Origin Energy under siege - pt 1

For a dozen years, Origin Energy’s chief executive Grant King has basked in the glory of ever growing profits; earnings per share growth has averaged 16% per year since the company was spun out of the Boral empire in 2000. That run is coming to an end. For the first time ever, Origin will announce falling operating profits this financial year.

Instead of rising 10% as previously foreshadowed by management, earnings before interest, tax, depreciation and amortisation (EBITDA) is likely to rise just 5% for the year ended 30 June 2013 , leading to a fall in net profit after tax of between 5-10%. The most surprising part of the downgrade is that it has nothing to do with the controversial LNG project and everything to do with changes in the retail energy division.

Energy retailing used to be a stable business. The most important costs—relating to the purchase of wholesale electricity and transmission to end user—are both regulated. When costs increase, Origin is permitted to pass them on to customers via higher retail prices. Despite stiff competition, retail margins are therefore relatively stable.

Two major changes have rocked this cosy arrangement. Regulators are becoming stingier on allowing retailers to recoup higher costs, and the demand for power is falling. Here, we’ll deal with the regulatory changes buffeting the industry. Next week, we’ll delve into important changes affecting power consumption.

Power of the sun

If forced to identify the immediate cause of its woes, management would have all fingers pointed at the sun.

Subsidised rooftop solar panels have been more popular than anyone could have imagined. Their combined electrical output has exceeded all expectations and Origin is being forced to buy this pricey power in order to meet its renewable energy targets. That itself is not the problem; that Origin can’t recover higher costs is.

Apart from Victoria, states regulate the retail price of electricity (and gas). The regulatory process is supposed to take account of all costs, allowing retailers to pass on uncontrollable costs to customers. One such cost is the price of renewable power that retailers are forced to buy.

Origin’s energy costs have soared as it has bought output from rooftop solar panels but some state regulators haven’t allowed it to recover those costs from customers. For the time being, Origin is going to have to wear the difference, a shortfall to net profit of about $40m for 2012/13.

Ordinarily, that shortfall would be recovered in subsequent regulatory rulings. So profits lost today will probably be recouped in the future. That’s what happened in the past. Whether it happens again depends, however, on rational regulation.

Irregular regulation

Regulators in South Australia and Queensland have already made changes to the way they allow retailers to recover costs. As a result, AGL and Origin have stopped competing in Queensland altogether; discounts have ceased and neither is now prepared to invest in new generation capacity. New South Wales, the largest energy market, is expected to make a regulatory ruling in March next year.

The low share price reflects a growing fear of regulatory risk. That is no idle threat. Origin’s business depends on sensible regulation and several recent decisions call that into question.

Almost everyone involved in the industry agrees that the regulatory regime needs reform. One of the key problems is that costs and regulations are imposed from different parties. Although the Commonwealth imposes costs on Origin, the only way for the company to recoup them is through regulators controlled by state governments.

With both intent on lowering energy prices, that spells trouble. Fear may be driving the share price lower, but it is a rational fear.

The Commonwealth government has released a White Paper on power that aims to correct the systemic flaws responsible for today’s uncertainty. It is a clear path for improvement and, if followed, should be beneficial to Origin over time.

Worth buying

Regulation remains a key risk to the business and a good reason to keep a portfolio limit of 4%. But it’s also the reason why an opportunity exits today. Without the fear created by regulatory uncertainty, the stock wouldn’t be as cheap as it is. Origin’s assets are worth more than the market is imputing.

If we conservatively value the equity in APLNG at $3.80 a share (see The temptations of Origin Energy on 15 Oct 12 (Long Term Buy - 11.47)), and the 50% stake in listed subsidiary Contact Energy at $1.90 a share (after applying a 30% discount to the valuation on the New Zealand stock exchange), then the equity in the energy retail business is being priced at just over $5 a share. Add another $2.20 per share for the liabilities (mostly debt) of the retailing business to arrive at an enterprise value of $7.20 per Origin share. In practice, the figure is likely to be even lower but Origin doesn't separate debt from other liabilities at the divisional level. That energy business earned underlying EBIT of $1.3bn last year, or about $1.18 per share.

It may not earn that sum again for some time but trading on an EBIT multiple of 6 or less means it doesn’t have to. A fairly dire outcome for profits is already priced in, even though an unfavourable regulatory outcome is not assured.

There is one more trend that could rock the business; falling energy consumption. We’ll turn our attention to what is driving that trend, how it might impact the industry and whether Origin should be upgraded next week. We're chopping the top end of our recommendation guide to account for lower profits until 2015 but, at current prices, we're closer to upgrading to a Buy than downgrading to Hold. With the share price down marginally since 09 Nov 12 (Long Term Buy - $10.47), Origin remains a LONG TERM BUY.