Origin Energy Extracts More Value But Risks Remain

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

-Addressing declining returns
-Main advantage in gas portfolio
-Volatility heightened for electricity
-Concern over coal contracts
 

By Eva Brocklehurst

Origin Energy ((ORG)) remains intent on extracting higher returns from its utilities business. This was the main message brokers received from the recent energy markets briefing. The company expects to expand gas margins, maintain electricity margins and reduce both operating and capital expenditure, as well as grow exposure to residential solar.

JP Morgan was impressed with the assessment of the core energy markets and how the company intends to address a decline in returns. Cost savings measures appear robust and achievable and the company's attitude to asset sales is rational. On the negative side, the broker expects solar energy will be a drag in the near term and the company's message was similar to that offered by competitor AGL Energy ((AGL)).

Citi suspects a lack of balance sheet flexibility will constrain both growth options and/or returns to shareholders. The company has identified cost savings but these are in the area of lower customer acquisition costs and more low-cost digital interactions with customers. The broker observes the company has the strongest gas portfolio domestically, with a significant competitive advantage, but in electricity markets it is a price taker, using generation to support its retail position rather than earning significant margins. Moreover, Citi suspects the market is already factoring in the company's gas flexibility.

Origin Energy expects some demand growth in the electricity market from LNG, although notes increased solar penetration, energy efficiency and battery storage represent risks longer term. Hence, the company is expanding its solar business and positioning for growth in renewables. The company believes battery storage will take off but will not drive defections from the electricity grid. The company expects oversupply of electricity capacity will produce lower prices at the same time as peaking prices rise for gas generation. Origin Energy considers this a win-win situation, as lower electricity prices are in its favour given it is short on generation capacity.

Citi suspects electricity prices will become more volatile but is not sure the market will play out as the company hopes. Higher gas prices are considered the main cause of higher electricity prices. Higher gas prices mean intermediate gas generation is no longer able to compete with coal. This will produce more short-term price volatility because it is not economic to keep gas-fired generation on stand-by in case of demand spikes, reducing short-term flexibility. Citi emphasises forward electricity prices are a function of supply, demand and volatility.

On the subject of Origin's coal exposure, Credit Suisse notes the company's main supplier has signalled Origin faces price increases of more than 50% over the next few years as legacy contracts roll off. While the broker acknowledges the supplier, Banpu, is incorporating overly optimistic assumptions, what is clear is that legacy contracts were well below export parity. As the domestic market for both gas and coal is stepping up to export parity Origin is poorly positioned, in Credit Suisse's view, with an overweight position in gas amid the expiry of these legacy coal contacts.

New energy is envisaged as a necessary hedge versus the risks to the more material retail earnings. Origin has guided to a net loss of $25m in FY16, in order to create the required scale in new energy. Citi was surprised by the size of this forecast loss, having thought, with 5.0% market share, Origin was doing better on solar. Still a large increase in the cost base shows just what is required to deliver market-leading sales. Citi retains a Neutral rating and believes, while there is longer term value in the stock, it is too early to enter.

Morgan Stanley was a little more positive after the update, expecting the stock price will be driven by the APLNG development over the next 12 months and cost reduction targets are achievable. Where the company differs from competitors is its gas position, in the broker's opinion. Gas margins are growing as Origin Energy can buy cheap ramp-up gas in the market to sell to customers. This is a short term filip. As the Queensland projects ramp up to full production the availability of this gas will wind down. It should still be offset by increased sales volumes to LNG projects at oil-linked prices, with the ability to call any gas back if required to run generators through periods of high electricity prices, Morgan Stanley observes.

After two years of declining energy market earnings Deutsche Bank expects the incremental initiatives will sustain recent momentum, with the first half of FY15 having marked a return to growth in the division. The broker expects higher gas margins will be extracted on account of the company's low-cost legacy gas portfolio. Underpinning the broker's Buy rating is the emerging recovery in utilities and the near-term start of APLNG.

Origin Energy appears to Deutsche Bank to be a net beneficiary of subdued wholesale electricity prices, given relatively low vertical integration. The broker notes expectations for flat electricity margins in the face of subdued demand and increasing wholesale supply. Deutsche Bank also notes the company's increasing solar strategy and focus on power purchase agreements, with break even expected by FY17 and 170MW of solar installations as a FY18 target. 

FNArena's database contains five Buy ratings, two Hold and one Sell (Credit Suisse). The consensus target is $13.50, suggesting 4.7% upside to the last share price. Targets range from $11.00 (Credit Suisse) to $15.80 (UBS).
 

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