EPW (ASX) 3 Brokers downgraded

Originally posted by joewolf ↑

Strawman68 Thanks for your input. I have at times spoken to parts of management. In these latest discussions which are always very complex and I cannot say I understand everything I raised an interesting point.

You have to surrender LGC's based upon our sales of Twh. If the market is as they (ERM) are stating becoming far more competitive and also far shorter in contract horizons is it not better to pay the penalty as if you have supplied the certificates but your usage drops you have a banked LGC but no need to have surrendered them.

I got the impression that this was not a case of we have been caught out but rather that we took a considered view of a multiple of factors directly related to ERM and that this was the best route for ERM.

I took the following from the results:

1. The new half yearly dividend is $8.825 million so the franking credits used are a total of $17.6 million - By paying $37 million in tax they have $123 million of dividends they can frank. That's around 7 years at same level. The recipient gets what is equivalent of 5c So the company saves around $7.56 million in cash flow each year.
2. The forward hedges mark to market yielded a very large unrealized profit.
3. Dont ever think that this company is not run with one eye on the impact for the St Bakers. Even if their holding is in a company they would have had to pay tax on an unfranked dividend. So they are neutral to receiving 3.5c franked vs 5c unfranked.
4. Dont also think that St Baker went into partnership to purchase a coal power-station without understanding the risk of not having a down stream user like ERM. Both seem to benefit from the deal.
5. The companies future growth actually lies in the USA.
6. With electricity prices climbing and the market becoming so volatile I am not surprised they didn't just want to pop these LGC's on the table.
7. I would not be at all surprised to see a sale of the Australian business given the hedges they have versus the shorter contracts people are purchasing. I think the country is in a mess and in fact once a few more coal power stations close I think the prices can only go up...

I dont think that this management team is just reactive certainly not in dealings I have had with them and really I am not of the opinion this was just a finger up the nose to the government agency.

Yes it came out of left field but I think they want to conserve cash - are no longer of the opinion that their load will keep increasing. Look at the SME load barely worth all the effort ... margin better but load very low.

Is there some input you could give to my thoughts?

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Joewolf - well generally speaking I don't think they got caught out at all, I think it was deliberate given where the market prices have been last year or so and are now, however, paying the penalty which buys you an option for the future has to be based on your view of the next 3 years prices for LRECS and whether or not there will be 1.9m LRECS surplus (surplus is to all other obligations by EPW and others for LRECS for the next 3 years obligations).

If you think prices are going to stay up and demand will be high, then the chances of buying cheaply are significantly reduced, so to take an option (depending on how much you have paid or given up for it) you have to take a view on forecasting the future. and given everything really is supply and demand, then for price to go down, forecast supply must be more than demand (clean energy regulator says there is plenty of certificates out there to buy at the moment - so if that is the case why is price so high, wouldn't you think if supply signfiantly is greater than demand the price should have gone down not up. Maybe they are banking on way more large scale renewable projects coming out to meet the RET targets (still means more projects than are needed so supply is still way more than demand), or that the governments will significantly water down the RET target, which may mean fewer new projects and that supply is way more than demand.....so really a very political event as papers are full of this stuff lately - so effectively maybe they are punting on politicians policy...

So yes they have commercially bought and option, but like all options they have effectively paid a price - at least $5m and more likely more - so therefore you have to work out have they paid an appropriate cost to buy that option given the risk/return relationship - that is the real question?

Now from their presentation they said that the results will be skewed to second half because of the settlements of the greens, so why would that be, they pay the penalty in mid Feb - so $123m paid to regulator is already come out of the free cash at bank as at end of Dec 16 so operating cash flow should have a big drop this half as opposed to big increase last half as shown in the graph.

So why would they be getting lots of money in the second half to skew profits upwards from renewables, the only way I can see that being is that they did have a whole swag of LRECs which they were holding and had bought cheaper maybe a year or more ago, ready to surrender now for 2016 but given prices went up so much they decided to pay the penalty and buy option forward (at what real cost?) and sell the LRECS they have on hand hence deriving a profit on the sale of the LRECs - that's the only logical conclusion I have.

As the customer contracts become shorter, then I assume that when they price a tender to customers, in competition with the others, that everyone must base that price on either what inventory cost they have, or think they will have and add a margin to make profit - otherwise how do you price. So therefore with LREC prices being high now, then one assumes customers are getting new prices that are higher, that being said, though the $/MWh profit should increase as if you are getting 3% on a $60 cost you get $1.80 profit, but if you get 3% on $90 cost you get $2.70 - still the same margin, but more actual $ in quantum, unless competition is driving down the 3% to lower so that retailers nly still get $1.80 on the $90 cost, mean means a margin 2%... not sure maybe someone who is a business customer of these companies could explain what is actually happening in the market - I can only really look at many alternative options, which is correct - well I don't know.

Also remember that if EPW buys LRECS in the future and surrenders then they unwind the penalty (to be paid back from consolidated revenue...I am sure the government is licking their lips at the moment with an extra $123m in cash to spend) then you will unwind the $36.6m tax so get a tax credit, which them means less of a chance t get a franking credit for dividends later, so it could be as simply commercially as bringing forward a franked dividend, but again at what cost. remembering that paying a dividend to shareholders means that the company doesn't need the cash for anything or that they cant find anything with a good enough return, so give it to shareholders to get a better return with whatever that may be.

This post is now too long so I will make comments against your points in the next post for ease.

Joewolf - well generally speaking I don't think they got caught...