AGL gives shareholders a bargain deal

WITH few prospects for making a profit in present market conditions, AGL shareholders are being offered the rare chance of a sure thing, thanks to the handy discount on the $900 million share raising it launched last week.

WITH few prospects for making a profit in present market conditions, AGL shareholders are being offered the rare chance of a sure thing, thanks to the handy discount on the $900 million share raising it launched last week.

And with a solid yield of about 4 per cent at a time when returns on bank and fixed interest deposits are tumbling, this will provide its shares with downside support.

AGL is issuing shares at a ratio of one for six at $11.60, a discount of about 20 per cent to its retail investors to raise $543 million. The issue closes on June 19. It has already raised $361 million from institutional investors as part of a $900 million raising through the sharemarket for the purchase of the Loy Yang A power station in the Latrobe Valley.

Trading in the rights began uncertainly this week, with some entitlements sold at as low as $2.85 before they closed the gap with AGL shares, trading yesterday at about $3.50, with AGL shares trading at about $14.90, after being suspended for several days after the company received approval to take full control of Loy Yang.

Earlier this year, AGL raised $650 million via a subordinated note issue to part-fund the acquisition, with a sizeable amount of money also needed to prop up Loy Yang's balance sheet. Further subordinated funds are to be raised again later next year, although the amount is yet to be clarified. AGL says the Loy Yang acquisition will be earnings accretive, and brings with it the advantage of enabling AGL to "balance" its electricity market risk in-house, since it will be able to produce most of the electricity it then sells to its customers.

A concern for some investors is that since the power station uses brown coal, it has a big exposure to the carbon tax. To help limit its initial exposure, it is to receive by the end of the month $240 million from the federal government as well as free carbon credits every year from 2014 to 2017. All up, the help package is valued at $1 billion.

But even though securities analysts are unwilling to criticise the company's risk profile openly, the carbon tax exposure means AGL will not be a "set and forget" investment for many investors.

In particular, the value of the asset closer to 2020 is at best uncertain. A high carbon price will affect adversely the future value of the asset although its value could be insulated if the carbon price is weak.

Until then, the outlook for wholesale electricity prices is poor, which may cloud the earnings growth potential of AGL, and its competitors. The closure of the Kurri Kurri aluminium smelter in the Hunter Valley and speculation that the Point Henry smelter at Geelong may also shut, or at least have some of its capacity cut, means electricity demand will remain weak.

Typically, electricity demand grows steadily, broadly in line with the growth of the economy. But that link has broken down over the past year or so. Wholesale electricity demand declined by a steep 5 per cent so far this financial year, even before the large industrial plant closures, and it will fall further.

At the same time, AGL and the other utilities have been hit by weak energy demand due to unseasonably warm weather over the past year, which has also put pressure on wholesale electricity prices as well as leaving all utilities with a surplus of gas, which is weighing on earnings.

But for most stockbrokers, those concerns do not detract from the company's fundamentals.

"It's a quality company. I'd be advising any client in the stock to take up their rights entitlement," Henry Jennings, client adviser at Cameron Stockbrokers said.

Even though AGL's yield is only a modest 4 per cent, which brokers such as Ord Minnett forecast will rise to 5.1 per cent in 2013-14 and 5.7 per cent the year following, it has a healthy cash flow and is paying out only about 60 per cent of earnings.

This leaves it with significant flexibility to fund ongoing capital spending demands internally, or to boost dividends in the future, unlike several other high-yielding stocks, such as Telstra, which are paying out virtually all of their earnings in dividends and left them with limited flexibility.

The Loy Yang purchase will put AGL on a par with Origin Energy, and slightly larger than TRUenergy, in terms of generation capacity.

Origin has a large direct exposure to oil and gas with its extensive exploration and production acreage, which AGL has sought to mimic over the past decade, by building up its own gas exploration and production arm. TruEnergy has "outsourced" its needs by participating in exploration activities of other groups, without building up its own in-house expertise.

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