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Morningstar | AGL Reports Good FY18 but the Outlook is Deteriorating; FVE Trimmed to AUD 20

Narrow-moat-rated AGL Energy's fiscal 2018 underlying net profit after tax, or NPAT, increased 28% to AUD 1,023 million, slightly ahead of expectations. The strong result was mainly driven by a big increase in generation earnings thanks to the stronger wholesale electricity price, while headwinds in retail markets and cost inflation were a drag. Guidance is for relatively flat NPAT in fiscal 2019, in the range of AUD 970 to 1,070 million. We downgrade our forecast by 8% to AUD 1,030 million on a lower wholesale electricity price and slimmer retail margins. With weak electricity futures prices for the next couple of years and intense retail competition likely to continue, we also downgrade medium-term earnings forecasts. We now forecast earnings remain relatively flat for the medium term before growth picks up again over the longer term as we doubt wholesale electricity prices will remain depressed indefinitely. Our fair value estimate falls 5% to AUD 20. At current prices, AGL screens as fairly valued.

AGL's balance sheet is strong, putting it in a good position to cope with earnings headwinds and fund the large development pipeline. Net debt/EBITDA fell to 1.1 times in fiscal 2018, from 1.7 times in the prior year. With such a strong balance sheet, we think AGL is highly likely to refinance its AUD 650 million hybrid with cheaper senior debt, likely saving the firm more than AUD 10 million per year. The hybrids have a call date in mid-2019.

Cash flows were strong, with an unwind of wholesale electricity price margin calls boosting cash conversion to 111%. Strong cash flows allowed AUD 504 million in debt to be repaid despite generous dividends and elevated capital expenditure of AUD 778 million. Capital expenditure will increase to AUD 1.0 billion in 2019, roughly half spent on maintenance and half on new power stations and other projects.

Growth capital expenditure is likely to remain high for several years as the firm builds new generation supply to offset the closure of Liddell in 2022. However, if the government succeeds in driving down wholesale electricity prices, we would expect AGL to reduce the amount of new power stations it builds, and divert surplus cash flows to share buybacks instead.

Utility bill shock and intense competition drove retail customer churn higher, with the firm being forced to increase efforts to maintain customer numbers. This was a major driver behind a 15% increase in operating costs to AUD 1,569 million in fiscal 2018. Guidance is for operating costs to fall 5% in 2019 as lower marketing spend and cost out initiatives offset CPI, debt forgiveness for struggling customers and better deals for loyal customers. Management expects further cost-out initiatives to reduce costs to AUD 1,364 million by 2021.

The electricity portfolio was the star performer in fiscal 2018, with gross margin increasing 30% to AUD 1,906 million. The main driver was higher wholesale electricity prices, benefiting the electricity generation assets. Generation output was flat on last year, as increased renewable output offset unplanned outages at two of its major coal-fired power stations.

The Silverton and Coopers Gap wind farms should come online over the next year, helping output improve. The outlook for wholesale prices isn't as good, with futures markets expecting significant declines in the next couple of years. For now, though, wholesale prices remain attractive following a decent rally in the past couple of months. Since early June 2018, wholesale prices have increased 15% to AUD 79 per megawatt hour in NSW, 20% to AUD 88 per MWh in Victoria, 11% to AUD 68 per MWh in Queensland, and 12% to AUD 95 per MWh in South Australia. That's a good way to start the new year, and perhaps the futures prices are too pessimistic; AGL seems to think so. Should wholesale prices stay relatively strong, that would significantly reduce downward pressure on retail prices and earnings.

A minor negative in the generation performance was markedly higher fuel costs due to higher gas and coal purchase prices. Fortunately, most of AGL's coal supply comes from its own mines or under cheap long-term contracts. Generation running costs also increased more than expected. Looking forward, we expect continued upwards pressure on fuel costs as some of the firm's low-priced coal supply contracts end, which makes keeping Liddell open past 2022 even less appealing. The other negative was lower electricity sales volumes--with retail customer volumes down 1% and business volumes down 13%.

The smaller gas portfolio also performed well, with gross margin up 8% to AUD 729 million. The main driver was pushing price increases through to customers, flowing on from higher wholesale gas prices. While the firm lost substantial business customers, these were low margin and didn't have a major impact on earnings.