Origin and AGL: Result 2014

Rooftop solar panels and falling electricity demand is radically changing retail electricity markets. In Electricity disrupted - part 1 and part 2 we detailed why the sector was changing and how participants would fare. We argued that generators, retailers and distributors all had cause to fret. The release of full year results from industry giants AGL and Origin confirm this to be the case.

Origin and AGL are battling the same problems and, as Table 1 and 2 suggest, they are doing a fine job of hiding the extent of the pain. Underlying earnings per share fell just 5% at AGL and 7% at Origin – hardly reason enough to panic.

A deeper look at divisional results, however, confirms the extent of the problem. Earnings before interest and tax (EBIT) at AGL's retail business fell 10% while Origin's energy markets business – which combines retail and generation – reported a 24% fall in EBIT.

AGL's divisional result was better because it increased volumes over the year. On a per customer basis, EBIT fell 16%.

That was partly because Australian electricity demand fell for the seventh straight year and partly because competition forced margins lower. Both AGL and Origin have accepted lower demand as a structural shift and say they will expand activities in solar, storage and electric vehicle power supply to compensate for lower volumes. This suggests that future cash flows are unlikely to be allocated to generation plants or big acquisitions.

Capping capex

Origin chief executive Grant King was explicit on this point, saying that Origin would limit capital expenditure in energy retailing and pour cash into oil and gas production. This is already happening. Capital expenditure accounts for just 9% of EBITDA in the energy markets business but 75% of production EBITDA.

This is significant. For more than a decade, Origin has deployed vast amounts of capital at decent rates of return in a growing market. Yet the retail market is no longer growing and investment opportunities are now scarce. We should not expect these businesses to repeat the growth of the past decade.

In the years to come, Origin could look a lot more like an energy producer and less like an energy retailer.

AGL, in contrast, will continue to invest in its retail business where it is winning customers and lowering costs. In some ways, its strategy in retail has outperformed Origin's acquisition led one. Faced with fierce competition and lower volumes, however, the retail business will remain a tough one.

Oil and gas difference

The salvation of Origin, and a key differentiator between the pair, is the strength of its production business, which generated $487m in underlying EBITDA, up 23%. In comparison, AGL's equivalent business recorded a small loss. That Origin's result was respectable at all was entirely because of the production business, boosted by higher output and higher prices.

Cash flow from APLNG will increase the gap. The LNG project should generate $1bn in free cash flow for decades starting in 2017. AGL's attempts to mimic APLNG have failed and it is now selling its Bowen Basin gas fields.

Both companies are calling for regulatory assistance to lower the renewable energy target, which has encouraged a large supply of wind and solar power, and to ease regulation in some states. Success in either will benefit shareholders but won't change the industry's structural problems.

AGL's result was, under the circumstances, an impressive one but the caveat dictates the outcome. With the share price down marginally since Electricity disrupted part 2 from 31 Jul 14 (Avoid – $14.77), we recommend you AVOID.

Origin is a more difficult case. Long on our buy list, we downgraded the company as the share price increased but, with LNG cash flow imminent, we'd happily upgrade if the share price fell another 10-15%. The stock is up 4% since 31 Jul 14 (Hold – $14.29). For now, HOLD.