If you live on the east coast of Australia, the big news story last week was soaring electricity prices and the threat of load shedding through power blackouts. In response, the Government, through the Australian Energy Market Operator (AEMO), capped wholesale prices and then suspended the operation of the spot market.
For Australia’s largest generator of electrical power, AGL, this came two weeks after the Board abandoned plans to demerge the business into a “green” business (renewables generation and retail distribution, to be renamed AGL Australia) and a “dirty” business called Accel Energy (coal-fired power generation). Pressure from AGL’s newest and largest shareholder, Mike Cannon-Brookes’ Grok Ventures, plus industry super funds such as HESTA, was too much. Following the withdrawal of the proposal, the Chair, CEO and two Non-Executive Directors fell on their swords, leaving Directors Vanessa Sullivan and Graham Cockroft to review the company’s strategic direction and figure out ‘what’s next’.
AGL is a fascinating case study for investors. From being a market darling five years back and trading at almost $30.00, its share price got absolutely smashed falling to as low as $5.13. Three main factors drove the decline – the flood of new renewables hitting the market which crashed wholesale electricity prices, Covid 19, which softened demand, and ESG-inspired selling. But as Covid-19 eased, demand picked up and wholesale prices moved higher.
AGL – 5 years to June 22
Recognizing that ESG was becoming increasingly important to many investors, plus cognizant of the awful share price performance, the Board conducted a strategic review, leading to the plan to split the company in two.
Last August, when AGL was trading at $7.23, I wrote that “AGL is long past a sell. I think it is in the ‘buy’ zone for long term investors”.
Noting that demergers have a good track record in Australia (that is, the sum of the parts is worth more than the whole), I went on to say: “I think that the demerger should be positive for the stock. As investors narrow in on this in coming months, it will be viewed as a sound way to unlock value and at the same time dealing with the challenges and opportunities presented by the rapid evolution of renewables and decentralised energy technology, as well as changing customer and investor expectations.”
By February, I was a little more cautious. With AGL trading at $6.93, I wrote: “The demerger should be a positive but could be quite messy in the short term. The combined AGL looks cheap when you look out to FY23 and I guess that makes it a hold. But I can’t see a re-rating by the market in the short term, so at current prices, my answer is “prefer others”.
That was two weeks before Brookfield Asset Management (and Grok) lobbed their first indicative takeover proposal at $7.50 per share. This was subsequently revised higher to $8.25 per share on 7 March and then rejected by the Board. On 2 May, Grok announced that it had acquired an 11.28% interest in AGL.
So what were Cannon-Brookes’ (Grok’s) arguments against the demerger, and now that he is the biggest shareholder, where does he see the company heading? What are the opportunities?
Grok opposed the plan on five key grounds:
- One-off demerger costs of $260 million.
- Coal-exposed Accel Energy could de-rate.
- Cash flow headwinds for Accel Energy.
- No green premium for the renewables/retail business (to be called AGL Australia).
- Loss of vertical integration benefits.
There is no argument with the costs, or for the potential for Accel energy to de-rate because of its exposure to coal. That’s expected, but Grok goes on to argue that Accel might also de-rate because its cash flow quality will decline.
Clearly, there is considerable contention over whether there might have been a “green premium” for the new AGL Australia. After all, that was largely the intent of the exercise. Grok contends that a re-rating on improved ESG credentials is unlikely as it will still rely on Accel Energy and its coal generation assets for approximately 60% of its energy following the demerger.
Grok argues that the standalone Accel Energy would be considerably weakened, and at risk of insolvency if various factors play out including unplanned outages in its ageing power stations, increasing coal costs, wholesale price curve exposure and other commitments. Given that it is also worried about AGL Australia’s ‘high debt burden’ and Accel is responsible for the bulk of AGL’s revenue and earnings, these don’t appear to be new factors arising from the demerger.
Potentially, the strongest argument is around the loss of vertical integration benefits. The Board argued that the ‘gentailer’ model (generator and retailer) was no longer fit for purpose and that it was broken. Grok contends that having these together reduces the cost and complexity of risk management (the generator produces the power the retailer needs), but moreover, it can leverage its retail customers to underwrite renewables development. It says that AGL has lost customers and market share to tier 2 retailers because it hasn’t been able to match their “green” credentials.
Grok’s vision for AGL is to be the leader in the energy transition and to leverage its two most important assets – its large retail customer base, and the grid connection from its Bayswater and Loy Yang A power stations. It suggests that the demand for electricity could grow by more than 2.5x by 2050 due to the decarbonisation imperative, and cites an AEMO forecast that by 2050, 75% of dispatchable capacity will be provided by ‘behind the meter’ assets.
Servicing these ‘behind the meter’ assets, essentially homes and businesses that provide solar power into the grid is an opportunity for AGL and why its existing customer base is so important. Grok says that these ‘behind the meter assets’ are unlikely to be self-sufficient with the growing load (they will still need to buy power from a retailer in morning and evening peaks) and that the opportunity for AGL is “deliver low-cost electricity from large scale renewables whilst helping customers to optimise their behind the meter assets to deliver the lowest cost energy to homes, businesses and industry”.
AGL could support its customers in decarbonising their homes and businesses by delivering the best ‘behind the meter’ bundled products (e.g. solar, batteries, EVB charging), energy management software and financing products that help retail customers convert their homes to 100% renewable energy (estimated to cost the average home about $100,000).
Bayswater and Loy Yang A would be closed by 2035, potentially becoming new energy precincts for firmed renewable assets due to their grid connections.
Grok says that the market is more likely to reward AGL if it executes an ambitious plan aligned with the Paris Climate Accord and it will attract a “green premium”. They say: “At a minimum, AGL’s EBITDA multiple could re-rate by 1.0x.”
What do the brokers say?
The analysts at the major brokers are more focussed on the near to medium-term financial outlook for AGL – the production of coal-fired power and wholesale electricity will be the major drivers of AGL’s profitability for many years to come. They are also no doubt influenced by the corporate activity in AGL.
Overall, they are neutral to positive on AGL, with a consensus target price of $9.25, about 10% higher than Friday’s closing price of $8.41. As the following table shows, the range on the target prices is relatively tight – a low of $8.50 from UBS through to a high of $9.92 from Morgans.
Broker Target Prices and Recommendations
On multiples, they have AGL trading at 22.4x FY22 earnings and only 11.8x forecast FY23 earnings. With regard to the FY23 forecast, there is a wide range in estimates – from an EPS (earnings per share) of 50c from UBS through to 93c from Morgans.
Bottom line
During the recent market sell-off, AGL has held up well which suggests underlying demand for the shares. Moreover, further corporate activity (e.g. Brookfield coming back for a third bid or some new entrant) can’t be ruled out.
And despite its current generation challenges (Loy Yang A Unit 2, which was originally due to come back online in August has been delayed until mid-September) and AEMO’s intervention in the market, the short to medium-term profit outlook for AGL is improving. That makes AGL at least a “hold”.
If you can get behind Mike Cannon Brookes’ vision for AGL and his confidence that AGL can re-rate and attract a “green” premium, then it is potentially a “buy”. He has spent about $600 million acquiring his stake, and while that might be loose change for a billionaire, there are worse ideas than “following the money”.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
