Originally published by UBS
We have a strong positive investment thesis on AGL Energy Ltd (AX:AGL). It is predicated on its earnings leverage to wholesale electricity prices which we expect to remain elevated due to tightening supply coupled with a gradual influx of renewables. In addition, we believe retail deregulation, tapering off of per capita consumption declines and a major cost out program will drive retail cash flows and returns. A strong balance sheet and reduced capital expenditure requirements going forward will provide significant potential for capital management.
AGL is leveraged to rising wholesale electricity prices because it generates more electricity than is required by its customer base. It also owns some of the lowest cost generation assets across the network providing a significant cost advantage over its competitors.
The 2017 interim result shows evidence that key parts of our long-term thesis are beginning to come to fruition. Underlying profit was ahead of expectations primarily due to strong performance in wholesale electricity, due to higher prices from tightening demand, despite lower demand due to a mild winter and slow start to summer. A tighter generation market is driving up the wholesale price which has finally started to translate into cash flows, earnings and material return on invested capital. This is evident by our earnings forecasts of 10% p.a. growth out to 2019. It has taken a few years for the high quality generation portfolio of AGL to start reaping robust returns. Loy Yang A was purchased from a distressed seller in 2012 whilst Bayswater and Liddell were purchased in 2014 as part of the NSW government privatisation of Macquarie Generation at a time when the market was in oversupply. It has taken three years for the longer term thesis to start playing out in terms of supply tightening and the 2017 interim result is evidence of this.
We regard the management team highly both from a capital management standpoint and for their forward looking strategies to transform the business to capitalise on new technologies and trends including the move towards large scale renewables (and away from coal fired generation), battery storage as well as smart meters.
Despite strong relative performance of AGL over the past 12 months, we continue to see valuation upside. It remains one of our top portfolio picks as a defensive growth, non-bond proxy stock with well regarded management and a robust balance sheet.