As it looks to the future and mulls what to do with outdated coal-fired generation, AGL Energy ((AGL)) has decided a separation will be best for all concerned. Management has signalled the split will be internal at first until key details are worked out.
AGL will divide its business into retail, working title NewAGL, and generation, PrimeCo, and finalise the structures during FY22.
There is little financial information regarding the capital structure, offtake (a contract is expected to be struck between the two entities) and final asset allocations, which make it difficult to assess just how investors will greet the decision.
Macquarie suggests AGL is tapping into the growing need for “green”, as being a coal-fired generator it is becoming compromised. Separation ensures there are strong ESG (environmental, social & governance) credentials for NewAGL.
PrimeCo will have the bulk of the business and the polluting element and its influence on the structural changes in energy markets could be stronger as an independent entity, in the broker’s view, promoting a fairer outcome for the orderly closure of thermal coal-fired assets across the National Electricity Market.
Yet Ord Minnett considers it unlikely the retail business (NewAGL) will take significant wholesale price risk by signing long-term power purchase agreements with PrimeCo, and so PrimeCo cannot be structured as an infrastructure asset – with higher gearing and distributions.
So this would leave the latter exposed to spot pricing. Furthermore, the exposure to coal, leverage to wholesale prices and weak spot prices currently makes it difficult for the broker to envisage how PrimeCo can attract investors as a stand-alone entity. Given the challenges, Ord Minnett downgrades to Hold from Accumulate.
Morgans notes AGL did not update earnings guidance at the announcement and conditions remain weak. The draft default market offer prices for eastern states other than Victoria are softer for FY22 and futures prices are well below levels of FY19.
The broker had anticipated that if AGL wanted to split its assets it would need to tie the two businesses through an offtake agreement and this is considered critical to determining the value of each entity. Nevertheless, the broker believes the strategy makes sense, although the devil will be in the detail as to how much PrimeCo will lean on NewAGL before it can be self-sustaining.
Downside risks are envisaged by Goldman Sachs, with increasing capital intensity for NewAGL as well as cost duplication and declining vertical integration. Corporate appeal may increase for NewAGL while the reverse could occur for PrimeCo, which has potential to be considered critical infrastructure that limits foreign ownership options.
Meanwhile, AGL has also bought a 51% stake in Ovo Energy, with an agreement to use its proprietary cloud-based technology platform called Kaluza in Australia. Macquarie notes this is similar to the Origin Energy ((ORG)) investment in Octopus/Kraken. It is unclear whether any licence fees are involved.
NewAGL
Over time, Morgan Stanley expects NewAGL will develop into a carbon-neutral integrated generator/retailer, although agrees the main uncertainty lies with initial offtake agreements. The broker anticipates stable margins and reasonable debt capacity and considers the new entity will be attractive with re-rating potential.
The carbon footprint will drop dramatically for NewAGL as the only emissions will come from peaking generation. Macquarie points out this should immediately expand the investor interest as AGL was considered un-investable in some segments because of the coal portfolio.
Moreover, the shift to firming from just earning baseload generation means the new company is no longer as sensitive to the forward curve. Carbon price risk becomes immaterial. In addition, unplanned outages to the gas fleet will be lower as these are relatively new and more reliable. Profitability will stem from selling variable volume at fixed price and buying variable priced volume.
Earnings growth will come from corporates that explicitly target 100% renewables as well as Victorian and Queensland policies of 50% renewables. Assuming NSW finally gets going, Macquarie calculates the market will need to replace 46TWh of energy from coal generation in the next nine years.
The broker also points out the structural changes will require NewAGL at least to maintain an investment-grade credit rating. To this end, asset sales of $400m have been announced including Newcastle gas storage and Silver Springs, ensuring debt levels will remain flat in FY21.
Yet Crib Point LNG import terminal plans have been rejected by the Victorian government, which Goldman Sachs suggests will probably require AGL to re-position its gas strategy. AGL has estimated total committed expenditure to date is $130m.
Morgans asserts that at current futures prices, NewAGL will need to effectively transfer value to PrimeCo by underwriting its offtake for a period. Still, the broker concedes it possible NewAGL may re-rate higher, given a number of low-carbon listed electricity retailers in New Zealand trade on much higher earnings multiples, although there are major differences between the two markets.
PrimeCo
So, what’s in the deal for PrimeCo which, as Macquarie points out, will now have the largest carbon footprint in Australia from its coal-fired asset base? The broker answers this by noting the same problems shareholders found with the current AGL Energy will be no worse with the new entity.
Index funds will remain key investors as long as the business stays in the ASX100. Customers will include large retailers such as AGL, aluminium smelters and some very large industrial users.
The business is also likely to benefit from the bulk of cost savings, as lower minimum operating levels and potentially idling of generation should lead to lower costs. A growth path is less obvious, although AGL has emphasised the latent value in existing sites where batteries and additional gas capability can be added.
Morgan Stanley notes this could be one of the main benefits of the new structure going forward, yet the business will have rising reliability costs over time, re-contracting pressures and around $1.4bn in rehabilitation costs.
It may be able to negotiate risk-sharing contracts for closure, based on the precedent set by Yallourn for 2028. Morgan Stanley suspects investors will value PrimeCo using discounted cash flows, carbon price scenarios, debt amortisation and near-term un-franked dividends.
If AGL is successful in its separation, moreover, the broker anticipates further thermal generator carve-outs will occur in the industry, but highlights the challenges of limited debt and equity appetite.
Based on current modelling, Ord Minnett estimates PrimeCo will generate earnings (EBIT) of $352m in FY21, falling to $183m in FY22 and $100m in FY23 and assumes 60% of current valuation will come from new NewAGL and the remainder from PrimeCo.
Goldman Sachs, not one of seven stockbrokers monitored daily on the FNArena database, envisages increased uncertainty for investors and continued downside risk to earnings into FY22, retaining a Neutral rating and lowering the target to $10.45.
There are three Hold ratings and three Sell on the database. The consensus target is $10.11, signalling 5.7% upside to the last share price. Targets range from $9.28 (Morgan Stanley) to $11.00 (Ord Minnett). The dividend yield on FY21 and FY22 forecasts is 8.7% and 6.8%, respectively.
