The Heat Is On Origin And AGL

This story features ORIGIN ENERGY LIMITED. For more info SHARE ANALYSIS: ORG

-FY14 forecasts subdued
-Gas demand falls
-Churn and discounting ease
-Benefits in FY15 expected

By Eva Brocklehurst

The two major retailers of gas and electricity in Australia remain despondent. They've had trouble growing business in a market that's been the subject of aggressive price discounting over the past year or so. A warm winter has now affected them by reducing demand for heating, particularly gas. With a hot summer being predicted some clawing back of earnings may be possible as the populace rushes to turn on air conditioning but that's not expected to compensate much.

AGL Energy ((AGK)) and Origin Energy ((ORG)) have both pointed to the dampening effects of the warm winter on FY14 earnings forecasts. Origin declined to make a specific forecast at the AGM but noted that the lagged effects of discounting in FY13 would also delay earnings recovery. AGL's guidance suggests a flat year, with underlying profit forecast in the range of $560-610m. At the lower end of the forecast that's a decline year-on-year around 4.3% while at the upper end it's growth of around 4.2%.

Even with a recovery in electricity demand in summer UBS thinks it won't offset the low consumption of gas during the winter. The broker believes the step down in guidance was driven by lower gas demand, not so much electricity. Both companies have highlighted a surplus gas position which they hope to realise value from by selling into the LNG market. Macquarie expects the earnings impact of AGL's surplus gas in Queensland will more than offset the drag from the loss of the carbon tax benefit – in FY15. For Origin APLNG was the positive story. Origin, which has a 37.5% interest in the venture, reported the project on budget and on schedule. Macquarie notes the risks around the project are starting to diminish with upstream facilities now 50% complete and downstream at 54%. Again, it's not a short-term positive.

Aside from the vagaries of the weather there are other concerns about FY14. Competition for market share remains strong and the margin deterioration that was a feature of FY13 is unlikely to diminish, in JP Morgan's opinion. Benefits of reduced discounting are now expected to take until FY15 to be realised through earnings. BA-Merrill Lynch has made the positive observation that industry churn has slowed, with NSW down to 15% from 18% in FY13. Also, discounts are 10-12% off the regulated tariff against being up to 25% off the tariff a year ago, but they're still there.

Macquarie observes that the variance in AGL's guidance from consensus expectations hinged on the pace of recovery in the electricity markets. The consensus factored in a more optimistic timing. Additionally, in Queensland, the company will benefit from better regulated recovery on costs. Credit Suisse notes, consistent with its surveys, discounting may be easing, but more so in NSW. In Victoria it remains elevated. The broker is also guarded regarding competitive behaviour. Door knocking campaigns may have ceased but other online forms of aggressive and lower-margin customer acquisition are gaining popularity. UBS suspects the acquisition of Australian Power & Gas is likely to end the discounting wars in NSW as AGL has now hit customer number targets. 

The AGMs confirmed Deutsche Bank's suspicions that FY14 will be subdued, but broker believes the drivers of growth for the two companies are materially different. Origin's earnings should improve because of the absence of transmission constraints in Queensland, which affected the FY13 result, as well as a full-year contribution from the Mortlake power station and lower churn in Victoria. AGL's earnings will be driven by a full year contribution from the Macarthur wind farm, improved retail tariffs in Queensland and lower churn in Victoria.

With Origin, Macquarie believes the company avoided giving specific guidance because it lacks confidence in FY14 outlook. The steep discounting has crippled earnings and a rebound is not expected until FY15. One uncertainty for FY15 is the deregulation process in NSW. Origin will be asked to provide a discount to the regulated price. Macquarie estimates a 5% discount could cost $21-28m after tax. CIMB was also unsettled by the lack of detail in Origin's outlook. The company may have noted some improving trends but the decision not to provide guidance leaves the broker concerned abut the sustainability of improvements in the short term. Further afield, with potential retail price deregulation form 2015, upside from more rational competition and improved earnings in the gas business the outlook is considerably brighter for Origin.

UBS is of the mindset that retail earnings disappointment is now priced in. Falling churn rates, scaled-back discounts and increasing retail prices are all positive signs for the industry. This should allow retailers to recover margins lost in the churn battle earlier this year. Discounted contracts are lengthy and the broker does not expect meaningful favourable financial impact … until FY15. 

The FNArena database shows three Buy and three Hold or equivalent ratings for AGL. A consensus target price of $16.33 suggests 6% upside form Friday's closing price. Origin shows three Buy and five Hold. A consensus target of $14.64 suggests fair value.
 

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