Origin Energy under siege - Pt 2

One of the few certainties offered by economics is that electricity consumption rises with population and income. The theory is obvious enough to pass as cliché; more people consume more power and wealthier people buy ever more gadgets, widgets and doodahs that consume more power.

In Australia, that law has ruled for a generation. It was assumed by all, including your analyst, to continue undisrupted and undisputed. Yet, as Francis Bacon reminds us, if a man begins with certainty, he will end in doubt. The old law is no more.

For the first time in living memory, electricity consumption in Australia is falling. If the trend continues, it has significant implications for energy retailers like Origin Energy and AGL.

In Part 1 of this series, we examined the regulatory risks that have frightened the market and argued that, although the risks were real, it had been factored into share prices. Now we turn to the causes, and the consequences, of this new twist. Why are we buying less power?

Economics works

The answer to that question is partly cyclical. Economic growth in Australia is flattered by high mineral prices and an unprecedented mining investment boom. Industrial production, however, has fared less well, falling almost 10% since 2008. Energy demand may rebound as the non-resources economy does.

A larger part of the explanation, however, has to do with dramatic increases in electricity retail prices which have, on average, doubled in six years. Higher prices aren’t by themselves a problem for retailers. They can pass on higher costs to consumers, although, as we saw in Part 1, it can be harder in some states than others. The larger problem comes from how consumers respond to higher prices; they look for substitutes and buy less. Who would have thought it?

Rooftop solar panels (heavily subsidised, of course), have created a power supply beyond Origin’s grip. The number of installations is staggering (see Chart 1). More than 850,000 homes now boast solar panels with an installed capacity of 2.3 gigawatts. According to the IEA, last year more residential solar panels were built in Australia than anywhere else in the world.

Every watt of electricity harnessed from these panels is a watt not purchased through traditional channels. Worse, (as explained in Part 1), the South Australian and Queensland regulators don’t allow Origin to recover the full cost solar panels impose on the system. They are a powerful headwind for the company. As subsidies taper away, growth in solar installations will slow but panel costs are falling dramatically sans subsidies. Solar remains a long term threat.

Households are also pursuing efficiency gains with more rigour than ever before; they are responding to higher prices exactly as one would expect. The combined effects of solar and high retail prices are clear in Chart 2. Consumption per customer has fallen 2.5% in each of the last two years.

Solar panels and the pursuit of efficiency are wonderful things for the environment but hurt the revenues of Origin and AGL. Origin’s recent profit warning focused on regulatory risk but, according to our numbers, more than half the downgrade due to lower electricity demand.  

As long as electricity prices stay high, the pursuit of efficiency is unlikely to go away. Origin charges customers much more for power but it certainly isn’t keeping the extra cash. So who does?

Build it and they will profit

Electricity network businesses, like Spark Infrastructure and its unlisted peers in other states are the prime beneficiaries. They receive a regulated return on every dollar they invest, creating a strong incentive to, politely, keep investments up to date. The critics call it gold plating.

That’s no easy job. The National Electricity Market, into which Origin sells surplus power and from which it buys deficit power, is monstrous. Over 300 generators feed a network that covers 90% of the Australian population via 40,000km of high voltage transmission wires and 750,000km of low voltage wires.

Most important of all are the 1,500km of interconnectors that allow for trade between states on the east coast. The network consumes colossal levels of capital that must come from a relatively small population. The UK, for example, uses half the transmission wiring to service three times the population.

Network costs have been responsible for almost all the increase in retail prices because electrical capacity is built to handle peak demand rather than absolute consumption.

When the weather is very hot or cold, air conditioners fire up, driving up short term consumption time. The network is built to handle such a ‘peak’ event and the peak has been rising even as absolute consumption has been falling. More than half of all network capital expenditure is to maintain demand on the 40 most used hours of the year.

Retailers may have nothing to do with causing higher prices, but they do bear a financial burden through lower demand. The energy retail business isn’t as stable as once thought.

How cheap?

That stability becomes important because Origin relies on cashflow from the retail business to fund its foray into LNG. Lower profits mean cash must come from elsewhere. It’s a key reason why concern about a capital raising persists.

Such concerns are genuinely important, but they need to be weighed against today’s share price, which represents a 20% discount to book value. The stock appears even cheaper when you consider that the retail division houses $12.9bn of assets and $2.4bn of liabilities for implied equity of $10.5bn.

With a market capitalisation of $11.5bn, Origin is trading at just above the equity in the retail division alone. The stakes in APLNG, Contact Energy and the oil and gas division are all valued at close to zero.

Of course, that’s only true if the assets in the retail division are justly represented by book value. We can’t know for sure, but we can look at the division’s return on assets (ROA) to glean if they are being fairly valued.

Out of favour

Last year, the energy retail division earned ROA (measured by EBITDA/Assets) of 12%, which sounds reasonable. By comparison, AGL earns 10% from its generation assets. If Origin were overstating asset values on its balance sheet, returns would look slimmer than they do.

It’s possible that APLNG has a negative value but unlikely. A huge cost blowout or a sustained collapse in the oil price to about US$50 a barrel would be needed for that. There are concerns, such as a changing regulatory environment, falling demand for conventional electricity and worry about the economics of the massive APLNG project that will probably keep the share price low for some time.

For patient investors, it shouldn’t matter. Out of favour it may be, and maligned it may remain, but for the first time in a decade Origin appears genuinely cheap. While the stock is close to being upgraded to an outright Buy, for now, with the share price up marginally since Origin Energy under siege part 1 (Long Term Buy - $10.25), we’re sticking with LONG TERM BUY.