The temptations of Origin Energy
Recommendation
What’s the simplest measure of a good business? Easy, you say: A high return on equity (ROE). Businesses with high ROEs are unambiguously good and those with a low number aren’t.
If only it were that easy. There are two major problems with using ROE this way. The first is that debt, which heightens risk, can supercharge ROE, a point well made in our recent review of Resmed and F&P Healthcare. Debt-free ResMed features an ROE of 14% but debt juices up F&P’s ROE to 23%, despite the fact that ResMed is clearly the better business.
The second problem is that a high ROE only compounds returns if profits can be reinvested. Yet the nature of most high ROE businesses is that they don’t require much capital. IT services and funds management businesses, for example, can generate sensationally high rates of return because they don't require much capital. Yet the capital light nature of those industries also means that profits are rarely reinvested at high rates of return.
Key Points
- Net profit understates performance
- A cheap share price implies scepticism about APLNG
- Sticking with Long Term Buy
This leads to something of a paradox. What if you could buy a business that generates a decent, although not sensational rate of return, but has ample opportunity to reinvest profits consistently at those rates of return? Is that a good business and, perhaps, a good investment?
An impressive record
We’d argue it is, and that Origin Energy is a good example of it. It appears to be a mediocre business: Despite hefty debt levels, ROE climbed from just 2% last year to 6% this year. It’s capital intensive and delivers poor rates of return. On numbers alone, Origin looks more like a steel mill or airline than a genuinely good business.
Now look at it another way. Between 2001 and 2011, Origin grew earnings per share at 17% per year (see Chart 1). Its share price has risen from under $2 at listing in 2000 to $11.47 today and the company dominates the energy retail sector. How does one reconcile these different perspectives? Let's start by investigating two metrics that stand out.
As Chart 1 shows, earnings per share have compounded swiftly. Chart 2 shows that the balance sheet has grown too; assets have grown at 18% per year for a decade. It's clear that Origin has been investing earnings into new assets and, from a higher asset base, it has grown profits. It's been a classic compounding machine, a feat made possible because of the capital intensive nature of the business. A key question is what the rates of return on all that investment have been.
Many would answer that question by turning to ROE. Yet numbers both reveal and obscure the truth. In this case, ROE is based on net profits that, for Origin, are a poor measure of performance because they include items (such as derivative movements) that tell us nothing about the underlying business.
Returns measured on an underlying basis, stripping out the effects of these volatilities, would be more useful and, since so much investment has taken place, debt levels should also be counted. To capture both underlying returns and debt, we'll use return on capital employed (ROCE), which is shown in Table 1.
2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |
---|---|---|---|---|---|---|---|---|---|---|---|
EBIT ($m) | 223 | 284 | 306 | 613 | 710 | 816 | 930 | 766 | 800 | 1,157 | 1,572 |
Equity ($m) | 1,626 | 1,789 | 1,939 | 3,748 | 3,851 | 6,969 | 5,176 | 11,411 | 11,438 | 13,516 | 14,458 |
Total debt ($m) | 650 | 748 | 904 | 2,600 | 2,514 | 3,226 | 3,703 | 3,862 | 3,486 | 5,104 | 6,233 |
Total capital ($m) | 2,276 | 2,537 | 2,843 | 6,348 | 6,365 | 10,195 | 8,879 | 15,273 | 14,924 | 18,620 | 20,691 |
ROCE | 10% | 11% | 11% | 10% | 11% | 8% | 10% | 5% | 5% | 6% | 8% |
At first glance, Origin's ROCE is underwhelming; last year the company generated returns of just 8%, hardly scintillating. Yet this largely reflects growth in capital employed (both debt and equity) which, since 2008, has more than doubled. That growth represents investment in the giant Australia Pacific LNG (APLNG) project that is still under construction. Origin is investing capital into the project but won't earn a return from it until 2015 so, until then, it's a drag on returns.
The point is underscored by looking at ROCE over time. From 2002 to 2008, ROCE average 10% but since then, it has averaged just 6%. Valuing Origin on the basis of today's returns uses incomplete earnings because it neglects likely returns from APLNG. Yet today, that is exactly what the market is doing.
The LNG gap
Origin recently sold a 10% equity stake in APLNG to Sinopec for $1.1bn. This values its existing holding at $4.1bn, or about $3.80 a share. From this, we can impute that the market is paying less than $8 a share for Origin’s retail business, a business that produced operating cashflow of $1.8bn and underlying net profit of almost $900m last year. That translates to a price to earnings ratio of under nine. In comparison, AGL trades on a PER of 17.
Either the market thinks Origin’s retail business is far worse than AGL’s, or it’s not paying up for the value of APLNG. Either way, the stock looks cheap.
For the first time in living memory, the retail power sector faces declining consumption and new regulatory risk. Those are long term changes that will be the subject of a future review. It's unlikely those risks are being priced into Origin's share price yet, and are ignored in AGL's. More likely, the market is sceptical about returns from APLNG.
Our own estimates indicate the project will generate higher rates of return than any other coal seam gas (CSG) LNG project, perhaps between 15%-18%. Origin itself indicates that APLNG will break even at an oil price of US$35 a barrel and earn its cost of capital at US$50 a barrel. It appears an attractive project. So why the concern?
Australian construction costs are one answer. Almost every big project built on the continent in recent years has suffered higher costs. In Queensland, where APLNG is being built, three other CSG LNG projects are also under construction and each has announced a budget blowout. Expectations are that Origin will do the same and lower returns.
Upgrade to Buy?
The decision to upgrade to an outright Buy can only be made if the margin of safety has widened and that depends on two things; risk and price. Origin's share price has certainly marched lower along with other energy stocks; the shares are down 14% so far this year. Yet risks have equally climbed.
The APLNG joint venture has put more work into development studies than its peers and it holds the best quality resources in the sector, indicated by industry-leading production rates, so it is more likely to meet budget than any other project, but higher costs can’t be ruled out. The market may be right. To account for that uncertainty, we're adjusting the limits in the recommendation guide down slightly.
Over the next three years, as project construction continues, capital expenditures will rise and risks will peak. That’s why the stock is cheap today but also why enthusiasm should be tempered. The share price is down 4% since 24 Aug 12 (Long Term Buy – $11.99) and if it fell a further 10%-15% we’d think far more seriously about an upgrade to outright Buy but this isn’t warranted just yet.
Origin remains a LONG TERM BUY for 4% of a risk tolerant portfolio.