Boring Today, In Turmoil Tomorrow

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

By Rudi Filapek-Vandyck, Editor FNArena

In the world of business, change is ever present and constantly lurking around the corner. In most cases, threats can be foreseen and anticipated. Sometimes, though, change comes in the form of a sledgehammer and industry participants do not appear well-prepared at all.

It happened to owners of print media a few years ago. It shouldn't be too difficult for most investors to think back about the time when Fairfax Media ((FXJ)) seemed but an honourable owner of great newspaper assets and its share price was still pleasing long-lasting, loyal shareholders.

The same applies to modern brick and mortar retailers. Can anyone still remember when Harvey Norman ((HVN)) shares hit $7 and nowhere was there any talk about an outdated business model that would not survive the advent of online competition?

Or imagine this one: David Jones ((DJS)) was one of the better performers on the Australian Stock Exchange between 2003-2010. Its total return generated for shareholders over that period was more than twice that of Rio Tinto's ((RIO)), even when the latter had the wind in the sails because of China starting a Commodities Super Cycle^(*).

All these examples have one key factor in common: in all cases the threat was there for everyone to see, but it seemed such a long way off, still, before the threat would start materially impacting on the ruling incumbents, until changes suddenly arrived faster than anyone had anticipated, surprising even the better prepared incumbents and revealing that, in its core, nobody had genuinely prepared for something that was not supposed to impact so quickly.

This is why the boards at APN News & Media ((APN)) and at Ten Network ((TEN)) looked so hapless when their share prices turned from dollars into cents, literally.

All these sectors had one other thing in common: by then significant changes had already challenged and re-shaped their international peers many years earlier.

In other words: it is possible, in many cases, to look overseas and prepare for changes yet to arrive in Australia.

This may well be the case today for Australian companies engaged in generating, distributing or marketing electricity. The fact that the sector, which is largely government regulated, is facing serious challenges is today mostly discussed between industry participants and by a lone market analyst here or there. Public discourse via mass-media channels is largely concentrated on rising prices for consumers and on the potential scrapping of the carbon price by the Abbott government.

Look beyond the surface, however, and there seems to be a lot more going on. A hell of a lot more. In fact, those susceptible to conspiracy theories might well conclude the recent build-up in rhetoric from the Coalition government against costly government sponsored projects that stimulate the usage of renewable energy sources, or against targets and limitations set by the previous government's Renewable Energy Target (RET), are likely nothing but a direct translation of the power sector incumbents' concerns about industry dynamics changing in an unfavourable manner.

Worst case scenario, the likes of AGL Energy ((AGK)) and Origin Energy ((ORG)) might find themselves trapped in government policy that forces them to maintain a high cost power grid, while significant investments in new technologies and to ward off new competitors will eventually become inevitable. A change in pricing differential between coal and natural gas already is restoring coal as the most preferred source for Australia's power grid, with potential closures and write-downs lurking for some of the more expensive gas-fired power plants.

The latter threat will only gain strength if the Abbott government's intention to abolish carbon pricing in Australia does become reality next year. Meanwhile, it's hard to blame the industry for whinging and complaining because the current uncertainties regarding carbon pricing, renewables and the RET are likely to persist for the rest of 2014, potentially much longer.

Investors in the sector today might be comforted by the fact the present government in Canberra is clearly taking a stance in favour and in support of the fossil fuels dominated power incumbents, and we may well experience a medium term setback for renewables as a result, but it remains to be seen whether this is nothing but a delay rather than preventing the type of bigger picture industry changes taking place that today can be witnessed in overseas markets.

In Germany, for example, arguably the market that has enjoyed most government support of solar and other renewables, peers of AGL and Origin have seen their share prices half in value in the years past and the industry has been dramatically re-shaped. A similar change is taking place in California right now.

A recent report by Citi, which has been publishing regularly on these international changes in years past, acknowledges every market is different and has its own internal dynamics, but it also talks about "energy darwinisn in Australian utilities", predicting renewables, smart meters, distributed generation, battery storage, energy efficiency and greenhouse gas reduction measures are all emerging factors that are likely to impact on the sector in Australia in coming years.

As a matter of fact, and mostly outside the scope of most mass-media reports, various companies inside the local industry are already investing in new technologies and making preparations for the changes that are coming because most of tomorrow's changes are already impacting on the power industry today.

