AGL Energy’s Earnings Have Probably Bottomed; Strong Recovery From 2024 Is Likely

Business Strategy & Outlook

AGL Energy is one of Australia’s largest integrated energy companies. It has a narrow economic moat, underpinned by its low-cost generation fleet, concentrated markets, and cost-advantages from vertical integration. Earnings are dominated by energy generation (wholesale markets), with energy retailing about half the size. Strategy is heavily influenced by government energy policy, such as the renewable energy target. AGL Energy’s planned demerger was scrapped and the firm is undergoing another strategic review, with a focus on decarbonization strategies to keep banks happy. AGL Energy’s consumer market division services over 4 million electricity and gas customers in the eastern and southern Australian states, representing roughly a third of available customers. Retail electricity consumption has barely increased since 2008, reflecting the maturity of the Australian retail energy market and declining electricity consumption from the grid. Despite deregulation and increased competition, the market is still dominated by AGL Energy, Origin Energy, and Energy Australia, which collectively control three fourths of the retail market. AGL Energy’s wholesale markets division generates, procures, and manages risk for the energy requirements of its retail business. The acquisition of Loy Yang A and Macquarie Generation means electricity production significantly outweighs consumption by its retail customers. Exposure to energy-price risks are mitigated by vertical integration, peaking generation plants and hedging. More than 85% of AGL’s electricity output is from coal-fired power stations. AGL Energy has the largest privately owned generation portfolio in the National Electricity Market, or NEM.

Financial Strengths

AGL Energy is in reasonable financial health, but banks are increasingly reluctant to lend to coal power stations because of risks to their reputations. This poses a risk despite the firm’s relatively conservative credit metrics. From 1.4 times in 2020, net debt/EBITDA increased to 2.3 times in fiscal 2022 as earnings fell. Nonetheless, net debt/EBITDA is in line with Australian and New Zealand peers, and reasonable. The rapid improvement to a conservative 1.5 times in fiscal 2024. Funds from operations interest cover was comfortable at 13 times in fiscal 2022, comfortably above the 2.5 times covenant limit, and should remain strong as earnings growth offsets expectations for costs of debt to rise. AGL Energy aims to maintain an investment-grade credit rating. To bolster the balance sheet amid falling earnings and one-off demerger costs, the dividend reinvestment plan will be underwritten until mid-2022. Dividend payout ratio is 75% of EPS, though may be cut to help fund investment in renewable energy.

Bulls Say

As AGL Energy is a provider of an essential product, earnings should prove somewhat defensive.
Its balance sheet is in relatively good shape, positioning it well to cope with industry headwinds.
Longer term, its low-cost coal-fired electricity generation fleet is likely to benefit from rising wholesale electricity prices.

Company Description

AGL Energy is one of Australia’s largest retailers of electricity and gas. It services 4 million retail electricity and gas accounts in the eastern and southern Australian states, or about one third of the market. Profit is dominated by energy generation, underpinned by its low-cost coal-fired generation fleet. Founded in 1837, it is the oldest company on the ASX. Generation capacity comprises a portfolio of peaking, intermediate, and base-load electricity generation plants, with a combined capacity of 10,500 megawatts.

(Source: Morningstar)

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