AGL: Not yet cheap at 75% off

It’s not often that I look at large-cap developed market stocks, but it’s also not often that you see utilities trading down -60% to the broader market in a year. That was enough to prompt a quick look at AGL.

AGL makes its money as an electricity generator and retailer with about a 60/40 split of EBIT coming from the generation business after (crudely) allocating overheads.

On superficial valuation metrics it’s interesting. It has paid out 13% of the market cap in dividends over the past 12 months. You’re not paying a lot for the concrete and steel; it’s trading at a decent discount to pre-writedown tangible book. They’ve guided FY22 EBITDA of around $1,300m. Subtracting out maintenance capex of around $450m gives $850m of EBIT on an enterprise value of around $7bn, so an 8x EV/EBIT multiple. So far so good.

I’ll tidy up an accounting point here. AGL’s EBITDA guidance is really EBITDABA: Earnings before interest, tax, depreciation, amortisation and bullshit accounting.

As part of their big bath writedowns in FY21, they recognised $1.3bn of post tax losses on onerous contracts. Essentially they’ve taken many years of losses up front. It’s beyond me how an ongoing, future cash loss can be written off as an extraordinary item, and I believe that AGL had discretion in applying this treatment. As a result, post tax cash flows will lag profit by $1.3bn over the course of these contracts, the term of which I wasn’t able to find. I’ll adjust by adding that amount to enterprise value which gives an EV/EBIT multiple of closer to 10x.

Regardless, there are much lower expectations baked into the valuation than a year ago, and the reasons are easy enough to grasp.

Wholesale electricity prices are nearly 50% lower than in 2019. Secondly, shareholders are truly losing their minds about AGL’s responses to climate change with some fairly nutty demands:

“Last year, more than 20 per cent of AGL’s investors supported a motion filed by the ACCR calling for the company to bring forward its coal exit plans.” SMH.

AGL doesn’t seem unreasonable in firstly trying to generate value for shareholders from its assets, and secondly believing it’s important to maintain adequate generation capacity to keep Australians’ lights on while we transition to renewable energy. The piece I really don’t understand is why you’d simultaneously remain a shareholder and ask your company to commit to plans to decommission its most valuable assets.

(I don’t actually have a particularly strong view on the environmental aspect, only the shareholder response. It’d of course be better if the coal plants could be decommissioned, but that relies entirely on our having replacement generation capacity as AGL is rightly pointing out.)

The economics have materially worsened for Australia’s biggest CO2 producer while they are simultaneously being ESGed out of existence. That combination of reduced expectations about the business in parallel with idealism-driven selling is what got me interested.

As for the economics, given AGL is leveraged to electricity prices (a relatively fixed cost base plus $3bn of debt) it’s entirely possible that a halving of prices could have reduced the equity value by 75%. But it could be too much.

Having looked closer though, the stock is not obviously cheap. Indeed I wouldn’t be terribly surprised to see another 50% fall from here. The reason is beautifully captured in the CEO’s remarks in the annual report (my emphasis):

AGL Energy has a strongly competitive cost position in electricity generation. However, the lower wholesale electricity price environment has put pressure on the profitability of all generators, at the same time as government policy continues to stimulate the development of new supply capacity ahead of market demand.

That supply picture and the resulting impact on wholesale electricity prices is the key assumption. The market is anticipating that the $58/GWh realised in FY21 is more representative of future pricing than the $100/GWh earned in FY19.

That reduction in electricity prices makes sense in the context of renewable generation capacity having grown rapidly. There is every indication that even more supply will be added in future. Capital will continue to be raised and deployed as long as markets reward companies for doing so.

Companies like Genex in Australia (ASX: GNX) can raise a dollar and turn it into $1.80 of market value by buying off-the-shelf batteries and pumped hydro. And this has plenty of room for this to get crazy. Genex’s Israeli counterpart, Energix (TASE: ENRG), has a USD$2bn market cap, trading at 4x book, buying and deploying solar panels and wind turbines. If you’re a manager of these companies, of course you’re going to raise capital.

It’s very easy to see this turning into a tidal wave of excess supply and crushing prices. Renewable energy is a trendy growth sector with valuation-insensitive government and ESG capital flowing in, and managers being rewarded for growing assets. There are long delays between raising money and completing the assets. Those assets then operate with near-zero marginal costs.

We could see generation expand and prices crash further, and there could still be a pipeline of years’ worth of projects completing into that supply glut.

This growth in renewable supply is no secret, but while researching I had still held out hope that the subtraction of baseload supply, coupled with the increasing mix of high variability renewable generation, might provide baseload power with the opportunity to make decent returns in part by picking up super high prices during periods of electricity shortage.

That also looks very unlikely. I was quite surprised by the slow speed at which coal plants are due to be decommissioned, and there is already enough committed renewable supply coming onto the National Electricity Market to offset the Liddell plant closure. (AGL owns Liddell and Bayswater.)

It gets worse. There’s no relief on the demand side, where supply added by energy efficiency and rooftop solar supply is outrunning demand addition through population growth. There’s also no way that electric cars will soak up that demand in any reasonable timeframe.

Even though AGL has pretty low marginal costs to produce, with fuel costs of around $20/MWh for coal, fossil fuel generation is still the highest cost marginal producer when competing against solar, wind and batteries, with either zero or vanishingly small marginal costs.

Sadly for AGL, thermal coal prices are at all time highs right now. This may well be temporary. But with the approval and funding of new coal mines unpopular, there’s no guarantee that prices will fall even while demand is being subtracted. Supply might be subtracted even faster.

I haven’t touched on the retail side of the business because this all suggests the generation issues are enough to kill the investment thesis. Today’s AGL is a half decent business stuck to a larger, potentially awful one, sharing $3bn of debt. Whatever value in the retail business the demerger might unlock, I expect just as much to be lost on the generation side; a pure-play sin stock with challenged economics and a healthy serving of debt trying to find its way alone in the world.

I came into this analysis expecting to find that investors were over-extrapolating recent poor results and underweighting possible upside cases. I found no evidence of that, and if anything the opposite. I don’t see any opportunity in AGL. It’s difficult to value with precision but it’s certainly not obviously cheap.

My base case is for continued growth in the addition of renewable generation and storage. There’s the potential for a complete bloodbath for AGL if, as the CEO described, valuation-insensitive capital continues to flood the industry. I’ll be steering well clear.