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Origin Energy Capital Initiatives – Positive for Subordinated Notes

On 30 September 2015 Origin Energy Limited finally gave in to pressure to stabilise its balance sheet following a collapse in Oil / LNG prices and a deterioration in the operating business. The group has announced a series of capital initiatives to improve the credit metrics of the group but more importantly start a process to remove any reliance it had on APLNG cash flows to service debt obligations. Origin is set to raise $2.5 billion via fully underwritten pro rata renounceable accelerated entitlement offer, reduce capital expenditure and working capital requirements, reduce its dividend payout ratio and target asset sales. These initiatives were highlighted as upside risks to our previous analysis and will materially change the markets perception of the security.

Some of the announcements (such as proceeds from a reduction in capital expenditure and sale of non-core assets) are subject to fairly optimistic assumptions and therefore we assume comparatively conservative assumptions. Overall the risks have significantly reduced as a result of these new initiatives (our analysis suggests the $2.5bn capital raising alone would reduce Origin’s adjusted gearing from the 45% to 34% but this excludes consolidated APLNG debt and any equity credit value attributed to the hybrids). Based on successful implementation of these initiatives the core business should be able to support the company’s leaner balance sheet with no reliance on APLNG cash flows while maintaining the a stable outlook. This is a clear shift in strategy from management who are now willing to pro-actively tackle the debt that Origin borrowed during the development phase of the APLNG project. They are now under pressure to reduce the net debt-to-EBITDA ratio to below 4x by the end of 2017 (note that it is currently still over 5x).

It is important to recognise that the pro-forma entity is still highly leveraged when compared to its peers and realisation of asset sales and improvement in cash flow as a result of operational changes is yet to be seen. As part of the announcement Origin also gave FY16 EBITDA guidance from existing operations of $1.45-1.55bn. This is down over 25% and confirms our thesis that Origin has not been focused on its core business (retail energy market) during a phase where a decline in margins and heavy competition are weighing on the industry. This change to forward guidance effectively means the new capital raising is leverage neutral for FY16 and only contributions from other capital initiatives will reduce earnings leverage.

Origins commitment to funding APLNG was confirmed at $1.8bn with first production from APLNG expected in November 2015. At this point we expect that the guarantees provided by Origin on the project finance debt will be removed and the liabilities associated with the project will come to and end.

Recommendation: The notes are due to come out of a trading halt on 6 September 2015. Based on price action of all European hybrid securities we expect the notes will open significantly higher and investors should not buy this security above par ($100). Based on this expectation BondAdviser recommends the Origin Energy Subordinated Notes as a Hold.

Valuation: Our valuation assumptions are based on the security being redeemed (in full) on the first optional call date (22 December 2016) and all interest payments being made in a timely manner. If this security is not called on this date (extension risk) the price of the security will drop significantly. The corporate actions taken by Origin significantly improve the probability of this security being called at its first optional call date. The company explicitly assumes the notes will be refinanced by existing debt facilities at the call date. We remain of the opinion that free cash flow from the operating business (not APLNG) is in decline but the common equity capital raising will be used to partially pay down the senior banking facilities and improve the debt headroom (so that they can repay the Subordinated Notes). This also changes our thesis on redemption being closely linked to the timing of dividends being paid from APLNG, as the operating entity alone (excluding APLNG) has sufficient capacity to redeem the notes. It is also our understanding that the project finance facilities for APLNG (which are substantial) are being refinanced with separate syndicated facilities under different terms to allow more flexibility (including dividend payments to shareholders i.e.Origin Energy) for shareholders and removal of guarantees by shareholders. This ultimately means APLNG will exist on a standalone basis and the reconstructed balance sheet of Origin Energy is no longer reliant on cash flow from APLNG.

From a relative value perspective there are few relevant comparable securities in our universe, with AGL and APA Group the closest. While these securities also have a similarly short term to expected maturity we believe Origin still has a higher credit risk and therefore its trading margin should be reflective of this risk. For this reason we expect the trading margin to tighten materially but remain above that of its peers.

Investor Protection: Noteholders do not benefit from much protection on these notes. The only protection being an interest rate margin step-up in 2036 (if the notes are not redeemed prior to this date). Most of the terms embedded within the documentation protect the issuer (i.e. there is no step-up in interest margin if the notes are not redeemed at the first optional call date – December 2016). Moreover, the issuer has the ability to defer paying interest at its discretion (meaning the payment of interest is linked to capital management) and if a mandatory deferral event is triggered (i.e. minimum interest coverage covenant of 3.5x vs 5.8x current) interest payments will be suspended (this is partially mitigated by an equity dividend stopper). The terms of the security were amended in June 2013 to temporarily remove the leverage trigger until June 2016. In our opinion 4.0x earnings leverage remains a key investment grade criteria (which is also a key operating criteria for the Australian Energy Regulator). Breaching this threshold for an extended period will put significant downside pressure of the price on this security.