In August AGL reported that its underlying EBIT (Earnings Before Interest and Tax) grew by 22% during FY18. The result was driven by gains in earnings from Wholesale energy sales in both gas and electricity markets. However, AGL’s earnings from providing Retail energy to households and other customers declined. The retail energy market was very competitive which meant that wholesale prices couldn’t be fully passed on to household and business customers.
Since the FY18 report, the AGL share price has declined by 12%. Adding back the 63cps dividend, the net decline in value is still 9%. That leaves the securities looking cheap on a forecast 12-month forward price/earnings ratio of 12.3x and a dividend yield of 6.1% (historically 80% franked).
But is that really the case?
The result highlighted the imbalance in Australian energy markets and potentially marked a medium-term high point in the wholesale market price.
Today – the forward energy curve – i.e. the price of contracts for energy to be delivered in 1,2 and 3 years – slopes downward and is below the current price. The implication is that the cost of providing energy to retail distributors will decline over the next two to three years. AGL and the market operating authorities (AEMO and Clean Energy Regulator) expect electricity generation capacity to increase up to 5% as renewable generation projects are brought online over 2019 and 2020.
Whilst that scenario would benefit AGL’s retail business, with its profit margin improving, the pressure will be transferred to the wholesale business and that arm of AGL is a much larger source of profit. Earnings growth expectations for AGL are now lower with the range of consensus expectations at +2% to -2% p.a. to 2021. This, of course, is the cause of the current apparent cheapness.
Therefore, the outlook for AGL has changed over the last 6 months. It has moved from being a company that was perceived to have good earnings growth to one which faces potentially flat or declining earnings over the next two years.
Whilst there is clearly room for consensus to be wrong, the mid-term outlook is moderate. Whether additional capacity comes quickly onto the market or new projects are slowed by construction delays, it seems unlikely that electricity demand will grow by the needed 5% over the next two years – particularly at current prices – to meet the predicted growth in capacity.
Whilst AGL can fund expected dividends, we perceive that if wholesale electricity prices decline more than forecast the share price will likely fall further. It’s a great yield but there are more risks to the value than you might expect.