Gottliebsen's Choice: Is AGL a bargain?

I have long wanted to compare a portfolio of aggressive globalising companies with a portfolio of equally aggressive stay-at-home stocks. Who knows what investment opportunities might be revealed? So I have chosen 26 companies – 13 “stay-at-homes” and 13 “globalisers” and set up a two theoretical portfolios with $10,000 invested in each stock. Every Friday in Eureka report I will analyse one or more of the stocks in the portfolio.

Viewing the portfolios for the first time you will see that I have got the “ stay at homes” off to a bad start by selecting AGL, which this week issued a “surprise” profit warning for 2007-08 and had its share price cut. But I want AGL in the portfolio because it is an energy company that is setting out to make money by adjusting its strategy to what it believes will be the carbon abatement forces set to reshape the energy market.

The AGL downgrade genuinely surprised its chief executive Paul Anthony, its directors and investors. Yet it should not have been a complete surprise to anyone who stood back and thought about recent reports, although I must confess my judgement is (of course) in hindsight. In my experience, rarely are there total surprises from routine operations, although sometimes great wisdom is required to isolate the warning signs. AGL is a valuable study for investors in other companies looking for danger signs. The three most obvious AGL warning signs were:

Complexity: Log on to one of the early pages of the condensed annual report and you will see Paul Anthony’s “mind map”. It is a very cleverly worked out strategy but the various arrows and bubbles show that it is extremely complex. It reminds me of Barry Jones’ famous Knowledge Nation diagram. To achieve the goals in the diagram AGL has undertaken a series of acquisitions and plans more.

Acquiring companies requires great management skill. AGL combined its acquisition strategy with a severe cost-reduction campaign in its retail business: the so called “project phoenix”. This required totally different skills. In other words, Paul Anthony’s mind map was a tough management task.

Inexperience: About 70% of AGL’s top mangers are new appointees as at June 30 2007. Given the difficulty of the task there were clear risks in using a new team, making AGL vulnerable to negative surprises.

Customer drift: The 2006-07 profit met all the analysts’ expectations which on the surface indicated that the company was coping with the difficult tasks. But then deep down in the announcement was the fact that AGL lost about 75,000 electricity customers and about 41,000 gas customers. While this was no disaster it was a warning that the managers might be struggling to maintain the customer base while at the same time re-engineering the operation plus expanding power generation and gas reserves.

So these three signs represented an amber warning light that the chief executive and board did not recognise. The new managers were new their tasks so, with the benefit of hindsight, it was not surprising that it was the retail business where AGL’s profit expectations have proved to be too high.

In addition, the company’s due diligence did not pick up a derivatives problem in one of the acquisitions. This is one of the biggest hazards of companies involved with rapid expansion. Some elements of the print media and institutions are calling for management blood to be spilt. That may well happen but if I were chairman Mark Johnston I would not be hasty unless the latest problems are really only signs of much deeper issues. .

Many leading institutions still have faith and have not downgraded their AGL estimates for the next financial year 2008-09. That’s one reason why the shares recovered. (AGL closed yesterday at $13.32.) And so whereas they expect earnings per share in the current year to be about 80¢ (mid point of the guidance) giving the company a price/earnings multiple of about 16.7 times in 2008-09, they are plumbing for earnings per share of about $1 (which would bring the price/earnings multiple down to about 13.3) and even more profit in 2009-10.

AGL has the opportunity to buy two-thirds of the AlintaAGL business for $1.06 billion in a Russian Roulette deal with Babcock & Brown. Alternatively, it can take $522 million in cash for its AlintaAGL stake. AGL had not made a decision but prior to the “surprise” had been leaning towards being a buyer rather than a seller because it would come close to completing all the market penetration targets that Paul Anthony had set. Now it needs to take great care. But underpinning the group is that is has a series of magnificent assets. If AGL does seriously stumble it’s a prime takeover target. (To read my recent commentary on the AlintaAGL dilemma, Can AGL afford to go green?, click here.)

Paul Anthony thinks that Australia will swing away from coal to gas, so believes the value of eastern states gas is going to rise. I agree. AGL’s biggest risk longer term is its minority stake in the Victorian brown coal power station (which is currently very profitable). But he has also made a plunge into hydro in near the Australian Alps, which requires better rainfall than we have seen recently. If AGL shares are heavily discounted they will represent good value. The current price earnings ratio of about 16.7 means investors are really banking that the company can overcome its management problems and return to its promised 15% growth.

nThe portfolio
Invest $10,000 in each stock. Start the portfolio on October 12
	Price 12/10	No of shares
nGlobal companies
AXA	8.06	1,247
ABC Learning	6.65	1,538
BHP	46.20	216
BlueScope	11.34	888
Brambles	14.32	698
CSL	100.00	100
Cochlear	73.00	137
Centro	8.04	1,244
Computershare	9.68	1,033
GPT	4.91	2,037
LEND Lease	19.84	504
National Bank	41.76	240
Orica	31.31	319
nThe Stay-at-Home companies
AGL	15.63	639
AMP	10.72	933
Bank of Queensland	19.20	520
Caltex	23.83	420
CBA Bank	59.79	167
Futuris	2.05	4,878
Gunns	3.65	2,740
Lion Nathan	9.30	1,075
Metcash	4.60	2,174
Telstra	4.56	2,193
Westpac	29.66	337
Woolworths	31.31	320
Wesfarmers	43.01	233