AGL's warm glow

AGL Energy paid a high price for disappointing investment banks last month when it suffered a mini share-price collapse after downgrading its profit outlook to less than what the banks had forecast. This created the perfect opening to buy Australia’s best-placed participant in the gas and electricity market.

From a high of $15.68 the day before the October 23 annual meeting and profit guidance announcement, AGL fell by 5.7% to as low as $14.83 when a projected profit of between $560 million and $610 million was revealed.

Click to enlarge

The forecast indicates that AGL could deliver a mirror-image profit to last financial year’s underlying $585.4 million, which will not be a bad result given an intensely competitive market and a mild east-coast winter that reduced demand for heating.

Most of last month’s selling came from investment banks, whose analysts had been caught by surprise with a profit estimate that was 10% below what they had been telling their clients; which is actually more of a comment on their mistake than the company doing anything wrong.

Since the downgrade on bank expectations, AGL shares have been creeping higher again. They have been trading recently at around $15.10 as investors with an eye for a bargain soak up shares in the energy utility with Australia’s best spread of gas and electricity assets. These include:

• Australia’s biggest wind farm.
• The biggest solar farm.
• The biggest hydro-power portfolio.
• The biggest gas-fired electricity generator.
• The biggest brown-coal electricity generator, and
• Legacy clients built up over 175 years of operation.

Rapid growth has never been a strong point of the business, which for many years behaved like a government-run utility. About seven years ago AGL suffered a series of crises, including ill-timed asset acquisitions, high levels of staff turnover, and missed profit forecasts.

Today, AGL is a near-perfect asset for investors (especially self-managed superannuation funds) seeking safe exposure to the energy sector and a rock-solid return on that investment, which delivered a dividend last financial year of 63c a share from earnings of 108.8c a share – a payout ratio of 57.9%.

The consensus view by analysts is neutral, with 12-month price targets ranging from a low of $15.40 (Goldman Sachs, neutral tip) to a high of $16.90 (J.P. Morgan, overweight tip).

Significantly, all major investment banks and stockbroking firms see AGL’s share price trending up over the next 12-months, which is encouraging for anyone chasing a modest capital gain.

Of greater interest to private investors is that the dividend yield offered at AGL’s recent share price is 4.17% –assuming the full-year’s dividend is held at 63c.

Some analysts doubt that the company will retain its payout rate at 63c. Goldman Sachs reckons the dividend will drop to 59c. UBS is more optimistic, seeing the 63c being maintained on a steady profit, while other banks, such as Credit Suisse and Macquarie, are forecasting a total payout of 65c a share.

NSW unconventional gas squeeze

AGL’s managing director, Michael Fraser, did not include a dividend forecast in last month’s outlook comments, which were part of his presentation to the company’s annual meeting.

Most interest in Fraser’s comments, before and after the meeting, was in the contentious topics of the NSW Government’s freeze on unconventional gas exploration (coal-seam and shale) and the prospect of Sydney and other major population centres facing gas shortages (and/or higher gas prices) as gas produced in Queensland and South Australia is piped north to catch the high prices on offer from the LNG projects nearing completion at Gladstone.

AGL, which is a growing gas producer in its own right, is directing most of its gas into the Queensland commercial sector where it is fetching between $9 and $10 a gigajoule compared with NSW prices of $3 to $4 a gigajoule – a price gap that says more than anything else about the energy crunch heading for Sydney.

Fraser’s frustration with the NSW gas exploration freeze is obvious and easy to understand given that last year the company booked a $344 million write-down on the value of its coal-seam gas assets in NSW because it is uncertain when the gas can be marketed, if ever.

Investors should, however, look beyond the NSW political impasse. That’s what AGL has done with its spread of gas and power interests that effectively cover all bases, even the politically incorrect brown-coal industry of Victoria where the company moved last year to acquire full ownership of the Loy Yang power station.

Optionality, the ability to mix-and-match fuel sources, is what lies at the heart of the business developing inside AGL. And while brown coal might upset some investors because of its status as one of the energy industry’s worst polluters (alongside Canadian tar sands), it is nevertheless a profitable and growing business.

Without realising it, opponents of coal-seam gas (a relatively modest producer of carbon dioxide) are ensuring the long-term future of brown coal because no coal-seam gas in NSW means the essential ongoing demand for electricity from Loy Yang and other brown coal power stations in eastern Australia.

Fraser outlined his policy approach in an interview last week published in The Australian. He described the energy sector as “dynamic, whether it’s market forces or government policy”, making it essential to have power-supply options, which is why AGL has invested across the energy spectrum.

The investment banks will get over their hissy fit and the embarrassment of not spotting the effects of a warm winter on a company selling heating, or the tight margins in the highly competitive energy market, which were the two factors they (not AGL) got wrong by 10% with their profit predictions for the year ahead.

UBS and Deutsche have swallowed their pride and retained their buy ratings on AGL. Goldman Sachs, Credit Suisse, Macquarie, Citi and Merrill Lynch are neutral. No one has a sell recommendation.

The view from UBS is that despite the weaker-than-expected outlook for 2014 it values AGL at $16.67, a downgrade on its pre-profit downgrade of $17.77. Deutsche values the stock at $16.05. Credit Suisse at $15.80, and Macquarie at $16.70.

What all of the investment banks see is a continuation of a solid dividend flow, with only Goldman Sachs suggesting that this year’s payout could be trimmed, though that forecast of a 59c payout is mitigated by a prediction of a big jump in 2015 to 73c a share.

The overall view is that the current dividend yield of close to 4.2% will continue to rise, thanks to AGL’s rock solid cash flows and progressive dividend policy, which should see an investment today yielding up to 5% in 2016.