Origin's capital call

It was a bold idea from the start. Take gas trapped within coal seams hundreds of metres underground, pipe it to gigantic freezers to be converted into a liquid and then transport it aboard colossal ships to generate power. In Asia. Only 100 years ago, the very notion of LNG would have been considered madness or magic. That perception hasn't completely disappeared.

Origin Energy, which has a 37.5% stake in the Australian Pacific LNG (APLNG) project, is just weeks away from beginning LNG production. Rather than celebrate the achievement, however, shareholders are weary.

APLNG will generate substantial revenues for decades and has contracts in place for 20 years of supply yet the business has taken on enormous debt – which will peak at $13bn – to complete the project.

It was expected that cash flows from APLNG and a stable energy retail business would help to rapidly lower this debt. Instead, cash flows will be far lower than expected because of lower oil prices (see Origin, Santos and the oil price), while Origin's formerly stable retail business is being disrupted by solar panels and lower demand (see Electricity disrupted part one). Less cash flow must now repay a towering debt.

Origin does have additional funding options but, after seeing its peer Santos forced into sell assets and Glencore punished for its dependence on debt, it is taking no chances. It has launched a heavily discounted rights issue to raise $2.5bn from shareholders.

The raising is part of a package of cuts and changes that will, collectively, generate $6.9bn of cash over the next two years. The aim is to lower debt and reduce the risk of forced asset sales.

The offer

A renounceable rights issue will raise $2.5bn by issuing 600m new shares at $4 a share, a heavy 34% discount to Origin's share price prior to the announcement. The institutional part of that placement has already been completed and paperwork will soon reach shareholders asking for their money. Retail investors can either take up their entitlements or sell them in the market. Doing nothing means the company will sell rights on your behalf but you are beholden to the rights price at sale. The details and key dates are shown in Table 1.

The raising is recognition that lower debt is needed. Origin will also cut its dividend from 50cps to 20cps to save $210m a year; it will reduce capital expenditure by about $1bn over the next two years and look to sell about $800m of assets.

Putting it all together with the $2.1bn worth of cost cuts and asset sales already announced, the company will save or raise $6.9bn to help it meet final expenditures and reduce debt. By 2017 we expect debt to have fallen from $13bn to about $9bn.

While these measure reduce the odds of balance sheet problems, Origin can do nothing about the oil price which has been the source of its woes.

Oil price effects

At $100 oil (Australian dollars, Brent), Origin was expected to generate about $1bn in free cash flow per year from APLNG. Instead, in its first year APLNG will record a loss as some costs are recognised upfront and production ramps up slowly. As the project reaches full production by 2017, it should generate about $400m in free cash flow at current oil prices.

With a breakeven of about $35 a barrel, APLNG will still be a decent generator of cash. A large portion of that cash, however, will go towards debt repayments in early years, raising total costs to about $55 a barrel. Shareholders won't see the cash bonanza expected earlier but Origin also doesn't face the existential crisis of, say, Santos.

The big problem now is the dilution caused by raising money at a hefty discount to book value. Net assets that stood at about $14 a share before the raising, for example, are now worth just $10.50 a share because so many new shares will be issued.

The valuation of the business likewise takes a heavy hit. As Table 2 shows, we had roughly estimated Origin to be worth $5 a share in the bear case – that is, with permanently lower oil prices and weaker energy retail earnings – and about $15 in the bull case, where we assume $100 oil and less disruption to the base business.

Lower valuation

Following the capital raising, those numbers fall to about $4 a share in the bear case and $11 a share in the bull case. The base case is likely to fall in between those numbers so, with the share price at around $5.80, Origin appears fairly priced.

There are two sources of potential upside. One is from higher oil prices, which would lift the value of APLNG; the other is the opportunity from lowering Origin's massive debt. The business carries debt worth about $6 a share which cripples value for equity holders. Cash flow that once was risked on new projects will now be earmarked for lowering debt which should help rebuild equity value. Our bull case therefore probably undercooks the long term upside.

Debt repayment, however, is still a long way off and dependent on volatile oil prices so caution is warranted.

Existing shareholders have been burnt by Origin. Our last recommendation to buy in Origin gets an upgrade (Buy – $11.41) has been a shocker but that shouldn't make us reluctant to ever buy this business again.

At current prices, however, with more shares on issue and poor project economics, risks are still high. What about your entitlements? Those who can't stomach further risk can sell their entitlements directly into the ASX and realise real cash to compensate for the dilution. At $4 a share, however, we would rather take them up. Buying at the equivalent of $4 a share could prove a bargain in the years ahead. For investors without entitlement rights, Origin is trading at a small premium to its ex-rights price and remains a HOLD.

Note: The Growth Portfolio owns shares in Origin.