"Madamswer, I sincerely hope that you will decide to buy some AGL shares, because I will be re-assured that my purchase some time ago was not so stupid. "
Steady on; this investing lark is The Great Leveller because no one comes even close to getting them all right. I can show you a long list of my great many mistakes over the years. However, the trick - when one does get them wrong - is for it to happen in a way that the damage is not too serious.
And the way to achieve minimum damage, I am convinced, is to always start with fundamental valuation, and to then consider the value-at-risk based on drawing upon as precedent as possible.
In AGL's case, I think the stock is currently undervalued.
Not extremely, but sufficiently so that it provides a degree of downside support to the share price, I believe.
But I say that with the caveat that the company is currently "over-earning" to some degree, due to elevated power prices which - should they normalise - would lead to quite meaningful earnings downgrades(by as much as 15% to 20% at the NPAT level).
In other words, this is one of those tricky investment situations of "Yes, it looks cheap, but we know that downgrades are possible/likely."
My approach to these sorts of situations is to focus on the valuation first and foremost, because very often I have found the market (being a far smarter animal than the broking analyst collective, whose forecasts often behave as lagging indicators) is already anticipating the inevitable downgrades.
Here's my thinking on the stock:
FINANCIAL FORECASTS
Based on management's guidance for FY2018 NPAT between $960m and $1,040bn, I've used a figure over $975m (for the sake of conservatism, closer to the bottom of the guidance range).
For FY2019, I have used the forward curve for power prices which provides ongoing (~5%) growth in the Wholesale business, and have also assumed:
- a further 20% fall in Consumer business EBIT,
- a 15% EBITDA return on the $500m of capital being spent on new generation capacity (fpor context, AGL's EBITDA-to-PP&E runs at ~13% and EBITDA-to-PP&E is close to 30%),
- $50m of the $100m targeted transformation benefits accrue
All up, that gives FY2019 EBITDA of ~$2.250bn, and NPAT of $1.070bn, increases on FY2018 of 6% and 9%, respectively.
The abridged P&L over FY2018 and FY2019 looks something like this (all figures in $m):
There are a number of factors that inform what appropriate valuation multiples should be for a business like AGL:
On the less favourable side, factors that detract from higher valuation multiples:
- AGL is a price taker, having little pricing power in any of its businesses.
- The markets in which AGL operates grow at modest rates (a little above CPI) and are highly competitive, across all of AGL's competencies of power generation, wholesaling and retailing.
- As a result, AGL's earnings are not fast-growing; long-run NPAT and EPS growth have averaged 11% and 7%, respectively.
- The business is capital-intensive: around 45c of each dollar of Operating Cash Flow needs to be retained for sustaining capital expenditure. As a result, ROE is modest, being in the high single-digit percentages.
- The energy generation sector is highly regulated and is a politically-sensitive part of the economy.
- There have been many structural changes underway in the energy industry, with moves towards renewable, environmentally-friendly energy sources.
- The business landscape has been riddled with uncertainty and flux, due to legislative bungling and an inability on the part of bureaucrats to formulate consistent and coherent energy policy in Australia.
- AGL is a complex business with many moving parts (some of them a bit of a black box).
- Because of the societal sensitivity around the cost of energy, AGL - and its competitors - are prone to coming under the public glare from time to time, just as we are seeing with the debate around Liddell.
For these sorts of reasons, AGL should not be valued at multiples that are at meaningful premiums to those of the broader market, I don't believe.
Some mitigating factors in favour of a higher valuation multiples:
- AGL operates an integrated business model, spanning generation, wholesaling and retailing. As such, it is insulated to some degree against its lack of pricing power.
- The company's long operating history, in which the business model has proven robust enough to be able to successfully negotiate the innumerable changes in the business landscape (structural, regulatory, competition).
- Non-discretionary nature of the services provided by AGL, with very granular customer base result in relatively stable earnings and cash flows.
- Operating Cash Flows are consistently high, with limited year-on-year volatility. This allows for effective capital budgeting and capital management.
