AGL Brightens Outlook With Capital Returns

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

AGL Energy has announced capital management initiatives, welcomed by brokers, and its near-term outlook looks considerably brighter.

-Upgrade of dividend pay-out and buy-back announcement increases confidence in earnings outlook
-Uncertainty over the closure of Alcoa's Portland and/or the Hazelwood brown coal power station
-Share price disconnect from electricity prices over recent weeks seen as a buying opportunity
 

By Eva Brocklehurst

AGL Energy ((AGL)) has announced capital management initiatives at its annual general meeting which are supported by the higher wholesale electricity prices flowing through to customers. The near-term outlook appears considerably brighter to brokers, given AGL is the largest beneficiary of strong wholesale electricity prices, and with the gas business going backwards this year because of increased spot sales at higher prices.

The company has provided FY17 guidance for profit of $720-800m, with contributions expected to come from wholesale electricity margins and the delivery of operational transformation targets. AGL is raising its dividend payout ratio to 75% of underlying profit and targeting a minimum franking level of 80%. This replaces the company's current progressive dividend policy which has resulted in a pay-out ratio of around 60-65% over the past five years. AGL intends to carry out an on-market buy-back of up to 5% of issued market capital (around $600m).

In applying the new guidance to FY17 earnings forecasts, Deutsche Bank estimates a dividend of 84c per share in FY17. The upgrade of the dividend increases confidence in the earnings outlook and while the guidance range is wide, it is not uncommon in Macquarie's view and likely relates to AGL being cautious about the competitive environment. The announcements suggest confidence in the cash flow and probably reflect a recent decision to move from acquiring any of the Alinta assets, Ord Minnett suggests.

There is potential for more buy-backs, brokers believe. Credit Suisse, adjusting for dividends, estimates AGL will generate $600m in free cash flow pre-growth, and $400-450m per annum after growth capital expenditure in FY17-19. The company is pursuing a light approach to renewables and there are limited opportunities elsewhere so Credit Suisse expects more buy-backs.

Capital management was the key issue weighing on broker minds, Macquarie believes, given the disappointment at the final result when nothing was announced. The timing, at the AGM, is ahead of Macquarie's expectations and largely reflects the fade of near-term acquisition opportunities and renewable investment being largely off balance sheet. The broker believes strong cash generation provides scope for the buy-back to continue in coming years and also provides additional flexibility above the current pay-out range.

Deutsche Bank had erased expectations of capital management in 2016, as the company's commentary at the results in both February and August seemed to suggest it favoured a growth focus. The turnabout probably, in the broker's opinion, reflects the 15% sell-off in the stock over the last six weeks, which has made buy-backs a more productive use of cash flow, particularly as the earnings outlook has stayed robust.

Allowing for higher dividends, capital management, and the unchanged credit rating from Moody's, Morgan Stanley estimates there is head room to pursue growth initiatives of up to $2.5bn and looks forward to the investor update scheduled for November.

Recent speculation in the Victorian market regarding potential closure of Alcoa's Portland smelter and/or the Hazelwood brown coal power station continue to provide uncertainty. Macquarie expects the closure of Hazelwood to be brought forward to the second half of FY17 which would be positive for AGL, although the benefit may take some time to be visible as hedging contracts need to be renewed. The closure of both facilities would be a net reduction in generation of 7TWh.

The broker expects that over 2-3 years renewables will start to enter the Victorian market, particularly wind. Given the correlation between wind farms in South Australia and Victoria, price volatility is likely to emerge which the broker expects would favour the tier 1 retailers such as AGL. Deutsche Bank agrees that AGL would be a key beneficiary of any decision to close Hazelwood, given the company's substantial leverage to Victorian wholesale electricity prices.

Equity market and electricity futures have diverged, Credit Suisse observes, which suggests the electricity market is giving more credence to the closure of Hazelwood than the equity market. The broker believes the speculation illustrates the inter-dependency between closure of Hazelwood and closure of Portland smelter, which is commonly cited as a downside risk for AGL. The broker believes divergence between AGL stock and the electricity curve has become too great and upgrades to Outperform from Neutral.

Citi also upgrades its recommendation, to Buy from Neutral, believing the case for higher electricity prices has strengthened, based on the likelihood of a Hazelwood closure and reduced flexibility in gas markets to support peak electricity demand. The broker raises electricity price forecasts by 5-9% for FY18 and 6-25% for FY19. Citi agrees the share price has disconnected from electricity prices over the past month and this provides a clear buying opportunity.

One of the issues Ord Minnett has with AGL's strategy is that it is not necessarily conducive to changing the company's mix in generation and increasing the proportion of renewables. AGL has reiterated that a capacity payment is the best way to incentivise generators to build new renewable capacity but the broker does not believe there are any immediate plans for this to be implemented across the national electricity market. That said, the broker concedes most of the negatives surrounding the stock have dissipated and retains an Accumulate rating.

AGL has five Buy ratings and one Sell (Morgan Stanley) on FNArena's database. The consensus target is $20.10, suggesting 3.7% upside to the last share price. Targets range from $18.13 (Morgan Stanley) to $21.00 (Ord Minnett). The dividend yield on FY17 and FY18 estimates is 4.2% and 4.6% respectively.

Goldman Sachs, not one of the eight brokers monitored daily on the database, believes the capital return sends a clear signal that AGL is no longer pursuing industry consolidating deals and provides some insight into what the company considers is intrinsic value. The broker has a Neutral rating and $19.50 target.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms