Origin Energy Investor Day: Sound strategy but maintain SELL recommendation

On 10 June 2015, Origin Energy held its investor day where management presented its strategy to improve returns in Energy Markets and its action plan for the entire company.

It’s four main priorities are:

  1. Improve returns in the energy markets businesses: In Energy markets (56% of the Group’s EBITDA), as demand for gas is due to increase, notably for export when APLNG and the 2 other Curtis island projects by QGC and Santos will come online, and the wholesale electricity market remaining oversupplied, Origin wants to become the most trusted energy solutions provider. In an extremely competitive retail market it wants to become a more customer centric organisation so it can build customer loyalty and trust. It wants to:
    • Reduce its cost to serve, by remaining flexible and improve capital efficiency: Origin aims to achive $100m in reduction in Natural Gas & Electricity cash cost to serve and Generation Operating expenses across FY15 and FY16 as well as reduce capital expenditure by a further $50m in FY16 to $250m in total;
    • Improve customer experience with the launch of a new integrated digital platforn and proactive retention;
    • Grow new products and services around Solar and Acumen metering as well as grow in embedded networks: Origin aims to become the number 1 provider in the solar market. It expects a net loss of $25m for FY16 and to become breakeven by FY17, with 170MW targetted to be installed in FY18;
  2. Deliver growth in natural gas and LNG: As Gas demand increases through the LNG start-ups, from below 750PJ to close to 2,000PJ, and gas prices are expected to rise as a result, moving towards exports parity, Origin has an opportunity to maximise the value of gas. With significant access to reserves, contracted resources at all major hubs and transport flexibility, Origin will be available to monetise ramp gas in Queensland and benefit from sales to other LNG projects with an ability to call back gas during periods of high electricity prices on the national electricity market (NEM) to run its own gas generation.
  3. Grow its capabilities and investments in renewables: Origin Energy is seeking to maximise fuel and electricity generation flexibility to remain cost competitive in electricity generation. As increased gas-fired generation will decrease with the rise of gas prices, energy supply will increase as wind built and rooftop solar penetration will continue, especially as significant built is needed to reach the 33 TWh Renewable Energy Target (RET) for 2020. The increase in renewables to achieve the 2020 RET will extend the supply curve and place downward pressure on wholesale prices, and as Origin Energy is less integrated than its competitors AGL Energy and Energy Australia and far less exposed to Coal, Origin has more flexibility in its portfolio to contract or build longer term to achieve its Large-Scale Reneawable Energy Target (LRET) as required by the new Renewable Energy Certificate (REC) market since 2011. Origin Energy has a short coal position, and as as renewables like wind introduce price volatility in the supply market, Origin’s gas-peaking portfolio is well positionned to respond to short periods of ramp up and down.
  4. Carefully manage its capital and funding: In its existing generation operations Origin Energy is aiming to increase asset performance through increased reliability and productivity so it can reduce operating costs and capital expenditure (current levels of approximatively $220m and $95m respectively). As the recently acquired (2013) Eraring Power Station is being progressively integrated and safety and reliability of performance is improved (capital investment program should be concluded by FY2017), Origin Energy has fewer capital requirements going forward. Origin will be also leveraging information technology with smart power generation data & analytics, providing systemic ongoing performance improvements and reducing commercial and technical risks like unplanned production events and predictive failure avoidance.

Origin Energy will not only focus on costs and expenditures but also on customers, where it will continue to meet the market on discounts to defend market share and increase customer retention by building loyalty and trust. Its strategy is based around customer segmentation and differentiated offerings, its new integrated digital capability, behaving like a ‘traditional’ retailer would do and not like an utility. This ‘retail transformation’ helps Origin Energy improve its operational metrics, its bad debt exposure and finally reducing its ‘cost to serve’. Cash cost to serve is on target to reduce by $30m in FY15, with a further $50m improvement expected in FY16.

In summary, Origin Energy is focused on reducing costs and expenditures as well as improving its customer experience and wants to become the number 1 in the solar market, which is more or less what AGL said a few weeks ago when it presented its own strategic road map. The main difference is that AGL will do asset sales and will try to secure further cost competitive gas supplies, as it is heavily weighted towards coal. Once APLNG comes online and contributes cash-flows, Origin might actually be in a better position than AGL on the generation side.

What about the Origin Energy Subordinated Notes (ASX Code: ORGHA)?

As we said in our previous research note, we believe Origin is taking the right steps “to focus on conserving cash flows and remain investment grade”. However all the measures described above take time to be implemented and have an effect on the bottom line and the main obstacle remains the $2bn needed of cash contribution for the APLNG project in the short term. $2bn is the remaining funding contribution to APLNG from January 2015 until start of Train 2 production, when APLNG is expected to become self-funded. We hear rumours that even its New-Zealand subsidiary Contact might be potentially sold as debt repayment is of higher importance than business diversification.

However as long as this financing problem is not resolved and we get clarity on the matter, we believe there is a risk that the notes might not be redeemed at its first call date (December 22nd, 2016) and at current yield, we do not think that investors are being compensated for this risk, therefore we keep our recommendation on the subordinated notes as a SELL.