Australia | Sep 03 2009
By Andrew Nelson
Origin is a city of two tales, the first is that of an integrated utility company, the second is that of a diversified energy explorer and producer. It has been the company’s diversity, and its status as one of few major utilities around that makes money from pulling energy out of a hole in the ground all the way to allowing customers to pull that same power out of a hole in the wall, that makes it such a tough company for even analysts to get their head around.
Origin has over three million retail customers of gas or electricity in Australia, New Zealand and the south Pacific, providing power to end user customers and sending them a bill for it at the end of the month.
Origin also has conventional oil and gas reserves in the Cooper Basin of South Australia and Queensland and in the Bass strait between Victoria and Tasmania plus coal bed methane reserves in Queensland. Outside Australia, Origin is developing the Kupe gas field in the Taranaki Basin of New Zealand. The company is also involved in the Australia Pacific LNG (APLNG) project with ConocoPhillips, the result of which saw a $9.7bn investment from the American energy major earlier this year for just half of Origin’s coal seam gas assets.
Origin is also a major generator of electricity from natural gas, with power stations all around Australia, and New Zealand via its majority ownership of Contact Energy, which is one of that nation’s leading electricity generation and retail companies.
Keeping this diversity and the resulting synergy it produces in mind always makes the company’s financial and operating reporting an interesting read. Especially when it comes to forming a picture of how all of the various facets come together to produce an overall result. Retail consumption may be low and the competitive landscape tough, but exploration might have been successful and production strong. Sales may be down and customer churn increasing, but production may be up and reserves increasing. I’m sure you get the picture.
So, taking a quick look at the 2009 result is a good place to start in looking at how the company is going and what its prospects are. The outlook was very strong for Origin for more than half of last financial year, with the coffers full from the ConocoPhillips deal and management expecting underlying profit for the financial year to come in approximately 30-40% higher than the previous year. And with the help of the windfall from ConocoPhillips, net profit for the year did jump to $6.94 billion from $517 million the year before.
But the headline number doesn’t tell the whole story. Management started the year predicting a 30-40% increase in net profit, and this was maintained well into the second half of the financial year, but then management issued two profit downgrades and 20% underlying net profit growth is what was achieved. Given the downgrades, at least this was in-line with consensus.
And even this result was more to do with the company’s cash in the bank, with analysts from Deutsche Bank pointing out that without the interest income on the cash proceeds from the APLNG transaction, net profit would have fallen around 10%. On top of that, the FY10 guidance was for only 15% profit growth, which was below the market.
So what’s gone wrong? JP Morgan points a finger at the retail business, which it says significantly underperformed. Retailing conditions were tough and continue to look difficult given churn and margin pressure. Deutsche Bank notes that while customer numbers were steady, a customer mix switch away from higher margin gas customers towards lower margin electricity customers saw a decline in margins.
BA-Merrill Lynch chimes in with a weak contribution from Contact Energy, which was not only a symptom of the weak retail environment, but also suffered from constraints from the company’s South Island electricity generators to its North Island customers. After Contact’s recent report, the general analyst expectation, if not Origin’s, is for Contact to start fixing itself. There are also the weak oil and gas prices that were seen over the course of the year, but again, these factors are seen to be on the mend.
So with tough customer conditions accepted as a given, but improvements from Contact and firmer oil and gas prices expected, why only 15% growth next year? Could it be that management is taking the opposite tack this year and looking to set the bar low in order to easily clear it? Wait a minute. Let’s take a step back. Since when has a prediction of 15% growth been seen as conservative?
The short answer is: it isn’t. And whether a broker has had to revise down its forecasts to bring itself into line with guidance, or whether it was already there, not many are arguing with the 15% growth prediction unless they believe it is too little. And while we’re still 10 months away from 15% growth being in the bag, no matter how you slice it, it ain’t’ that bad.
And that really is the crux of the Origin investment case. There are so many things that are seen as potential positives for the company of late, and so many opinions as to what these positives may generate, that it has become difficult to sort the wheat from the chaff. Yet while there are certainly positives, there are also negatives.
In the FNArena broker universe, there is only one call that isn’t a Buy (and there are seven of them) and that is a Neutral call from Credit Suisse. The broker downgraded down from a Buy back at the end of July on valuation grounds. And given the price was exactly the same the day after the company reported, there was no reason to change the call. What did Credit Suisse mean by valuation grounds? Simply put, the current price was getting close to the broker’s target, so it simply moderated its stance. Why was the price getting close to the target? Because Credit Suisse only assumes 25% probability of success for that second train of the APLNG project.
So with all there is to look at, the broker at that point simplified its outlook to the APLNG project as representing the majority of the potential upside for Origin. However, the plot thickens with Credit Suisse after the FY result. The broker wasn’t that concerned with FY09, it was more focused on FY10, saying earnings will be very sensitive to the company’s $100m five-well offshore drilling program. With Credit Suisse already expecting $50m in exploration write-downs for the year, it feels that if all offshore exploration is unsuccessful, net profit could be impacted by an extra $42m. This, says the broker would drop FY10 forecast by another 7%.
The broker has also lowered its assumed contributions for the new Darling Downs power generation and for Kupe gas to three months contribution in FY10. And Kupe pops up as a niggling problem with a few other brokers. Even management’s not expecting a contribution until after 1H10. But there’s even disagreement here too, with GSJB Were predicting a contribution from Kupe in late January 2010 and JP Morgan in April, not after June, as management and Credit Suisse do.