- Customer concentration is low, with AGL having a very granular customer base.
- Dependency on critical suppliers is negligible, as is technological obsolescence risk.
- While they have undergone several changes over the years, the company's board and management have a demonstrated track record of being good stewards of shareholder capital, without doing anything too dumb.
- Despite the high levels of competition and the changes in the domestic gas and electricity industries, AGL has still managed to grow its EPS and DPS at rates in high single digit % terms.
- With EBIT-Interest Cover of 7.5x, Current Assets-to-Current Liabilities of 1.4x, and Net Debt-to-EBITDA currently at 1.4x, and expected to end FY2019 at under 1.3x, the company's balance sheet is in the best position it has been for around 8 years.
- In a way, some of the factors discussed above (eg, capital intensity, elevated levels of competitiveness, strict regulatory oversight, intense public scrutiny) that make it difficult to operate in the fields of power generation, wholesaling and retailing, at the same time act as barriers for new entrants into the industry.
So, for these sorts of reasons, AGL should not be valued at multiples that are at a discount to those of the broader market, I don't believe.
As a simplistic maritime analogy, AGL is no sleek-lined, overpowered luxury motor yacht capable of doing 60 knots. On the other hand, it is also not a barnacled old sloop, all covered in seagull manure, and only capable of a top speed of 15 knots for 20 minutes at a time before its 1975-built diesel engine starts to overheat.
Instead, AGL is more akin to a large oil tanker. Difficult to speed up or turn around, but also almost impossible to knock off course; capable of continuing inexorably on its journey at 35 knots under even the most stormy weather and the wildest sea conditions.
Distilling all that preceding discussion, makes me conclude that AGL needs to be valued at a modest (5% to 15%) premium to the broader market, i.e,:
So, appropriate valuation multiples of around 16.0x on a P/Ebasis (my sense is that the overall market's P/E - excluding the banks - is somewhere around 15.0x to 16x today) and and EV/EBITDA multiple of around 9x (the market is probably somewhere between 8.5x and 9.0x today, I think), are where I would value AGL.
Based on the current share price, and the earnings figures derived above, the stock is currently trading on prospective FY2018 and FY2019 P/E's of 13.5x and 12.4x, respectively.
On FY2018 and FY2019 prospective EV/EBITDA multiples, the stock is currently being valued at 7.7x and 7.4x, respectively, based on my analysis.
For context, below are some historical average valuation multiples, which show that the stock's P/E has averaged 15.2x, and its historical EV/EBITDA multiple has averaged 8.5x (and that excludes the 2011 outlier which reflected the Loy Yang debt after AGL changed from equity accounting Loy Yang, to consolidating its financials into the AGL accounts).
In conclusion, from bot a first principles approach, as well as based on precedent, I am happy to conclude that the stock is fundamentally undervalued, by between 25% and 30%.
$27.00 is where I value AGL today.
(with around $3 of value-at-risk from that level.)
Accordingly, I commenced buying shares in AGL last week.
IMPORTANT CAVEAT
As mentioned earlier, I think that AGL is currently over-earning, by as much as 10% to 15% at the EBITDA level, and 15% to 20% at the NPAT level, a result of elevated near-term power prices.
My sense is that analysts run their forecasts off the forward price curves for electricity. To date, those forward curves have proven to be reliable indicators of achieved outcomes, so it might take some time for the "normalisation medicine" to be taken.
Then again, it is not lost on me that if the sort of downgrades (that I think are possible, although not necessarily likely) do result, it would result in the stock trading at the sorts of valuation multiples that I think are fair and reasonable, anyway (i.e., a 16x P/E and 9.0x EV/EBITDA).
Put another way, it looks to me like the market, as it so often does, has already factored in any worst case scenario in terms of possible downgrades, implying that the scope for meaningful permanent capital loss from the current share price level, is limited.
AGL Price at posting:
$21.10 Sentiment: None Disclosure: Not Held
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