Poor Grant King. Perhaps the longest-serving chief executive of a major Australian business, King has spent over 20 years fastidiously assembling Origin into an energy retail giant with the largest, most flexible fleet of gas generators in the market and the largest number of electricity and gas customers.
It should be a stable, boring business. Instead, it’s been a rollercoaster ride and a money losing recommendation.
Our investment case was that Origin was spending billions to build a two train LNG facility, APLNG, which would be fed by the best coal seam gas properties in the country. While in construction, debt would climb while profits stagnated but, once built, APLNG would deliver bumper profits – about $1bn a year by our estimates – to quickly repay debt and create an energy titan.
Decent result from retail
Losses from gas business
Potential break up
It hasn't happened that way.
What went wrong
Firstly, oil prices collapsed so cash flows from APLNG will be far lower than originally expected. That has been the obvious error. The subtler one was not recognising a structural shift in energy consumption.
Electricity demand, which has been rising every year since records began, declined over the global financial crisis. We thought this was a cyclical impact but, even after the economy recovered, energy demand didn’t.
It is now apparent that electricity has been disrupted, which has reduced the pool of cash flow with which to fund APLNG (for more see Electricity disrupted).
Origin had taken on additional debt to complete the project which was timed perfectly to meet the oil price meltdown. It has been recovering ever since. Judging from its full-year result, that recovery isn’t complete yet.
As always with Origin, statutory profits are best ignored as changes in the value of hedges and foreign exchange hit the income statement directly. Underlying earnings before interest, tax, depreciation and amortisation (EBITDA) fell marginally to $1.6bn and underlying profit fell 41% to $354m.
|Year to June ($m)||2016||2015|| /(–)
|U'lying EBITDA Energy Markets||1,330||1,260||6|
|U'lying EBITDA Gas||386||498||(22)|
|U'lying EBITDA Total||1,635||1,662||(2)|
EBITDA from the retail business rose 6% to $1.3bn but the gas business, which now includes earnings from APLNG, saw EBITDA fall 22% to $386m. Including depreciation and amortisation, the gas business lost about $200m for the full year.
That figure includes just three months’ contribution from APLNG and Origin is now recognising the full burden of costs before counting a full revenue share so this result alone doesn’t reflect the earnings power of the project. But it does illustrate that lower oil prices still hurt.
The gas business now includes over $16bn of assets and is earning a negative return. Even adjusting for full revenue, if oil prices match our expectations (you can read about those here), the return on assets from APLNG is likely to be around 6%.
APLNG is a multi-decade project and it’s too hasty to condemn the entire venture but it does appear that the foray into LNG will, at best, disappoint.
Management has acknowledged as much by suggesting splitting the business into a stable energy retailer and a sexier LNG producer. There is no certainty this will happen but, in our view, it is likely.
For shareholders, a break-up would be a good thing, allowing the retail arm to pay generous dividends and the gas business to grow independently.
As it stands, funding LNG continues to consume cash generated from retail. As a consequence, dividends have been suspended altogether to gather cash for debt repayments. This is the right decision, albeit a late one.
There are things to like about the result: debt fell 30% to $9bn thanks to asset sales and an earlier equity raising; and cash flow, at $1.2bn, was reasonable while capital expenditure has fallen.
Origin’s peaking gas plants will better adapt to a disrupted energy market than competitors' baseload coal plants and Origin maintains its advantage in the generation and transport of gas fuel.
Against these advantages, however, we must consider low returns from LNG and a balance sheet that remains stretched, to put it politely.
Origin should be able to repay debt but an unforeseen oil price decline could imperil the company as it has Santos. This is a better business than many peers and management is sensibly looking at splitting the business. We would consider upgrading at lower prices but Origin isn’t cheap enough today. For now, HOLD.