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Morningstar | Record Hydro Generation Leads to Record Earnings for Mercury in FY18

Narrow-moat-rated Mercury NZ's underlying EBITDA increased 7% to NZD 561 million, 1% above our forecast, as heavy rainfall pushed hydroelectric generation 24% above an average year. But favourable weather won't last. Fiscal 2019 guidance is for EBITDA to fall 8% to NZD 515 million, broadly in line with expectations, as rainfall reverts to more normal levels. The firm opted not to pay a special dividend as it refocuses on investing in growth projects. Guidance is for dividends of NZD 15.5 cents per share in 2019, representing a reasonable yield of 4.5% fully imputed. We remain comfortable with our existing NZD 3.60 fair value estimate, while our Australian valuation falls 3% to AUD 3.25 on currency weakness. At current prices, the stock is mildly undervalued.

Fiscal 2018 underlying net profit after tax, or NPAT, increased 13% to NZD 198 million. We forecast NPAT falls 13% to NZD 173 million in 2019. The main headwinds being lower hydroelectric output and a higher debt balance, partly offset by expensive interest rate hedges rolling off and an earnings contribution from the recently acquired stake in Tilt Renewables. Fiscal 2019 EBITDA guidance assumes hydroelectric generation remains 5% above average, after a good start to the fiscal year. We estimate full reversion to mean rainfall would knock another NZD 10 million-plus off guidance.

Putting aside unpredictable weather, the outlook appears sanguine. We take comfort in nationwide electricity demand improving 1.3% after normalising for temperature, led by the residential and dairy sectors. The Tiwai Point aluminium smelter's decision to increase production should add another 1% to annual electricity demand. Wholesale electricity prices are elevated and volatile, which bodes well for gentailer earnings. The main negative remains intense retail competition, evidenced by Mercury's customer numbers falling 1% in fiscal 2018.

Free cash flows were flat at NZD 259 million in fiscal 2018 as stronger earnings were offset by increased maintenance capital expenditure to refurbish hydroelectric assets and invest in IT systems. This went to shareholders via NZD 207 million in ordinary dividends, or NZD 15.1 cents per share, and a NZD 50 million share buyback.

In addition, Mercury invested NZD 144 million in a 20% stake in Tilt Renewables and NZD 6 million in other growth opportunities, funded by debt. Despite the increase in debt, its balance sheet remains sound. Over the past year, gearing rose 360 basis points to 27.5% and net debt/EBITDA increased to 2.3 times from 2.0 times. Based on earnings guidance, we estimate net debt/EBITDA will be around 2.5 times in June 2019, or 2.6 times if Tilt's Dundonnell wind farm goes ahead, which would require a AUD 60 million equity injection from Mercury. These credit metrics are reasonable and consistent with major peers, but we don't think management should increase gearing much further. With an increasing focus on growth and limited scope to increase gearing, large special dividends and share buybacks are unlikely in the near term.