NZ's electric opportunity - part 2

Electricity generators and retailers are under threat. Once thought cash cows, persistently low electricity demand combined with growth in renewable energy – especially rooftop solar power – has smashed industry profitability around the world. We raised concerns back in Electricity Disrupted part one and part two and, in NZ's electric opportunity part one, we looked at the New Zealand electricity market, unique for its high proportion of renewable power.

We recommend reading those articles for a background to the economics of renewable energy and how they are affecting the conventional industry. Now, we'll turn to three recently listed power businesses in NZ – Genesis Energy, Meridian Energy and Mighty River Power.

All three businesses employ the 'gentailer' business model similar to AGL Energy and Origin; they generate their own power, buy and sell power from the wholesale electricity market and retail electricity to consumers.

AGL and Origin generate profit by both generating power and retailing it. They are helped by a favourable industry structure in Australia, where the top three retailers claim an 80% market share. In NZ, five retailers capture 80% of a far smaller market, ensuring fierce competition. Because the NZ industry makes so little money retailing power they tend to make more money generating it.

Meridian Energy, for example, generates less than 5% of operating profits from retailing activities whereas AGL derives 30% of operating profit from retail. Since most profits come from generation, the quality of generating assets is vital. We'll get to those assets in a moment but first, (apologies in advance), we need to insert a note on accounting treatment.

Dam valuation

A quirk of the NZ sector is that all three businesses book the market values of generation assets, a move that has important implications for valuation. Origin and AGL value their generation assets at cost less depreciation so balance sheet values typically understate replacement cost.

The three NZ businesses use independent experts to provide market valuations of their generation assets. Businesses heavy with hydro power are especially prone to revaluing their dams higher, inflating book value. Mighty River Power, for example, values its generation assets at almost NZ$5bn but, if it used the same accounting treatment as Origin, those same assets would be valued at just NZ$1.1bn. We need to be careful when comparing these three to companies in Australia. With that in mind, let's have a look at them in more detail.

Genesis Energy

Genesis is NZ's largest energy retailer with more than 520,000 customers. Although it operates some smaller hydro dams, most of the business's value is tied to its ownership of NZ's largest electricity generator, the Huntly coal and gas power station, which is capable of supplying up to 20% of the country's electricity.

As we explained in part one, 70% of NZ's power comes from renewable energy which attracts low marginal costs. Since the wholesale market will dispatch the lowest cost power first, Huntly, which must purchase expensive fuel, is often uncompetitive against plentiful renewable energy.  

Genesis has already mothballed half its original coal-fired generation units – an admission that Huntly was built for very different market conditions. As NZ's largest polluter, the plant attracts plenty of controversy and has been threatened with closure although low coal prices and a lack of substitutes mean the plant is hard to replace and it's still potentially valuable if water storage levels are low or electricity demand spikes. We're not prepared to write the asset off just yet.

Uniquely, the company also has a 31% stake in a large NZ gas field, Kupe, which generates about a quarter of the company's profit. Although Genesis collects profits from Kupe, it doesn't reinvest in renewing gas output, instead electing to pay dividends. Kupe gas will run out in 15-20 years and Genesis has no resources to replace that output. A yield of nearly 9% is inflated and may not be sustainable.

Genesis compares poorly to its peers on profit metrics, generating return on equity of less than 3% and earning less than half as much revenue per customer as Meridian.

Yet there are things to like: aided by Kupe, the company generates high cash flow and Huntly offers options to increase profit. We suspect the company can lift profits with some tweaking.

The company's generation assets carry a market value of NZ$2.6bn compared to an enterprise value of NZ$3bn. This suggests that the retail business and the stake in the Kupe field are being valued at just NZ$400m. The retail arm has an enormous customer base but earns little cash; the Kupe stake is stunningly profitable – it made about NZ$45m in pre-tax profits last year – and appears undervalued. Of the three businesses here, Genesis looks the cheapest if we assume no further writedowns for Huntly.

Braver investors might leave it at that and jump in now but we'd like to see a fresh set of results before upgrading. We're initiating coverage of Genesis with a HOLD and will be doing more work on the value of Huntly.

Meridian Energy

Meridian is the largest generator in New Zealand, typically generating a third of all of NZ's power – and it proudly reminds investors that it's all 100% renewable.

Although it has the fewest retail customers of the three, Meridian generates more profit than its peers by selling surplus power. This is a great strength when weather conditions are favourable but, because it depends so heavily on hydrology and wind conditions, earnings from its seven hydro stations and seven wind farms can be volatile. Over 90% of profits typically come from generation activities. With water flows currently above historic averages, we wonder whether Meridian is benefiting from benign conditions.

So significant is Meridian's generation activity that we'd classify it as a cyclical business, dependant on power consumption from NZ's manufacturers and farmers. The potential closure of a local aluminium plant, the largest single power user in NZ, would hurt, although no decision has yet been made.  

The company's valuation isn't straightforward. Although an EV/EBITDA multiple of 10 doesn't sound obviously cheap, things look more interesting on an asset basis. Generation assets that are worth NZ$2.8bn on a cost basis are booked on the balance sheet at NZ$6.1bn, suggesting the company's dams and wind farms are worth more than its enterprise value.

We're not quite comfortable with that appraisal. Wind asset values depend on regulatory rulings and we note that, at over 10% of revenue, Meridian spends far more cash on capital expenditure than its peers. The company has also been aggressive with volume estimates and a long dry spell, should it come, could lower asset values. This is still a business to watch and we'll keep an eye on its full-year result. For now, we're introducing Meridian with a HOLD.

Mighty River Power

In many ways, Mighty River is the most attractive of the three businesses because it generates 40% of its total power output from geothermal sources. Just 2% comes from a gas plant near Auckland that only fires up when energy prices are high and the remainder comes from dams along the Waikato river system.

Whereas hyrdo power depends on water flows and typically produces energy when prices are low (water flows tend to affect many dams at once), geothermal power can operate at full capacity almost 100% of the time, irrespective of climate. It can therefore take advantage of energy price spikes. A return on equity of 7%, 50–100% higher than its peers, suggests the company has been able to capture peak prices successfully.

Mighty River has completed three new geothermal plants, increasing capacity from 500Gwh (gigawatt hours) in 2008 to 2,185Gwh last year. With significant capital investment behind it, free cash flow should now start to build.

The success of the business, however, is already reflected in the price – the company trades at a healthy premium to book value and, on an earnings basis, an EV/EBITDA multiple of 11 is dearer than the rest of the industry. On the balance sheet, Mighty River's generation assets have been revalued from NZ$1.1bn to NZ$5bn. With an enterprise value of NZ$5.4bn, the market is implying that either asset values will rise or that the retail business is worth NZ$500m.

As Mighty River doesn't break down its retail earnings, it's impossible to determine whether that is a reasonable claim but we are reluctant to pay for higher asset values. That said, it's a reliable cash generator and its 4.5% dividend yield appears sustainable. For those reasons, we're starting coverage with HOLD

It is rare for investors to come to a business and decide to buy it on first glance. More often, we learn about businesses over time and, when the opportunity is ripe, take action. That's the idea here. We would be enthusiastic buyers of these three businesses if they traded at a discount to book value but, at current prices, we're reluctant to take the leap.

Mighty River is arguably the highest quality, but it is priced as such. Genesis is cheapest and Meridian also warrants further inspection; both stocks are close to upgrades. Having done the analytical work, we'll now employ patience and await our opportunity.