AGL and Origin: Making a profit didn’t use to be a crime

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Both AGL and Origin are earning more than cost of capital, but so they should be at this point in the cycle.

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“To err is human”

Should we nationalise all the home owners in Australia? After all, many of them have made vast profits in the past few years. Let’s hold a Royal Commission into home owners.

Or maybe we should hold one into iron ore manufacturers. Better still, let’s hold one into coal producers. Coal prices are very high, surely they are ripping off the public. And while we are at it, let’s look at the diesel fuel rebate, a gift to the mining industry. Anyhow. Enough of the rant, back to analysis.

Both AGL and ORG are earning more than cost of capital, but so they should be at this point in the cycle

The following figure is constructed from the segment accounts of AGL and Origin. We measure return on capital as NOPLAT/Funds employed. This is a technical definition that is particularly useful when looking at segment accounts of large companies.

NOPLAT is defined as earnings before interest and tax [EBIT] less notional tax which we take to be 30%. It’s a measure of the ungeared after-tax profit, and removes the impact of gearing from return on equity calculations.

Capital employed has been measured as segment assets – liabilities. We looked at Origin’s Energy Market’s segment and basically used all of AGL except for a 2014 adjustment for their upstream business.

We measured the “hurdle rate” at 5.8%. This will cause shock and horror to fund managers who want to earn 10% or more but when the 10-year bond rate is 2.5% you can’t expect that most of the time.

We think that utilities to have a credit rating of BBB+ which we think is the right level for this sort of utility need to manage Debt:EBITA to about 3X but we simplified it down to 50% debt, 50% equity assumed capital structure. The 10-year bond rate is 2.5% in Australia and adding a 2% corporate risk premium gets to 4.5% or 3.2% after tax shield.

The cost of equity is the bond rate + 6% or around 8.5%. This gives a WACC of 5.8%. Still we see 6% and 7% used in various government reports. Everyone thinks they know better than the bond market and that interest rates are going back up.

Figure 1: Return on funds employed. Source: Company results

It’s also important to understand that the accounting numbers are, at best, estimates and that both the numerator (profits) and denominator (capital employed) are subject to what can generously be described as changes in accounting treatments.

For instance, Origin has stated it expects it FY19 and beyond numbers to fall by $150 m (12%) due to now recording some hedge costs in profits that were previously excluded. It’s for this reason that many investors prefer to focus on cash flow, but it has its own traps.

The figure shows that returns are above the cost of capital but hardly at levels that are going to get say, Amazon, Google or Facebook investors to switch to AGL or ORG.

That’s particularly the case for AGL, which has the most carbon intensive large business in Australia at present. We’ll return to carbon a bit later.

Neither AGL nor ORG have made any particularly significant capital investments in their utility business since AGL completed the $1.5 billion acquisition of Macgen in Sep 2014. Indeed ORG’s balance sheet has been totally constrained and to an extent still is.

This means we can look at earnings before interest, tax and depreciation [ ebitda] , but expect AGL’s FY16 number to show the full-year benefit of Macgen. Otherwise we are looking at like for like growth.

Figure: 2 Ebitda. Source: Company

Both companies have shown similar growth. Without proving it, the fact is that AGL has done it mostly with Loy Yang A and Macgen, that is from thermal power, whereas Origin, which only has Eraring power station has increased its gas profits very significantly.

Clearly with power prices headed down, AGL’s advantage reduces, but then Origin’s gas profits are finite as well, as we discuss next.

Business rather than consumers are the ones seeing the biggest percentage rise in electricity costs

Because of the false zero on the vertical axes, the changes in prices look bigger than they actually are:

A better comparison may be provided by the following table:

Figure 3: Price changes. Source: Company

In terms of consumers and all the pain they are feeling, excuse me while I have a cynical laugh. A 10% price increase over three years is hardly the difference between make it or break it for the average house or small business. Come on.

We like these numbers because they reflect actual results; not posted prices, but the actual numbers after discounts, after all the nonsense. These are the numbers Dutton want’s to take GST off. As usual the difference between perception and reality in this space is staggering.

However for big business it’s a bit more serious. ORG shows a 40% increase and AGL 17%. I think the AGL numbers are more representative as $121 that ORG showed back in FY15 is a very low number for anything other than the very largest of businesses. Recall that these are numbers that include network, environmental and every other cost as billed by the retailer.

