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AGL Strategy Road Map: No change to our HOLD recommendation

This week was a big week for AGL Energy, as it released its strategic road map ahead of a two-day investor briefing at AGL’s Macquarie Generation power plants in the Hunter Valley.

It was also the occasion for newly appointed CEO Andy Vesey to outline its plan on how to improve its return on funds employed and hopefully deliver sustainable earnings growth in the future.

The plan has 3 main components:

  • A new organisational structure: AGL wants to create an “anticipatory” culture, leaner and more entrepreneurial so it becomes more flexible and is able to adapt to face the increasingly current competitive environment, as well as having an orderly transition to a carbon constrained future
  • Productivity improvements:
    • through better capital allocation: AGL is currently doing a portfolio review of its assets targeting $1bn of assets sales (including its 50% interest in the giant Macarthur wind farm in Victoria) and around $200m of working capital reductions by the end of FY17. As it wants to be competitive in the retail gas markets, it is also looking to secure cost competitive gas supplies and its asset portfolio review is overlapping the previously announced operational review of the Upstream Gas business. Additionally AGL is also evaluating the cost to develop and expected gas recovery from the controversial Gloucester coal seam gas project
    • through improvements in operational efficiency: management is targeting around $170m costs reductions in its operating cost base and $100m in capital expenditures for the same time horizon of FY17 as AGL is committed to achieve below-CPI cost increases in electricity generation costs for FY16-17. Recurring cash benefits of around $200m are expected from FY17.
  • Generate growth: AGL sees two main areas of development
    • the Retail market: where it intends to apply more sophisticated customer segmentation strategies to increase customer acquisition, retention and loyalty and enter AGL to the digital age with digital solutions to better meet customers’ needs in a low-cost way and offer new capabilities such as digital meters and battery storage business
    • AGL intends to become a leader in “new energy”, meaning mainly rooftop solar and smart metering, targeting to create one million “smart” connections by 2020 by providing metering services, rooftop solar, commercial energy services, energy storage and electric vehicle services

At the same time, the company reconfirmed its profit guidance for FY15 of $575-635m of underlying net profit after tax, thanks to improved power production, higher wholesale prices and better than anticipated performance from AGL’s Macquarie Generation. Management commented that it is expected to be in the top half of this range and as a consequence of its organisational restructuring it will book around $30m pre-tax of significant items for FY15.

Commencing with full year results, a financial scorecard with 8 key performance indicators will be reported to keep track of the different initiatives:

  • one-off cash flow benefits from optimising working capital and asset sales
  • recurring free cash flow benefits through transformation
  • cost of generation in $/MWh
  • EBIT per customer
  • New Energy progress to become break-even (expected by 2018)
  • New Energy smart connections
  • New Energy revenue growth
  • Return on Funds Employed

As AGL is reducing its growth capital expenditures, there is additional cash expected to be available by 2017, which will force management to make a capital management decision at that time: either debt repayment, growth options or cash returned to shareholders? As there is no major benefit for a utility company like AGL Energy to increase its credit rating above BBB, where it is now and there doesn’t seem to be a lot of growth opportunities, the third option: cash return to shareholders is the most likely.

What about the bonds and in particular the subordinated notes? We assess AGL Energy as having a solid credit profile and the strategy plan as well as the different investor presentations lead us to believe they have it well laid out. There are some challenges ahead nevertheless given the competitive environment, the ever changing regulations on energy production and distribution, as well as the non-easy transition to a less carbon-hungry energy generation as most of AGL’s energy production comes from coal. We believe there is little room for capital appreciation from here and expect the bonds to trade range bound, we therefore maintain our HOLD recommendation on the subordinated notes.