Origin Energy: Result 2013

Origin Energy’s reported net profits would please headline writers but fail to illuminate investors. The statutory net profit – down a shocking 61% to $378m – rarely offers an accurate account of the business. So it was this year. Movements in the value of derivative contracts and restructuring costs from newly acquired assets all featured in the reported number. Free from such shenanigans, underlying net profit fell 15% to $760m. From earnings per share of 69.5 cents, down 16%, a 25 cent interim dividend was declared (unfranked, ex date 27 Aug), bringing full-year dividends to 50 cents per share, or a current yield of 3.8%.

Lower profits were solely the fault of the energy markets division, which generates power and sells it on to consumers. Underlying earnings before interest, tax, depreciation and amortisation (EBITDA) for the division fell 15% to $1.3bn as electricity volumes continued to fall and fierce competition ate into margins.

Underlying EBITDA from the production division and the stake in Contact Energy rose impressively but they are far outweighed by structural difficulties in energy markets, where declining electricity volumes shaved $27m from underlying EBITDA.

Those losses will likely be clawed back as regulators adjust their forecasts for energy volumes. Of more concern is the decline in underlying EBIT margin, from 13.6% last year to 9.6% this year. It suggests competition is intensifying.

More competition

Although Origin's customer numbers were roughly flat over the year, it lost high-margin electricity customers and won lower-margin gas ones, lowering the overall margin. Higher wholesale electricity prices also wiped $100m from underlying EBITDA, while unfavourable regulatory decisions cost the business $110m.

Years of declining wholesale energy costs have attracted new entrants who simply buy energy from the open market and sell it to consumers. These entrants have been aggressive on price, but higher wholesale prices could test their business model. Without their own power generation, they will be forced to pay higher market prices for energy and will struggle to compete with Origin and AGL. In time, higher wholesale prices should reduce competition from small entrants.

Improvement may still take time because lower prices are typically locked in for at least 12 months. Origin has lost about $150m to discounting but we suspect there is irrational discounting in the industry that will ultimately end. We’ll be watching margins in the energy markets business closely.

APLNG progressing

Lower cash flow from energy markets makes funding the giant Australia Pacific LNG (APLNG) project more challenging. To that end, Origin announced it had secured additional debt of up to $7.4bn from a banking consortium. Although Origin needs an additional $4.1bn to complete APLNG, existing debt will need to be refinanced and the new loan takes advantage of low interest rates.

Net debt currently stands at $6.8bn, giving a net debt to equity ratio of 46%, which is at the higher end of our comfort zone. Interest cover of under four times confirms that the balance sheet is finely poised. Next year will be the peak for capital expenditure and cash flow should soar as APLNG starts in 2015, so today’s debt position should swiftly improve.

Although things appear bleak now, pessimism is baked into the share price where there remains little value ascribed for APLNG. At today’s price, Origin trades at a slight discount to book value. We maintain that APLNG should generate a rate of return in the low to mid teens and Origin remains undervalued. The share price is up 14% since 22 Feb 13 (Long Term Buy – $11.36). BUY.

Note: The Growth portfolio owns shares in Origin Energy.