EUR 850.00 For Business Accounts Only

Morningstar | Strong 1H19 for AGL but 2H Will be Tougher; Upgrading FVE 5%

AGL Energy’s first-half fiscal 2019 underlying NPAT rose 10% to AUD 537 million, mainly on stronger wholesale electricity prices. Despite this, management believes the firm is tracking towards the middle of the full-year NPAT guidance range of AUD 970 to AUD 1,070 million, which implies no growth from last year. Second-half headwinds include lower gas sales volumes, lower average retail prices, and higher fuel costs. We make minor changes to incorporate the result and increase our fiscal 2019 NPAT forecast 1% to AUD 1,027 million. We also marginally upgrade medium-term earnings forecasts to reflect higher electricity futures prices and marginally reduce the discount rate used in our valuation to reflect a higher expected debt weighting. These changes see our fair value estimate increase 5% to AUD 21 per share. At current prices, AGL is fairly valued.

New CEO Brett Redman highlighted his three priorities: invest in electricity generation and storage; invest in digitisation and new technologies; and ensure AGL maintains its social licence to operate. This represents a more conciliatory management approach that balances shareholder returns against meeting community expectations. Returns may be lower than otherwise, but hopefully so too will the risk of government attacks. There are no guarantees though, especially with federal Labor highly likely to return to power in the next election.

The electricity portfolio was the star performer in the first half with operating income up 8% to AUD 955 million. The main positives were higher prices for large business customers following increased wholesale electricity prices, as well as lower costs because of the falling price of the renewable energy credit that the firm is obliged to buy. These factors more than offset the negatives, which included lower average retail prices as most remaining customers were put on discounted rates in the aftermath of last year’s government and media attacks.

Only 3% of AGL’s residential and small business customers remain on undiscounted “standing” offers. The firm also reported higher fuel and running costs at its power stations, as well as lower business customer sales volumes. Generation volumes were flat, with higher renewable output offsetting unplanned coal-fired power stations outages.

Spot electricity prices and futures prices for 2019 and 2020 have rallied strongly in the past six months because of dry conditions hurting hydroelectric generation volumes. Other factors pushing up prices include unplanned outages at coal-fired power stations, delays in new renewable projects coming online and higher gas and coal prices pushing up the cost of producing electricity. These factors tightened electricity demand/supply conditions and caused prices to rise. However, futures pricing continues to imply electricity prices moderate from 2021 as a wave of new renewable generation projects come online. Risk of higher and more volatile prices remains as uncertain government policy deters much needed investment to cope with the changing industry.

Management backed away from prior cost savings targets, instead spending more to keep the aging power stations in good condition. The fiscal 2019 operating cost savings target was halved to AUD 60 million, before considering the impact of CPI.

The gas portfolio also performed well, with gross margin income increasing 5% to AUD 411 million, mainly on higher prices for retail and wholesale customers. The main negatives were lower sales volumes to retail and business customers, and sharply higher gas purchase costs. Gas purchase costs should continue rising as contract prices catch up to high market prices, which would imply more than 40% upside. However, this also suggests further upside to prices charged to customers, particularly business and wholesale customers on multiyear contracts.

Even after redeeming its hybrid securities in mid-2019, paying generous dividends and funding more than AUD 1 billion in capital expenditure this year, AGL will still have a strong balance sheet. Management previously suggested the firm would return capital to investors via a share buyback if it didn’t find an acquisition or other use for surplus capital. However, a share buyback no longer appears likely in the near term as the firm appears happy to maintain firepower while it waits for growth opportunities. A small acquisition in Perth would help build scale in this new market and would be unlikely to sap financial strength.