On the basis of positive contribution from Kupe and Darling Downs, JP Morgan feels that management’s FY10 earnings guidance is a bit on the conservative side, thinking that there is the definite possibility of upside to FY10 earnings if earlier commissioning can be achieved for either project. However, a miss on either could provide some problems. Of the two projects, the broker considers Kupe to be at most risk of a delay in scheduling given the history of capex blow-outs for this project and the more complicated nature of an exploration and production project compared to a power station.
JP Morgan did push though some downgrades to its FY11-12 forecasts, predominantly due to a weaker operational outlook for the retail business, but these downgrades were smaller than they otherwise would have been given the contributions JP Morgan expects from Kupe and Darling Downs.
Another key factor for Origin is the performance and contribution from Contact Energy. GSJB Were sees Contact as struggling until FY11, but then it expects the company’s gas storage constraints will be in hand, seeing the investment become a “positive value driver” for Origin. Analysts at Macquarie and BA-Merrill Lynch are pretty much in-line with this view, believing that there is undoubted medium to long-term value in Contact, but that the shorter-term risks in the stock are stacked to the downside.
Credit Suisse notes that another issue that could impact on earnings is weakness in the average coal seam gas price, which it expects will fall from $3.13/GJ to around $2.80/GJ. But then it also expects the average cost of production to fall to by around $1.30 in FY10, as the company’s growing economies of scale begin to impact. So these factors should balance out.
There’s another big story that is brewing for Origin and it comes as a direct result of its foray into the international world of coal seem gas and the resulting war chest it is sitting on post its deal with ConocoPhillips. It would be an understatement to end all understatements to say that Origin’s funding capacity is strong. Citi estimates the company is sitting on $5.3bn in available funding capacity and while some of that is earmarked for the Pangaea acquisition and the pending tax payment on the ConocoPhillips transaction, the broker still estimates that Origin will have around $4b of liquidity facilities available to it.
So another big question is what will Origin do with all of this money? Wind farms anyone?
Merrills points out that Origin has traditionally invested in wind farms via off-take agreements with third parties. However, management has made clear that with the passing of Canberra’s expanded RET (renewable energy) bill, the company will start building a few wind farms of its own, which would then be retained on balance sheet. Comments like this represent a major shift in the renewable focus for the company, which in the past has bet on gas, and to a certain extent geothermal and solar.
JP Morgan echoes the big balance sheet sentiment, also saying the company is in a great position to maximise acquisition opportunities that may arise in the short-term. The broker’s numbers are a little shy of Citi though, believing Origin has excess balance sheet capacity of around $3bn after taking into account current capex commitments. Only!
However, Morgans is of the belief that the company will probably sit on the sidelines for a while, given the highly uncertain nature of NSW privatisation, so it hasn’t included any possible acquisitions within its forecasts.
BA-Merrill Lynch goes a step further, saying Origin shouldn’t be looking to spend its war-chest at all, but rather salt the money away to alleviate any future funding pressure on APLNG. Such a move would also take pressure off the FY11/12 refinance, when $3.7bn of debt facilities mature. And like JP Morgan, Merrills also thinks it would be a good idea to have some money set aside in case Origin wants to build additional generation capacity if indeed it acquires NSW retail.
Credit Suisse summed it up best when it said a few weeks back that “The market is awaiting marketing agreements for LNG, with ORG expecting non-binding agreements by late 2009/early 2010 and firm contracts around mid-2010.” Really, no matter how you slice it, the future of Origin is all about APLNG.
There’s no arguing that despite how much is going on with Origin, and no matter how much diversity it is presented with in terms of opportunity, the key is putting a value on the coal seam gas assets that it owns with ConocoPhillips. And even importantly in the near-term, placing a likelihood on the LNG production facilities (trains) that will need to be built to bring this gas to market.
The going number is two trains, with analysts either very confident, mixed or sceptical as to when and whether these trains can be brought on-line. Origin is guiding for two with an annual capacity of 3.5 million metric tonnes, with management confident they should begin delivering by 2014.
BA-Merrill Lynch keeps its Buy on the stock while admitting that APLNG still has numerous hurdles to clear, including off-take contracts, as well as physical issues relating to the project, It’s current valuation ex LNG is $14.70 (around the current price), and the broker just can’t expect that investors buying at current prices would be getting a free LNG option, albeit subject to possible delays.
GSJB Were is actually banking the fact that the two LNG trains will be successful and thinks the only things holding LNG upside at bay is a lack of off-take agreements, which it expects will limit the share price until mid-2010, when the stockbroker expects to see confirmation.
GSJBW’s best case scenario for Origin would be an off-take agreement to underpin Train 1 in 2H10. GSJBW thinks that the JV should be aiming for this given scheduled FID is for late 2010.
You can see where this is going, the proposed LNG project with ConocoPhillips represents about the most significant single contribution to the Origin valuation, as it is the most critical catalyst for the future growth of the company. Failure or delay in the progress of the project towards FEED and ultimately FID are a represent about the significant possible downside risk to the company.
So where is Origin headed? That depends on which broker’s opinion you take as to the success and timing of the first and second LNG trains. But while you’re riding the trains, there will at least be plenty of things to watch out of the window.
