Australia | Nov 20 2013
-Increased focus on generation
-Plan to bid for MacGen assets
-Company transformation potential
By Eva Brocklehurst
ERM Power ((EPW)) has mopped up the minority interest in the Oakey power station and will repay the operation's debt. Full ownership makes life simpler for the power retailer and, despite the expensive price, enables faster utilisation of tax losses and the absorption of Oakey's franking credit balance. Brokers envisage the acquisition, and the announcement that ERM will take part in the bidding for Macquarie Generation assets, puts the company on a path to becoming the fourth largest vertically integrated power provider in the Australian market.
ERM has both power generation and retail electricity assets and is the fourth largest retailer of industrial electricity in Australia. Besides Oakey, it also has a majority stake in Neerabup power station, on the outskirts of Perth, Western Australia. It also has a small gas exploration business. The full acquisition of Oakey, located in the Darling Downs, Queensland, was logical, in Macquarie's opinion. The station is close to the Roma-Brisbane gas pipeline and a number of coal seam gas fields.The price including debt is $72.4m. This may look expensive, being at a 50% premium to previous prices, but Macquarie believes it's justified by the cash flow enhancement. Up until now the income at Oakey was passive, with the majority of the revenue coming from a contract with AGL Energy ((AGK)), which expires December 2014. Now, Oakey is expected to re-contract at least 50% of capacity to ERM's retail arm.
UBS sees more upside than downside for FY15 earnings from the acquisition, but the key to upside is how Oakey is employed after the end of the AGL contract. One aspect, noted by CIMB, is that Oakey, being a peaking power station, has a low annual usage factor. It only operates in times of peak electricity demand. No major maintenance is planned this decade and the useful life at completion of the AGL offtake agreement is likely to be significant. Furthermore, it operates on either gas or diesel, providing flexibility. Yet, given the uncertainty over the demand outlook, CIMB has factored in no upside from re-contracting. Peaking stations earn a return by providing an insurance to power retailers. Macquarie expects that, based on forecast demand for gas in 2015-2018, Oakey is unlikely to be cranked up at power prices below $160/MWhr. The falling electricity demand across the market means the outlook is somewhat challenging, in the broker's view.
The earnings-per-share outcome from the acquisition is likely to be mixed but CIMB expects strong growth in free cash flow, with Oakey no longer amortising outstanding debt and cash tax leakage reduced by the inclusion of the power station in the ERM group. The broker expect this cash to be redeployed in retail sales. Upside is expected to come from share gains in the small-medium enterprise market, the possible de-merger of the gas business and the involvement in the privatisation process of the NSW generation assets.
ERM has confirmed it will engage in the NSW privatisation process and bid for the MacGen assets, alongside AGL and Shenhua. The potential cost is $1.3-1.9 billion. Even via a joint venture that amount is intimidating and likely to hamper the company's near-term share price performance, according to Macquarie. The timetable for final bids looks to be late January. UBS considers such an acquisition, if achieved, would transform ERM. Hence, the broker has revamped valuation models for the company, splitting the power generation from the rest of the business.
Macquarie observes that ERM's interest in these MacGen coal fired power stations comes because of the power surplus it would provide to the group, particularly in NSW. To date, ERM has base and peaking power solely acquired through financial products. Macquarie notes, being short on power has been an advantage when base load power prices are falling. ERM has been able to rapidly grow market share by offering power to customers with limited financial risk. Nevertheless, Macquarie also considers there's a real risk that the company's retail business valuation is overwhelmed by the focus on power production. All up, the size of the investment in MacGen is too large and Macquarie thinks a JV is the most likely way it will pan out, if successful. UBS suggests investors should wait and see how serious a contender ERM is and how it intends to finance such an acquisition.
On the FNArena database ERM Power has one Buy rating and two Hold. The consensus price target is $2.82, suggesting 9.9% upside to the last share price. The dividend yield on FY14 forecasts is 4.5% and for FY15 it is 5.1%.
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