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Morningstar | Contact Shoots the Lights Out in October But Long-Term View Not Impacted

Conditions are extremely favourable for narrow-moat Contact Energy at present, with low lake levels and gas supply outages causing wholesale electricity prices to spike. Fortunately, the issues causing prices to spike haven't impacted Contact to a material extent and it has increased electricity generation to take advantage of high prices. We estimate EBITDA in the first four months of fiscal 2019 in the core integrated energy division is up nearly 30% on the previous corresponding period, and up nearly 90% in the month of October. But just as we didn’t get too worried about poor conditions in recent years, we're not getting too excited by the current hot streak. That's just life in the New Zealand electricity sector, and it all evens out over time.

There is a high degree of uncertainty regarding where Contact's earnings will end up in fiscal 2019, given the highly volatile wholesale price. Based on futures prices which show the market calming down, we estimate fiscal 2019 EBITDA increases 12% to around NZD 540 million. Longer-term earnings forecasts are largely unchanged, and we remain comfortable with our NZD 6.20 fair value estimate. At current prices, Contact is modestly undervalued.

The wholesale price spiked higher in October, with Contact receiving an average sales price of NZD 282 per megawatt hour, up from NZD 52 per MWh in October 2017. In response to high prices, Contact is maximising output from its hydroelectric schemes and gas fired power stations. Electricity production was up 28% in October and 8% in the fiscal year to date. The futures market expects wholesale prices to remain relatively high for at least a couple more months, so Contact is likely to keep running as hard as possible despite its dwindling lake storage. In Early November, its lake storage sat at 57% of average for this time of year. The best strategy is to make hay while the sun shines and worry about replenishing lake and gas storage when conditions normalise, which they will.

Separately, Contact hosted an investor day showcasing its geothermal power stations. Our main takeaway is the company has plenty of options to expand its geothermal production to accommodate demand growth or replace ageing assets. Much of this development can be justified at wholesale prices below NZD 70 per MWh, making it good value for baseload power. At this stage, demand growth remains muted and the company is remaining disciplined. But the longer-term prospects appear good as electric vehicles gain popularity and industrial companies increasingly transition from fossil fuels to grid power.