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Morningstar | Origin Looks Reasonable Value in an Expensive Market, But Only for Risk-Tolerant Investors

Origin Energy faces regulatory headwinds and increasing competition in its utility division, while the integrated gas division--mainly comprising the 37.5% stake in Australia Pacific LNG--will do well or poorly depending on oil and gas prices. Overall, we forecast earnings grow strongly this year on higher commodity prices before moderating in subsequent years. Strong free cash flows will mostly be used to pay down debt in the medium term, but once the financial position improves, this money should be redirected to dividends and growth projects.

We make some minor adjustments to our near-term earnings forecasts, mainly incorporating a softer outlook for spot LNG prices. In an expensive market, Origin screens as decent value, trading 5% below our unchanged AUD 7.80 fair value estimate. At the current share price, Origin offers a modest 2.7% fully franked dividend yield, but this is not representative of the firm’s strong cash flows. Its fiscal 2018 proportionate free cash flow yield is around 17%. Origin lacks an economic moat because of higher-cost power stations and subpar returns from LNG export. However, there are positives, such as low-cost gas supply and economies of scale as one of Australia’s largest utilities.

Fiscal 2019 guidance was reconfirmed at last week’s Macquarie conference. Earnings headwinds in the retail part of the utility business include the introduction of retail price caps, increased competition, improved transparency for customers and measures to help concession and hardship customers. Cost-out initiatives will provide modest support to earnings. Focus is on growing new revenue streams, such as Centralised Energy Services. CES provides integrated energy services to large apartment buildings, allowing them to save money by bulk buying energy and sharing infrastructure. It offers electricity, gas, hot water, solar panels, batteries and electric vehicle charging stations.

CES is an interesting business, which should see increasing demand, but is too small to move the needle. Origin’s efforts to sell solar panels and batteries to households is also unlikely to contribute much earnings.

In the generation part of the utility business, headwinds include falling renewable energy credit prices and a wave of new renewable energy supply which is likely to dampen wholesale electricity prices in coming years, thereby leading to lower retail prices. Origin is investing to increase the flexibility of its generation fleet so it can better flex output depending on intermittent renewable output. This will include a range of measures, likely including upgrading thermal power stations and investing in pumped hydro and battery storage. These should prove necessary and worthwhile investments.

In the integrated gas division, APLNG is on track to reduce operating costs to ensure it remains cost-competitive with U.S. LNG to Asia, helped by a material shipping advantage over LNG cargoes coming from the Gulf of Mexico. Spot LNG prices fell sharply since last September, which has likely hurt Origin’s share price. But oil prices and domestic gas prices remain relatively strong, which are more important. Substantial new LNG supply from the U.S. is expected from 2020, which also threatens spot LNG prices. This isn’t a major concern for APLNG as most of its LNG cargoes are sold under long term contracts with oil-linked prices. Additionally, Origin can divert more gas to the domestic market where prices are still strong or save money by cutting back on gas production. APLNG is expected to pay a cash distribution to Origin in fiscal 2019 of AUD 850 million, while retaining some cash to fund exploration and reduce debt.

We remain a little concerned with Origin’s debt levels despite the credit rating agencies’ more positive view. We were a little surprised Origin was recently upgraded to BBB and Baa2 by S&P and Moody’s, respectively. This puts it on par with AGL Energy, despite Origin having much worse credit metrics--net debt/EBITDA of 3.1 times versus AGL at 1.1 times--and more volatile earnings because of its commodity price exposure. The credit rating agencies place significant weighting on strategy, implying AGL’s strategy may detract from credit strength (acquisitions, developments, share buybacks) while Origin’s focus is on further improving credit metrics (paying only modest dividends and keeping a tight rein on costs, including capital expenditure). Over time, this could see Origin and AGL’s credit metrics align.

However, the future is uncertain and without hedging Origin’s commodity price risk, it is materially higher risk than AGL, in our opinion. Debt levels remain high and another oil price crash could see it in trouble again. Perhaps the best strategy for Origin would be to lock in oil price futures for the next few years to guarantee strong free cash flows to pay down debt to conservative levels. The Brent oil price is currently USD 71 per barrel and futures prices fall gradually to USD 61 by 2023. While well south of historical oil prices, futures prices compare favourably to the estimated USD 30 per barrel oil price APLNG needs to cover operating costs and interest expense. We calculate that locking in futures prices for the next four years would provide enough surplus cash flow to halve debt at Origin and APLNG, leaving the firm in good shape to deal with whatever comes.

Origin uses a small amount of hedging in the form of expensive options to limit oil price downside one or two years out. This leaves it fully exposed in case the oil price rises strongly and marginally protected if the oil price crashes. Remembering the horrible experience shareholders went through in 2015, we think management should be more careful.