There’s an old adage that says don’t try to “catch a falling knife”. Leading utility AGL has essentially been in free fall for the last 14 months, and arguably, for the last 4 years. It has been the classic “falling knife”, with very weak bounces, losing almost two thirds of its value over this period. For what was once considered to be a ‘blue chip’ stock, its performance has been terrible.

AGL – 3/16 to 3/21

Ever since it took on the Australian Government, the ACCC, and the community over the closure of the Liddell Power Station, it has been under pressure. AGL’s behaviour so enraged Canberra that it galvanised action with the ACCC to force wholesale power prices down, with consumer prices following suit – now down for each of the last 8 consecutive quarters. Covid hasn’t helped, with prices under pressure due to softer demand, and operating costs increasing.

For a company that makes 83% of its earnings out of generating electricity, mainly from coal, the fall in wholesale prices has been fatal.

But there is another adage that says “every dog has its day”.  So is AGL still a “falling knife”, in which case investors should be patient and wait for definite signs of a bottoming, or is at a “dog” about to see some sunshine?. Let’s have a look at the numbers and what the company is saying.

A disappointing half year with soft outlook

Underlying EBITDA of $926m was worse than expected, and down 13% on the corresponding half of FY20. The underlying profit after tax of $317m, which included $73m of insurance proceeds relating to an outage in Loy Yang in FY20, was down 27%. On a statutory basis, AGL lost $2,827m after booking a write-off of $2,686m for onerous contract provisions and impairment charges.

EBITDA of $926m for 1H21 comprised $911m from its energy generation businesses, $177m from its customer markets division (its retail gas and electricity distribution), and $162m of centrally managed expenses.

Energy generation saw EBITDA decline from $1,027m to $911m, a fall of 11%. Taking out the benefit of the insurance proceeds ($105m pre-tax, $73m after tax), the decline was 21%. Margin, costs and generation volume (down 4%) took their toll.

In the customer markets division, EBITDA declined from $201m to $177m. Despite more customers following the acquisition of Click and Perth Energy, compression in electricity margins and Covid-19 costs hit earnings.

Looking ahead, CEO Brett Redman was quite bearish saying the outlook “continues to reflect challenging market and operating conditions”. For FY21, they have guided to:

• Underlying EBITDA between $1,585m and $1,845m (this implies a second half of $659m to $919m);
• Underlying NPAT of $500m to $580m (this includes an after tax benefit of $80m to $100m from the insurance proceeds, of which $73m was received in the first half); and
• Flat operating costs (excluding Covid).

For FY22, the company expects  a “further material step-down in wholesale electricity earnings” as  older hedging positions progressively roll-off and are recontracted at lower levels reflecting the deterioration in wholesale prices. Further, AGL will not have the benefit  of the $80m to $100m in insurance proceeds.

To address this challenging outlook, AGL is seeking to reduce operating expenditure through  $150m of sustainable cost reductions by FY22. This is in addition to offsetting annual inflation. It has benchmarked its operating costs to FY15 levels, as it says that there is a strong correlation between underlying EBITDA and spot electricity prices. According to AGL, wholesale prices are now at levels last seen in 2015, and hence.: “it is likely earnings will follow”.

It is also targeting a $100m reduction in sustaining capex by FY23.

Analysts are bearish

With 4 out of the 7 major broking analysts holding a “sell” recommendation, the analysts are still bearish on AGL. They do, however, see some value with a consensus target price of $10.95 some 13.6% higher than Friday’s closing price of $9.64. The following table shows individual target prices are recommendations (source: FN Arena).

They expect to see earnings fall in FY22 due to lower electricity prices and higher gas procurement costs. Notwithstanding management’s commitment to reduce operating costs, they remain sceptical as to whether this can be achieved.

For FY21, they expect underling earnings per share of 86.4c (just below mid-range of AGL’s forecast). For FY22, they expect underling earnings to fall to 68.2c per share. This puts AGL on a FY21 price/earnings multiple of 11.2 times, and a prospective multiple of 14.1 times FY22 earnings.

But is there value?

If FY22 proves to be AGL’s earning nadir, then its shares are attractive, being priced on only a 14 times multiple. This will require a trough in power prices, AGL to achieve its cost reduction targets and the replacement strategy for the closure of Liddell in 2023 to be well advanced.

This is what the brokers are effectively saying with their consensus target price of $10.95. However, if earnings keep falling, target prices will be lowered.

The technicians are currently unenthusiastic. To quote the CommSec automated service: “AGL shares appear to be in a long-term bearish trend confirmed by multiple indicators. Long-term, the 200-day moving average is falling and shows that demand for this stock is low. Nearer-term, the 5-day moving average is beneath both the 20 and 50-day moving averages. This is a signal that investors see little opportunity in owning this stock at this time.”

Investors will be compensated by AGL’s high dividend payout ratio, which should stay at 100% of underlying earnings for the next two years. AGL is forecast to pay total dividends of 83.7c per share in FY20 and another 68.3c in FY21. This is equivalent to a dividend yield of 8.7% for FY21 and 7.1% for FY22. These dividends will be unfranked (as AGL has an accumulation of tax losses).

And while the income is tempting, it is not clear what the catalyst might be for the stock to be re-rated. Perhaps a surging local economy could be the support needed to increase demand for energy and put a floor under energy prices.

Bottom line is that while AGL looks attractive and is cheap, I don’t think there is any hurry to invest. I expect the cry to be “prefer others”. For the watchlist.