AGL Energy (ASX: AGL) is an Australian blue-chip company that is in a bit of a fix. The stock has shed more than 37% in 2020 and 23.75% in the last three months. Since the partial recovery AGL made in the lead up to June, the downward trend began with the release of its FY2020 performance. The business is facing major headwinds and hence the market has been pricing the firm accordingly.
What happened in FY2020?
Covid19 has affected most industries and companies globally. AGL has not been any different. AGL has a 20% market share in Australia’s electricity market. The demand for electricity has decreased with restrictions in place throughout the country. Coupled with low demand, AGL has also had to deal with customers who were and are unable to pay their energy bills due to the impact the pandemic has had on the job market. Thus, both the residential and business division in the customer segment has been affected. The only positive AGL had in FY2020 was the growth in customer accounts as lockdowns meant more people stayed home and hence used more electricity. However, the margins are very thin in this segment relative to wholesale. While the demand for electricity among households may have increased, it does not make up for the decrease coming from the temporary and permanent closure of businesses during the pandemic.
The Wholesale segment which is more profitable than the customer segment has been hit harder. Wholesale market pricing has dropped. The industry is also in the middle of a disruption with renewable energy on the rise. This rise of renewables has resulted in energy prices decreasing due to the reduced costs.
Both the electricity and gas portfolio that AGL maintains were affected in FY2020 – both mainly driven by decrease in prices and decrease in demand. AGL has also suffered from a rise in storage costs due to the fall in demand and higher volumes in generation.
AGL has quite a few renewable sources in its asset portfolio now. However, the generation capacity is still a fraction of what it generates from coal. This is arguably one of the biggest reasons for the dip in performance of AGL and also why the stock has performed miserably. The markets seem to have considered the damage coal assets will have towards costs and the resulting pricing.
Some of the highlights from its FY2020 performance is as follows:
- Revenue decreased by 8.2%
- EBITDA decreased by 12.75% as decrease in revenue was coupled with a slight decrease in margins.
- Net Income was higher than last year – a 12% increase. This can be rather deceiving. However, it is worth noting that the net income declined by 42% last year due to an increase in non-operating expenses and restructuring charges. Therefore, while there is a growth in net income, the performance has still not improved (considering 2019 was just an anomaly).
- Underlying Profit after tax which is known to accurately measure profitability as it does not consider anomalies and one-off charges has decreased by over 20%.
The above chart shows the trend of the profitability metrics. The returns the firm generated on its assets and capital were quite stable until FY2020, where a slight dip can be seen. This emphasises our analysis that the net income increases this year cannot be considered as AGL turning a corner. The return on equity is quite the opposite when it comes to stability. However, the increase should not be mistaken because share buybacks significantly inflate ROE.
Covid19 has immensely impacted the business during the year.
Given the impacts we discussed, let’s look at what should be done to combat these dynamics and forces that are in play, and also what AGL has set out to do.
Wholesale energy prices have declined as renewable energy sources are taking over. This means that AGL has to focus more on the customer segment and reduce its reliance on its wholesale segment. However, the per customer operating costs have to be decreased for this strategy to work. This means reducing its reliance on coal and increasing renewable assets in its portfolio. Another headwind which will most likely always persist is that there is only so much growth that can be driven by the Australian consumer market.
AGL has set a target of serving 4.5 million customers by 2024. The customer base now stands at 3.95 million. This translates to 28% of all Australian households – a rather healthy number. But the room for organic growth is tight. Acquisitions hence should lead the way when it comes to AGL hitting their target. In August 2020, AGL acquired Click Energy Group from Amaysim Australia Limited for $115 million. This acquisition adds 215,000 customers from Click – directly translating into an average customer acquisition cost of over $500. Canstar’s research reveals that the average AGL electricity bill is close to $1500 a year. This is in the lower range of average household electricity bills in the country (where an average Australian spends somewhere in the range of $1300 – $1800 annually). The acquisition thus looks like a fair deal for AGL if it can keep its customer churn rate low. Going forward, it becomes extremely important for AGL to increase its renewable assets in order to increase earnings margins and also find good acquisition deals that will bring quality customers at a lower cost. Ensuring both of these will further reduce customer churn and increase the performance of the firm in the longer term if it is to shift its business model to being focussed on the customer segment.
However, it is easier said than done. Another headwind that AGL has to combat is the declining cost of electricity throughout the country. Wholesale electricity costs are forecasted to fall by around $60 from FY2019 to FY2020. Residential electricity bills are estimated to decline as well across all states in the country as investments in renewable mean cheaper electricity generation. The trends are following what we have been seeing for the last few years. The decline is set to amplify given the dynamics and trends that have emerged during Covid19 and as countries make it a priority to go carbon neutral.
Weather AGL will change quicker than the demands of the market and industry remain to be seen. We can however answer the question – can they change?
Yes, given the strength of their balance sheet, AGL is flexible enough to change. The total debt on its balance sheet at the end of June 2020 was $3.17 billion. The firm is capitalised by equity to the extent of 71.8% and the rest 28.2% by debt. They also have been paying high dividends to its shareholders. In the past couple of years – AGL has also been buying back shares. This suggests that the firm lacked foresight to shift towards a more renewable energy driven business model as its profits were not reinvested enough to drive the change. Coal and Gas assets will be a drag and it thus becomes extremely critical to balance out the headwinds with investments in renewable assets.
AGL has close to $1 billion in undrawn debt facilities. While the AGL is not in any danger of its business failing as the share price may suggest, its growth potential is quite limited.
AGL’s guidance range for FY2021 underlying profit after tax is $560 million to $660 million – which is again a 20% – 30% decrease from FY2020. Gross margins from the wholesale business segment are forecasted to decline again by about $150 million and rising supply costs and lower pricing are a double whammy. Hence, there are three big risks that AGL has to combat and circumvent going forward – Rising costs, lowering of prices, and government and regulatory risks to increase renewable energy. While these risks are nothing new, the magnitude has been increased by Covid19 and the company is not being prepared enough to manage these risks.
The company is looking to maintain its dividend policy over the next couple of years – which is a reward for shareholders holding on to AGL in their portfolio despite the negative growth outlook. The maintenance of dividends suggest that the firm’s payout ratio will increase given the decrease in profit that is expected. Growth outlook, hence, take a massive hit.
AGL’s operating environment has been disrupted and put under immense pressure by the changing dynamics being accelerated by Covid19. The balance sheet is strong enough to emerge out of this crisis and AGL hopefully slowly realigns its business model. The market looks to have already considered the negative guidance for FY2021. Considering almost all investors hold on to AGL for its dividends, our recommendation is to continue to “Hold” and not worry about price movements in the short-term.