A recovering wholesale electricity market has bolstered AGL’s short term earnings profile. The strategy to decarbonise its electricity generating fleet remains undeterred – Liddell has closed with Bayswater (2033) and Loy Yang A (2035) on the clock. Even with a brighter earnings outlook, the financial challenge is large.
Earnings guidance. AGL has narrowed FY23 EBITDA guidance to $1,330-1,375m (previously $1,250-1,375m) with underlying net profit guidance now $255-285m (previously $200-280m).
FY24 guidance has been provided at EBITDA between $1,875-2,175m and underlying net profit of $580-780m.
The increase in FY24 earnings is based on higher wholesale electricity prices, improved plant performance and is partially offset by the closure of the Liddell Power station and higher operating costs. The FY24 guidance is ahead of consensus of $1,743m EBITDA and $560m net profit.
Dividend policy. AGL has adjusted its dividend policy to target a payout ratio of 50-75% of underlying net profit. Previously the payout ratio target was 75% since 2016. The reason for the change is the need to retain capital ahead of the company’s decade-long transition to renewable assets. The question for investors is whether this will be sufficient to fund the extensive capex program, or will the company still need to ask shareholders to contribute? CEO Damien Nicks said: “Our refreshed capital allocation framework and updated dividend policy are focused on striking the balance between investing in the opportunities of the transition, while maintaining a healthy balance sheet and providing appropriate shareholder returns.”
Considering the FY24 guidance, for example, and applying the target payout range at its extremes, AGL will pay a dividend in FY24 between $290m (50% of $580m) and $585m (75% of $780m). The implied retained earnings range of $195-290m will make a modest contribution to the required ~$1.2bn of annual capex required to achieve the transition goal over the next 13 years. This is in addition to the annual $450m-plus in sustaining capex. AGL’s balance sheet currently has net debt of about $2.7bn, so even the most ardent supporter of the strategy must face up to the likely very large capital raising that is looming. According to AGL’s presentation, $3-4bn is to be spent by 2030 with a further $5-6bn by FY36, so the $10bn load is fairly well spread.
It should be remembered only ~5.5 GW of the 12 GW ambition is to be funded from AGL’s balance sheet. The rest will be procured from joint ventures, partnerships and third party offtakes.
In addition, AGL faces a hefty rehabilitation bill in the order of ~$2bn. This includes the Torrens, Liddell Bayswater and Loy Yang power stations as well as a handful of other smaller legacy assets to be retired before 2030.
The Bayswater and Loy Yang A plants generate 28 TWh in a national electricity market of 200 TWh (in FY22) across Australia’s eastern and southern states (Liddell was 7.3 TWh). AGL’s total generation volumes in FY22 were ~37 TWh. The replacement of the thermal assets is therefore not only significant within AGL, but also to the broader economy. In capacity generation terms, AGL’s total installed capacity is 10,330 MW representing approximately 20% of Australia’s total electricity market.
The plan is to invest up to $20bn by building and accessing ~12 GW of new renewable generation and firming capacity before 2036. The initial phase targets up to 5 GW of new renewables and firming capacity by 2030. To meet the interim target, AGL is relying on its existing (already geared) balance sheet plus operating cash flows from the existing (and diminishing) coal-fired generation operations. It will also rely on some projects being backed by offtakes and partnerships.
Investment View
AGL’s mission is to replace its remaining 5.5 GW of thermal coal power generation with ~8 GW of renewables (wind and solar) and ~7.3 GW of firming capacity (grid-scale batteries) by 2035. Its large gas book will also be gradually wound down as electrification of the economy reduces demand. All this will be done while continuing to serve its ~4.3m customers (retail, business and wholesale) and the anticipated increase in demand for electricity over that period.
An overlooked piece of the puzzle is out of AGL’s hands. The transmission network required to connect all the renewable projects across Australia will be a limiting factor on how quickly generating assets can be brought online.
AGL’s latest earnings upgrade is a return to its original FY23 guidance. The upgraded FY24 guidance produced an enthusiastic market response but does not alleviate the long term angst over the capital spending. The lack of an institutional presence on the register indicates a broader scepticism on the company’s strategy.
The earnings rebuild may be a mirage, in our view. At 5.6x EV/EBITDA, investors must consider that capex will be running at 2x depreciation for many years to come and the thermal asset base is already showing its age with regular outages costing $100-200m in recent events. The rehabilitation bill cannot be ignored either.
We have relented on our Sell recommendation to give credit to the better short term earnings outlook, but the stock price has struggled to reach base camp. The climb to the decarbonisation pinnacle looks a step too far, in our view.
Risks to Investment View
Replacing base load thermal generation capacity (and its associated earnings) with variable generation and storage capacity could cause volatility in AGL’s future earnings. Government policy at Federal and State levels has been poorly co-ordinated and there is no certainty on how regulation will look on any time frame. Financing AGL’s plans requires a combination of its own balance sheet and external funding which could fail to achieve the necessary amounts and terms required. In our view, AGL’s plans will require further equity funding at some point in time and this might not be achieved on favourable terms. There is also a risk that the transmission capacity required for the renewable generation may not be available when the assets become ready.
Recommendation
We have lifted our recommendation to Hold from Sell.
Figure 1: AVERAGE WHOLESALE SPOT ELECTRICITY PRICES
Figure 2: EV/EBITDA. AGL IS CHEAP FOR A REASON
