail tariffs, plus a lower gas retail contribution, it was cutting its Energy Markets division’s operating earnings (EBITDA) guidance, now implying pre-tax earnings will decline -21–31% this fiscal year.

Origin has lowered its FY21 guidance for Energy Markets EBITDA to $1bn – $1.14bn (-$155m / -13%).

Based on current electricity prices (averaging $41/MWh across the four states), Ord Minnett estimates the value of both AGL and Origin’s generation assets at less than zero at current prices.

The broker believes prices would need to be $50–55 per megawatt hour (MWh) for these assets to be break-even in value.

Future tenability in question

At face value, the current situation appears untenable for the electricity businesses for both energy majors.

Fueling market concerns was a cautious outlook commentary from AGL in which management’s long-term outlook for wholesale electricity and renewable energy certificates now indicated a sustained and material reduction in prices.

AGL has shifted its longer term electricity price assumption from $65-75/MWh (long run margin cost) to $50-65/MWh.This results in the renewables recognising an onerous provision which unwinds in future years mitigating earnings, but generating a structurally weaker cash flow.

Despite both federal and state ministers threatening to build capacity, which could push prices lower than forecast, Ord Minnett doesn’t believe the end of the road is near for these electricity businesses.

Given prices will ultimately recover to their long-run average of $70/MWh (down slightly from $75/MWh previously) Ord Minnett regards the likelihood of these two largest retailers becoming unviable as low.

As a result, the broker has maintained its Accumulate recommendation on AGL and a Buy rating on Origin. While Citi doesn’t expect a downgrade to Origin’s credit rating, it has downgrade the stock to Neutral, and lowered its target price by -28% to $4.76.

Benefits of vertical integration are eroding

Morgans still sees value in AGL and Origin’s existing assets, but it too recognises long term the benefits from being vertically integrated (generation with retail) are being eroded.

What’s clearly not lost on the market, adds Morgans, is that the major lifecycle cost for renewable energy is the cost of capital, and there are entities with bigger balance sheets and/or lower acceptable capital returns than either AGL or Origin.

During the last five years, AGL’s lowest 12 month forward P/E ratio (based on earnings guidance) was 11.3x during FY19 and never exceeded 25x.

The earnings ratio has now fallen from 18.5x down to 13x this year which Morgans thinks is the market pricing in lower for longer electricity prices.

Given that Morgans expects future earnings to decline further in FY22, it doesn’t think the shares offer good value.

Morgans doesn’t see many opportunities for growth for AGL, but it thinks the company can continue to generate significant cash flow from its electricity business to support a high payout ratio and an attractive, albeit unfranked, dividend yield.

The broker maintains its Hold rating on AGL and has reduced its target price to $10.55 per share.

Given it’s a more diverse business and less baseload generation, and hence offers less downside than AGL, Morgans maintain its Add rating on Origin and has updated its target price to $6.06ps.

The broker expects Origin’s interest in APLNG to give the company’s earnings a significant exposure to oil prices and expects the ongoing recovery in APLNG to support earnings growth and cash flow.

FNArena's database has two Hold (or equivalent) ratings and two Sell for AGL Energy. The consensus target is $10.87, signalling -4.5% further downside to the share price.

FNArena's database has one Buy rating and three Holdss for Origin Energy. The consensus target is $5.53, signalling 19.5% upside to the last share price.

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