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Morningstar | Value Emerging in AGL Energy

Following a near 40% fall in its share price since mid-2017, we believe narrow-moat AGL Energy is beginning to look attractive again, despite ongoing regulatory risk. At current prices, the stock trades 10% below our unchanged AUD 20 fair value estimate, on a forward P/E ratio of 11.6 times, and paying a mostly franked enticing dividend yield of 6.5%. Although we reduced our medium-term earnings forecasts, our longer-term assumptions are largely unchanged. We now expect net profit after tax to fall at a CAGR of 2% for the next five years, compared with our prior expectations of broadly flat earnings. This reflects expectations for increased pressure on retail margins following on from the Australian Competition and Consumer Commission's, or the ACCC's, electricity price inquiry. We delve into this topic in more detail in our special report "AGL's Fundamentals Starting to Outweigh Intervention Risks," dated Oct. 31, 2018.

AGL's earnings are likely to moderate over the medium term on government intervention to reduce retail electricity prices and the closure of the Liddell coal-fired power station in 2022. These earnings headwinds should be partly muted by investment in growth projects and cost-out initiatives. The firm generates strong free cash flows and has conservative financial leverage, putting it in a good position to deal with earnings headwinds and potentially make acquisitions or return capital to shareholders.

We believe the ACCC's recommendations to squeeze retail margins could be even more successful than it expects. However, slim profit margins in the retail industry mean downside is limited unless the government is prepared to put small competitors out of business. Utilities like AGL have profited from disengaged customers, and it shouldn't be difficult to force better outcomes for this group by setting a retail price cap.

Other recommendations to improve comparability of retail offers should also help customers get better deals at AGL's expense.

However, the big driver of AGL's earnings is the generation division, and here we don't think the ACCC's plans of small subsidies for new entrants will prove effective. High wholesale gas prices should keep wholesale electricity prices well supported, benefiting AGL's low-cost coal-fired power stations. Risk will build over the longer term, though, as the government is likely to try new ideas until it eventually succeeds in driving down generation profits.