As the Citi report highlights, overall demand for Australia's power grid is in decline as rising prices have triggered efficiency measures both among households and in the corporate sector. Growing impact from solar (and other renewables) has already pulled peak demand as much as 9% lower than in previous years and, due to the requirement to keep peak demand capacity in place and spread costs out over all users, this is starting to cost distributors such as AGL and Origin in revenues.

Technological advances in the solar industry have started to catch the attention of private equity and investors in Europe and in the US, as well as from the Chinese authorities. It is now widely believed one of the innovators within the global solar industry will achieve the final break-through at some point in the coming years, the one that makes solar cheap enough to become viable without the need for financial support from governments. As one investor put it to me recently: the trick is to pick the one company that will achieve this and hope it won't be an unknown name that's not on today's list of potential candidates.

Even so, solar already has had a pronounced impact on the Australian power industry as it is. As stated earlier, both AGL and Origin are missing out on potential revenues because off-grid solar has effectively stolen their demand peaks which are now occurring earlier on in the day (cheaper prices) and at levels below what used to be the case (up to 9% lower, according to the Citi report).

The final break-through that is needed will be in energy storage and most power generators, including those in Australia, are looking into new storage applications and technologies. The threat is that improved, cheaply available power storage may not only increase the attractiveness of solar and other renewables, it might also allow users to move away from the existing power grid.

The latter represents a worst case scenario for distributors such as AGL and Origin as it leaves them with rising costs and a shrinking database of customers from which to retrieve those costs.

Citi analysts rightly point out that all these new technologies and potentially changing dynamics both represent threats and opportunities. However, most opportunities seem to come with low barriers for increased competition and thus the risks seem to be skewed to the negative. Customer loyalty towards power retailers is not very high as it is.

The fact that even Telstra ((TLS)) has shown interest in future changes for the industry probably indicates that once the wheels of change have started to rotate at higher velocity, increased competition may well emerge from unexpected corners.

One fact that may have escaped investors (myself included) is that 95% of the 1,000MW of new generation commitment recorded in 2012-2013 relates to wind energy, the remaining 5% is solar. As shown in the chart below, plans to increase further capacity from wind dominate the future in Australia. This may be negatively impacted if and when the Coalition government abandons the RET, while those intentions to add a lot of new gas-fueled capacity are likely to be impacted by rising gas prices (in particular on the East Coast) as well as by the potential abolition of the Carbon Tax in 2015.

Investors should also note that, apart from AGL and Origin, companies specialised in distribution and transmission of power will also be affected, including SP Ausnet ((SPN)), Spark Infrastructure ((SKI)) and DUET ((DUE)).

Admittedly, while all of these industry players are today trialing new applications and technologies, and testing their client base for tomorrow's changing landscape, it is virtually impossible to predict exactly how the future will look like in ten year's time for an industry that has arguably been the most boring and stable in Australia in decades past.

But changes are afoot. It is only a matter of time. According to a former chief of staff at the US Department of Energy: [this] "might be the end of utilities as we’ve known them for the past 100 years".

The Australian stock market already has one company symbolising (and taking advantage of) the changing dynamics within the power industry: ERM Power ((EPW)). Surely it'll be only a matter of time before this company appears on the radar of a larger group of investors, while other entrepreneurs will try to finance their own start-ups?

(This story was written on Monday, 17 February 2014. It was published in the form of an email sent to paying subscribers on the day).

^(*) The comparative "surprise" between shares in David Jones and in Rio Tinto for the period 2003-2010 was first documented by myself in a story titled "A Tale To Remember", initially published as a Weekly Insights on February 28, 2011. It also features as an addendum in my eBooklet from last year, "Make Risk Your Friend. Finding All-Weather Performers". And yes, total returns for David Jones over the seven year period were more than twice as high as Rio Tinto's. In fact, the return from David Jones' dividends alone almost matched the total return generated by Rio Tinto.

PRESENTATION IN SYDNEY THIS WEEK

I have accepted an invitation from the Australian Shareholders Association (ASA) to present this week at the ASA's Sydney Investor Forum. My presentation will commence at noon on Thursday, February 20. It'll be done by 1pm. Venue is the theatre, 1st floor, Sydney Mechanics School of Arts, 280 Pitt Street (near Bathurst Street).

Title of my presentation is "The Share Market: Always Different, Always The Same".

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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