Hothouse stocks: a year on

Last Christmas we published a special report on the power sector: Hothouse stocks: climate change and the power sector. In it we made some general predictions on the basis that an emissions trading scheme would soon be established: (1) electricity prices would rise; (2) renewable sources of energy would be in demand; (3) owners of natural gas assets would benefit; (4) businesses with high emissions would suffer; and (5) the costs of the system would find their way to consumers through higher inflation.

Individual winners and losers, however, weren’t so obvious. Not only are the precise developments difficult to judge, but stock prices were already reflecting many of the issues (and getting quite carried away with them in some cases), so it was hard to find a decent margin of safety. We therefore shied away from making recommendations and concentrated on flagging up a number of companies for future research.

Well events have rather overtaken us since then and our research efforts have necessarily been focused elsewhere. But those same events have also knocked the share prices of power companies, so it’s worth taking another stroll through the sector.

Interestingly, the two largest companies in our special report, Origin Energy and AGL Energy, have been star performers during 2008, with share price rises of 72% and 13% respectively. But they’ve been very much the exception, with the remaining 12 stocks posting losses, many of them substantial (see table). In most cases, though, this has been due to the general stockmarket malaise and company-specific problems, such as poor management and high levels of debt. Overall, with the government still planning an energy trading scheme for 2010, we remain happy with our predictions – but we still can’t find any opportunities.

Steadying the ship at AGL

AGL Energy provides a sad and cautionary reminder of the dangers that can be inflicted on a company by stupid management. During a brief but turbulent reign, Paul Anthony swapped boring but safe gas pipelines for the more competitive and risky businesses of power generation and retailing. Michael Fraser has steadied the ship after taking control in October last year, but the company has been changed forever.

Michael Fraser’s most important and immediate task has been to reduce debt, and within a couple of weeks of taking charge he saw the back of a large chunk by selling AGL’s one-third stake in AlintaAGL to Babcock & Brown Power (BBP) for $522m. It was an important move because each company had pre-emptive rights over the other’s share, and it would have hurt AGL – and maybe saved BBP – if it had gone the other way.

More asset sales have followed, including AGL’s 27.8% stake in coal-seam gas group, QLD Gas, to BG Group for $1.2bn in October this year. A couple of days later, the company also announced the sale of its 3.6% interest in a PNG gas project for $1.1bn.

An improved balance sheet will help the company expand its clean energy assets, which already include 16 hydroelectric power stations and three wind farms. It also operates two gas-fired and various landfill gas power stations.

So the company is in much better shape, but with its share price up 5% since our last update on 22 Aug 08 (Better Value Elsewhere – $14.15) it’s trading on a PER of 16 times forecast 2009 earnings per share of 90 cents. That’s no bargain, but we’re upgrading to HOLD because of its improved balance sheet and more sensible management.

Origin’s head start

Though AGL is much improved, we still prefer Origin. Led by the impressive Grant King, the company has been building a more carbon- and cost-efficient business for some time, so it has a big head start.

Its foresight paid huge dividends with the recent deal with US energy giant, ConocoPhillips. For selling 50% of its coal-seam gas business, the company received $6.9bn upfront and will get US$2bn on completion of an LNG project in Queensland. ConocoPhillips will also pay for Origin’s share of development costs.

As a result, the company has paid off all its debt, doubled its dividend and has started a share buyback. And even after all that it will be left with enough cash to develop or purchase other projects. The company already has its foot in the geothermal door with an 8% shareholding in Geodynamics and 30% ownership of its operating business.

The implied value of Origin’s share of the joint venture with ConocoPhilips is about $17bn, 24% more than its current market capitalisation of $13.7bn. So either the market is sceptical or it doesn’t respect Origin’s other assets, such as electricity generation and retailing. These collectively earned $650m in the 2008 financial year, so we suspect it’s the former. The share price is down 7% since we downgraded to Sell on 10 Sep 08 (Sell – $16.61) after watching the share price double since our previous full review. But we now think that was a mistake and we’re returning to HOLD.

Debt takes wind out of Babcock’s sails

Babcock & Brown Wind Partners is interesting because it’s already producing renewable energy and is profitable. Its worldwide portfolio of 73 wind farms recorded a 146% increase in revenue in the 2008 financial year to $423m.

And because the company doesn’t pay for its fuel (wind), profits were huge – in 2008 it reported earnings before interest, tax, depreciation and amortisation (EBITDA) of $334m, a margin of 79%.

Being a member of the Babcock family, though, you can probably guess that the company’s Achilles heel is its debt. At the end of June, it had $3.3bn in net debt – three times its equity – and during 2008 it paid $119m in net interest or 36% of its EBITDA, with a further $23m in interest being capitalised as an asset (work that one out).

We used earnings before depreciation to illustrate the company’s cash inflow, but of course it’s very expensive to build and maintain wind farms so depreciation is a major cost. In 2008 the company spent $250m on property, plant and equipment and a further $353m on acquisitions. It’s little wonder it has debt problems.

Hopefully – for the sake of shareholders as opposed to the environment – management will give up on expansion. So far that seems to be the case: in August the company announced the sale of its Spanish wind assets for $1.4bn and in November its Portuguese assets were sold for $998m.

The sales will reduce debt, our chief concern, but the two businesses provided 42% of 2008 EBITDA so future profits will be significantly affected. We’re also worried about Babcock & Brown, the manager and 12% shareholder. So far BBW has been defending the relationship, which soaked up $29m in fees last year, but for us to get interested in this stock we’d need much less debt and a new manager. It has potential but we’re not holding our breath. NO VIEW.

Energy’s methane developments

Founded in 1988 and listed in 1993, Energy Developments is a veteran of the renewable energy sector. Its main business is extracting methane from landfill or mine sites and using it to generate electricity, which it sells along with the green credits it gets for reducing carbon emissions.

The company operates 64 power plants across Australia, Europe and America. In the 2008 financial year, it reported a slight increase in EBITDA to $98m from a 12% increase in revenue to $204m. But as with BBW, the assets are expensive to establish and maintain and capital expenditure was $128m in 2008. On top of this, $26m or 26.8% of EBITDA was gobbled up by net interest, leaving not a lot for shareholders.

The company is trading on a PER of 17 times 2008 earnings per share of 13 cents. That’s not cheap enough for us, especially considering its poor balance sheet, and we’re offering NO VIEW.

Other stocks

Babcock & Brown Power is drowning in debt. With net interest costs of $202m in 2008 amounting to 61% of its EBITDA, the company will do well to survive and we’re not prepared to roll the dice.

Geodynamics is an interesting prospect, but there’s a long way to go before electricity is generated economically from ‘hot rocks’ that are more than four kilometres below the surface in a very remote part of Australia. Transfield Services owns gas power stations but also has too much debt. CSR is a large ethanol producer and also generates renewable power as a by-product of making sugar. However, offsetting this is its aluminium division, which would be one of the most severely affected industries from the introduction of a carbon price. The other companies in our special report are too small for us to recommend, but we don’t see any opportunities in any case.

So, despite the price falls, we’ve failed to find any interesting opportunities in the sector. Ironically, the two best prospects – Origin Energy and AGL, in that order – are the two stocks that have seen their prices rise. The two companies have interesting prospects and, while they’re too expensive for us at the moment, we might get an opportunity if their prices come back a bit. Here’s hoping.