A 17% or even a 25% increase in a basic commodity is serious but again hardly unprecedented in Australian business. And for this the socialist liberal party want to nationalize the industry?

AGL cedes its business gas market to Origin

One of the more fundamental shifts in the gas market is the way AGL has just given up its share of the business market. Most, if not all of that share has gone to Origin. This marks the final step in the transformation of  AGL, founded to own the NSW gas reticulation network, from gas into electricity.

It’s a little difficult to show the underlying picture, because both AGL and Origin have large wholesale contracts where they sell Queensland coal seam gas [CSG] to LNG producers, so not really domestic business. We can back this out of AGL and AGL’s business gas volume looks as follows:

Figure 4: AGL Business gas volumes. Source: Company

This is yet another example of how likely it is forecasts will be in error. AGL is giving up volume because it doesn’t have the supply contracts. It was probably hoping to get more from Bass Strait but they don’t have it. It’s interesting because one of AGL’s cost advantages was transmission pipeline rental.

If you pay a fixed amount for gas transmission from, say, Victoria to NSW, it’s easy to compete for a marginal contract. When you have less volume to cover the fixed pipeline costs, then profitability deteriorates.

Meanwhile ORG has picked up share. The overall picture, excluding households, where nothing much has changed is as follows. I don’t show state-by-state numbers, but it’s clear that Origin has picked up all the share that AGL has given up in NSW and Victoria.

Origin had a much better gas supply portfolio than AGL, by virtue of its upstream gas assets. But for the most part it’s sold those now to Beach Energy and over the next 3-5 years Beach will be able to get the price it charges Origin up to market. So the jump in gas profits Origin has seen in the past few years is temporary and we wouldn’t capitalise it into the PE ratio.

AGL & Origin business/wholesale gas
Figure 5: AGL & Origin business/wholesale gas. Source: Company

That’s particularly the case as LNG imports will provide new gas competition. Speaking of LNG imports, an AIE seminar this week provided some information around the proposed Pt Kembla LNG import terminal. This will be done via a $200-$300 million project using a floating regasification vessel.

The key point to note is that the project is proposing to sell gas at the A$9-A$12 range plus any delivery transport costs. For some gas users such as brick manufacturers and the like that don’t compete with importers, these costs will be very unwelcome, but manageable.

But in the electricity industry, $9 gas is basically useless for anything other than peak shaving. Pumped hydro is likely to be competitive with, or cheaper than, combined cycle gas generation using $9 gas. Maybe not Snowy 2.0 pumped hydro but anything in the $1 m to $1.5 m per MW capital cost.

The outlook

Without wanting to underestimate the investment banking research industry, we think there are only a few good analysts in this sector who have even the faintest idea of what is going on. Of course, those few good analysts are very good, even excellent. But there are less of them than there used to be.

That said, here are the current consensus estimates. Note that for Origin the estimates include the LNG business which is not otherwise discussed in this note, but for which the prospects are quite bright. That business was financed on the back of A$100 oil and that’s pretty much what it is today.

Figure 6: AGL estimates. Source: Factset

I personally think the AGL estimates are too high, given the forward curve and that now ex-CEO Andy Vesey indicated earnings would fall in the medium term if the forward curve was “correct”.

Carbon risk and goals – Origin “out of coal by 2032”

Origin’s FY18 contains a slide with the following key targets:

  • Out of coal by 2032
  • 50% reduction in scope 1&2 emissions by 2032
  • Renewables 25% of capacity by 2020

ITK thinks that everyone from AEMO to the investment banking community, to the NSW government simply isn’t paying enough attention to Origin’s statements. Origin is giving not three years, not five years, but 14 years notice of closure of Eraring, and it’s three years ahead of when AEMO and everyone else models it to close. Eraring is the largest power station by capacity in NSW and the second largest energy provider.

AGL compiles with TFCD recommendations

There are now semi-formal requirements to disclose process for considering climate change risks for businesses. AGL has done a good job on publishing on this with the key document “Powering a Climate Resilient Economy”. There is nothing substantially new in the document over previous policy disclosures which include:

  • – AGL will not build or finance any new conventional coal-fired power stations in Australia without CCS;
  • – AGL will not extend the operating life of any of its existing coal-fired stations;
  • – AGL will be out of coal by 2050;
  • – AGL will continue to invest in new renewable and near zero emission technologies (I guess gas fits in this category??);
  • – AGL will incorporate a forecast of future carbon pricing into all generation capex.

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