AGL Energy is on an irreversible journey to decarbonise its generation fleet and at a much harried pace, but the financial implications have become subservient to the ESG agenda. Shareholders should be alarmed at what this transition means in terms of the capital costs and the funding as well as the potential impact on earnings.
Earnings paradox. In FY22, AGL’s underlying EBITDA went backwards to the tune of -27% to $1,218 million while underlying net profit sank by -58% to $225 million. A range of factors contributed to this poor outcome, but the average household and business owner would be totally flummoxed by this given their sky-rocketing power bills.
Consensus forecasts have earnings recovering by FY24f, but this is occurring in a market that is volatile and where energy input costs are uncertain. For FY23f, we already know AGL will be accounting for 2½ months of Loy Yang outage, dismal plant performance in July, the closure costs of Liddell in April 2023, the unwinding of a previous onerous contract provision and the fact the company is largely hedged for FY23f. In addition, higher gas prices on a fixed book against lower volumes could impact on gas earnings.
As earnings recover by FY24f, as assumed by the market, AGL is currently being valued at just 4x EV/EBITDA. FY24f earnings will be dominated by coal-based energy and yet coal producers trade on a multiple of 2.5x.
The first checkpoint will be the closure of Liddell next year taking 14% (1,500MW) out of AGL’s generation pool and being replaced by batteries in Broken Hill and Torrens Island (300MW).
Strategy Review. The replacement of AGL’s sizeable thermal (coal) fleet with renewables and storage capacity is a mind-boggling undertaking just from the physical asset aspect. The ~12GW ‘ambition’ of new renewables and firming before 2036 includes 12 new wind farms the size of the Coopers Gap Wind Farm (452MW), 8 new solar farms the size of the Nyngan Solar Plant (156MW), 14 new batteries the size of the Torrens Island Battery (250MW) and 8 new storage projects the size of the Muswellbrook Pumped Hydro (250MW).
The pathway sets out a 5GW pipeline of new projects by 2030 in a total of 12GW by 2036. This is set against AGL’s FY22 generation portfolio totalling 10.4GW of which 6.4GW is coal-fired power.
Funding these new assets will be well beyond AGL’s internal capacity. The company says it will require a combination of funding sources including partnerships (Tilt Renewables and others), off-take agreements with developers, decentralised energy sourcing from its customers’ own solar and storage assets.
The important point here is that every dollar of outsourced funding will require a return on investment that does not belong to AGL shareholders.
AGL itself has a track record of sourcing capital for renewable projects having raised $3.5 billion of financing (equity and debt) since 2008. Obviously, this is a long way short of the ~$20 billion target now being proposed.
AGL claims that international peers who are transitioning to net zero are achieving a lower cost of capital and a valuation premium as a consequence of their green credentials. The inference that AGL could achieve a similar reward is dubious as interest rates rise, and input costs go up along with labour costs. It is worth contemplating the energy policy environment that pervades this transition which differs markedly between states and the Federal Government. It would also be wise to consider the heavy reliance on China for all the components of a wind and solar strategy.
Rehabilitation costs. Overlooked in the transition story is the cost of rehabilitation of the coal assets. In FY22, this amounted to ~$2 billion for the coal assets based on Loy Yang closing in 2045, not 2035.
Investment view
AGL is a $4.4 billion company planning a $20 billion replacement of its thermal generation capacity in just over a decade. The company will clearly need to seek funding not only from its own shareholders but also from multiple other sources, all of which will require a return on the investment. Internal funding sources would include reconsidering a more appropriate dividend payout ratio.
AGL has become an ideological football for activist investors. The most visible of these is Grok Ventures, the private investment vehicle of technology mogul Mike Cannon-Brookes. Grok has already played a central role in scuppering AGL’s previous plan to separate the company into its generation and retail parts. Grok is actively influencing Board appointments, as it is legitimately able to do as a shareholder, but clearly with nominations that support its own viewpoint.
With the Review of Strategic Direction now public and yet to be voted on by shareholders at the Annual General Meeting, shareholders should have a more informed view of the fundamental changes involved. The opportunity to assess this without the distracting noise of ideologically driven activists in their daily newspaper is to be welcomed.
The only thing we know for sure about AGL is that the earnings from its coal fleet will be gone by 2035. Anti-carbonistas may rejoice but shareholders may not.
Risks To Investment View
Changes in the wholesale electricity and gas prices present operational earnings risks. Government energy policy at State and Federal level presents a large risk as the pathway and timing to net zero creates challenges for the sustainability of Australia’s power grid.
Recommendation
We have retained Sell recommendation.
FIGURE 1: FUTURE GENERATION PORTFOLIO
FIGURE 2: POOL GENERATION FY22 GWH
