By Paul Rickard

While it is not exactly unusual for a stock to trade at a 11% discount to the broker target price, it is getting on the high side and shareholders (and Boards) should ask questions as to why. In this category is energy generator and retailer AGL.

AGL’s share price closed yesterday at $24.20. According to FN Arena, this represents a 10.7% discount to the consensus broker target price of $27.10. It is also a 14.8% retreat from the share price high of $28.42 achieved in April this year.

And although utility stocks have eased in general, I think one of the key reasons for its underperformance is that CEO Andy Vesey overplayed his hand with the Federal Government over negotiations for the Liddell power station. AGL’s refusal to consider selling Liddell was one of the factors that drove the Government to adopt its National Energy Guarantee (announced on Tuesday), which is the long run, will hurt electricity retailers such as AGL.

Vesey argued that it would cost AGL hundreds of millions of dollars to keep the fifty year old Liddell power station operating past its targeted shut down date of 2022, and that producing electricity from coal was not part of AGL’s go forward plan. Further, AGL could make up the shortfall through other sources including green energy.

He may be right about the cost of keeping the ageing Liddell operating, but it was his refusal to consider putting it up for sale and testing whether another operator wanted to try their hand that really got up the Government’s nose. After all, AGL effectively bought Liddell for just $1 (plus the cost of remediating the site) when it purchased Macquarie Generation from the NSW Government in 2014.

If AGL doesn’t want to run Liddell, why not see whether there is a willing buyer who might pay $1 or more for it?

Of course, Liddell is not AGL’s only fossil fuel power station. There’s the main asset of Macquarie Generation, black coal Mt Piper in NSW, the brown coal Loy Yang in Victoria, and the gas fired Torrens in SA. AGL doesn’t want a competitor undermining its position as an integral supplier of base load power to the grid.

Vesey has painted a wholly different picture for AGL as it exits the generation of electricity from fossil fuels by 2050. In the future, AGL will not only be producing and distributing green energy, but it plans to be a service provider to its customers, helping them to store and produce their own roof top solar, use smart meters in the household to optimise demand and manage devices, and potentially, operate charging stations for battery operated vehicles. So called “new energy”.

But the reality is that AGL earns most of its profit from the generation of electricity from coal and gas fired power stations. It is arguably Australia’s largest “big polluter” (to quote a phrase loved by the Greens), and this isn’t going to change in the medium term. The “new energy” business touted by Vesey lost $3 million in FY17, admittedly an improvement on the loss of $12 million the year before.

The market has decided that the Government’s intervention in the gas market and the establishment of the National Energy Guarantee, which will require retailers to contract to purchase dispatchable power plus the end the subsidy to green energy from 2020, will put downward pressure on wholesale energy prices. This will be a headwind for AGL.

What do the brokers say

The broker analysts are reasonably positive on AGL.  Of the seven major brokers tracked by FN Arena, there are four buy recommendations and three neutral recommendations. The consensus target price is $27.10, with Morgans the lowest at $25.10 and UBS the highest at $29.20.
 

The brokers see AGL earning 153.7c per share in FY18, rising to 177.8c per share in FY18 (a growth rate of 15.6%). This has AGL trading on a multiple of 15.7 times forecast FY18 earnings and 13.6 times FY19 earnings. The forecast dividend yield is 4.8%.

AGL has recently reconfirmed profit guidance for FY18 of an underlying profit in the range of $940 million to $1,040 million - an increase of 17% to 30% over FY17’s profit of $802 million.

Bottom line

I think that there will be consistent pressure on AGL by Government, Australian Energy Market Operator (AEMO) and the Australian Competition and Consumer Commission (ACCC) to reduce wholesale power prices, and that the best days of AGL extracting monopoly style rents are behind it. AGL will find it harder to grow revenue than some broker analysts are forecasting. Reduce.

On the question of Andy Vesey’s tenure, I think the jury is still out. AGL shareholders will be better served if the company is seen to be working with the Government and community, rather than being accused of executing a plan to boost profits.