AGL versus Origin Energy

The evening news won’t teach you much about successful investing. But it will, slowly, imperceptibly, make you more anxious.

Each night, you’ll be told of how America groans under the weight of debt and unemployment; how China’s strength is ailing; and why Japan is still fighting deflation. Then, of course, there’s Greece. Not since John Travolta slipped into his leather pants has the word sounded so scary.

Utilities offer a safe harbour, or so the theory goes. But Australia’s two big electricity utilities—AGL Energy and Origin Energy—are no such thing. In this review, we’re putting them head-to-head to see which stock comes out on top.

Table 1 compares the key financial metrics of AGL and Origin. EBITDA margins are similar for both, but AGL boasts far higher returns on assets. Origin generates higher returns on equity but only because it carries more debt. Origin's raw profit numbers are flattered by several asset sales which make it appear cheaper than AGL. Strip away the impact of those asset sales, however, and the price earnings ratio rises to 16.4. As a convincing coda, AGL is cheaper. On the numbers alone, it wins out.

If AGL is the better business, investors aren’t aware of it. Its share price has performed miserably over the past decade. By comparison, Origin boasts one of the best track records around (see Chart 1). Either Mr Market has been wrong for a decade or other more decisive, but hidden, factors are at play.

It so happens that Origin uses its fleet of generators to produce a lot more power than AGL, 50% more in fact (6,000 mega watt hours, a measure of electricity output, compared with AGL’s 4,000 MWh). That difference is important.

Powerful advantage

The shortfall between what each business generates and what it supplies to customers can be filled in several ways. Most commonly, AGL and Origin enter the National Electricity Market, an almost-national (Western Australia is excluded) market that trades electricity volumes in much the same way as the ASX trades shares.

But buying ‘spot’ (non-contracted) energy from the market is risky because energy retailers must meet demand. If a customer turns on a light switch, they expect light. Trouble is, electricity demand is highly volatile; prices can rise 100-fold when demand is high.

Energy retailers, like farmers and speculators, can enter into hedging or derivative contracts to reduce volatility. Or they can sign agreements with independent generators that oblige those generators to supply a particular quantity of power at a particular price. Both AGL and Origin use both strategies extensively, but exposure to volatile energy prices can’t be eliminated entirely.

That means a company less reliant on power from the market has a huge competitive advantage. Origin scores a giant win here. As Chart 2 shows, AGL generates just 14% of its own electricity requirements. Origin generates 40%.

Both companies have been trying to lift their respective figures. During NSW’s energy privatisation, Origin secured rights to the output of the Eraring power station. This black coal fired plant can increase or decrease output almost instantly, complementing Origin’s other assets that are similarly flexible (see box titled ‘Origin’s asset quality’).

AGL, however, has proposed to buy the giant Loy Lang A brown coal power plant in Victoria. Although this generates about 30% of the state’s electricity and comes with its own almost limitless supply of brown coal, the plant must run constantly regardless of energy prices.

The company has assumed $2.8bn of debt linked to Loy Lang A which, since privatisation in 1995, has had one owner after another, each time at a lower sale price. With a carbon price applying from July this year, its continued operation depends on billions of dollars of government subsidies. AGL appears to have traded one set of problems for another.

Mind the gap

The desperation is understandable. Over the next few years, AGL’s supply contracts with independent generators will start to expire (see chart 3). By 2015, that gap will become a gaping hole.

The Loy Yang A purchase goes some way towards filling it but further asset purchases or capital expenditure will probably be needed to lift energy output. If AGL doesn’t outlay cash, margins will surely shrink as wholesale energy prices rise (see Slowly begins the gas boom from 16 Nov 11).

Origin is far better positioned. Over the past year electricity prices from the National Electricity Market jumped 29%, yet Origin’s energy procurement costs have fallen 10%. Similarly, gas purchase costs fell 16%. AGL, meanwhile, registered increases. These are vital trends; despite increases in the wholesale cost of energy, Origin’s cost of energy has been falling. As wholesale energy prices rise, Origin’s cost advantage becomes ever more important.

Origin wins

Neither Origin nor AGL fit the image of a low-risk utility and, with miserly returns on assets and equity (see Table 1), current returns are underwhelming. Buying either company at current prices requires faith that the future will look better than the recent past. That being the case, the role of management is pivotal.

At Origin, Grant King has spent two decades carefully assembling a high quality asset portfolio with baked-in protection from higher wholesale energy prices. His track record is outstanding. Part of the reason returns appear so poor is because billions of dollars of debt and equity set aside by King for the giant Asia-Pacific LNG (APLNG) project aren’t yet generating returns.

Once APLNG starts production in 2015 (see Origin Energy’s royal suite part 1 on 20 May 11 (Long Term Buy - $16.09)) and those billions start earning a return, profitability will become more obvious. Origin’s share price is down 7% since 13 Dec 11 (Long Term Buy - $14.47) and we recommend you start building a position, starting with 4% of a diversified portfolio. LONG TERM BUY.

The track record of management at AGL is much less compelling. AGL blew billions on the awful acquisition of Alinta, followed Origin a decade later in building coal seam gas resources of questionable quality, and is now taking a large gamble on brown coal generation. The chief executive might be different, but the board remains largely the same.

Returns from AGL are unlikely to improve in the foreseeable future. At current prices, the risks that plague this business, especially over the next two years, aren’t being factored into the price. If you own this stock, we suggest you SELL.