AGL: Result 2019

Fragility isn't the word that leaps off the tongue to describe a business that has just announced net profit of $1bn. Yet that is exactly what AGL is. 

The results themselves were fine, as Table 1 illustrates. Operating profit and earnings per share both rose 2% in competitive market conditions. AGL raised customer numbers on the east coast and the acquisition of Perth Energy should make it more competitive on the west coast.

Peer closer, however, and fragility is clear to see. Profits were flattered because of a one-off provision gain related to labour costs. Without that cheeky gain, profits would have fallen for the year.

Away from the numbers, this is a business under considerable strain. The biggest problem remains the flood of renewable energy into the wholesale market which we have written about in Electricity, disrupted and Has AGL jumped the shark?

Wholesale energy prices have remained high as older generators have closed but renewable projects are plentiful and it's clear they impact the economics of traditional generators. AGL remains heavily exposed to this risk. Regulators are also determined to bring down prices and to integrate renewable capacity. 

Changes forced by the regulator will make famously opaque retail prices more transparent. Historically healthy profits from the sector remain at risk.

This risk is accompanied by high customer acquisition costs and the imminent closure of AGL's largest generator.

Up the risk curve

Structural difficulty is not the only concern. Businesses under strain tend to accept outsized risk and make poor decisions. We note, for example, that cash conversion has deteriorated to 88% of operating profit even though it has historically been strong. 

There are no doubt reasons for this, but it's remarkable how often businesses under pressure discover more profit and less cash at reporting time.

AGL management has made it clear the business requires significant change. Although the mad bid for Vocus has been abandoned, the pursuit of data and energy assets has not. Management confirmed that 'convergence' remains vital for the business.

This may or may not be true. The point is that such a shift changes the risk profile of the business. 

AGL is no longer a steady, utility-like generator and retailer of power. It will morph into a hybrid of more complexity and uncertainty. Shareholders ought to be prepared for this change. 

Poor allocation

AGL's decision to lift the dividend and announce a buyback, despite warning of sharply lower profits over the next few years, is telling. If this were a private business, would the owners really pay themselves more just as conditions threatened to become more difficult?

It appears to us that management are acting to minimise short-term harm to investors rather than to maximise long-term value. They are acting to protect the share price today rather than grow value over the long term. This is hardly the example of management we aspire to invest alongside. 

These results confirm that AGL is under structural strain. It must change but doing so will entail risk for an uncertain return and it pressures management to do something big to fill an earnings hole that has now been confirmed.

There are things to like about AGL: it's scale and customer captivity count for something. This is also a demanding business to run and AGL has a history of managing the details well. Yet the industry is rapidly changing and management offers little confidence that upcoming change will be well managed. There is little to reward to risk-seeking investor, least of all the price. We're switching to AVOID.