Markets

What About Australia?

By Lance Gaitan  |  September 4, 2018

Editor’s Note: We have a late-breaking addition to the lineup for the 2018 Irrational Economic Summit.

Joining us in Austin on October 25-27 are Roger Conrad and Elliott Gue, the dynamic duo behind Energy & Income Advisor, a comprehensive source of insights and data about and an authoritative guide to building long-term wealth in the global energy market.

Today, Roger provides an update on Australia’s energy market.

— Lance Gaitan

Australia now has its sixth prime minister in a decade, with the ruling Liberal Party/National coalition ousting Malcolm Turnbull last week.

Prime Minister Scott Morrison will have to boost the government’s sagging popular support in advance of parliamentary elections, which must be held by May 2019.

And it won’t be easy, with recent polls showing the Labor Party running 10 points ahead. Its leader, Julie Bishop, is also the first choice of voters to be Australia’s next new prime minister.

Political upheaval has pushed the Australian dollar to its lowest point in two years at $0.735. There’s also the question of how U.S. trade protectionism will affect China, Australia’s largest trading partner.

China accounted for 24% percent of Australia’s total imports plus exports in 2017. And that bilateral trade relationship has grown at a compound annual rate of 12.1% since 2007.

For Those Already Rocked…

Australia has also been rocked by an energy crisis.

A roughly 50% increase in liquefied natural gas (LNG) exports over the past two years has soaked up supply, pushing up prices as well as wholesale electricity rates.

Ongoing retirements of aging coal-fired power plants and subsidies for wind and solar generation provide even more upside support.

The defeat of Turnbull’s National Energy Guarantee policy at the hands of pro-coal forces was the immediate catalyst for his ouster.

Incoming energy minister Angus Taylor is a long-time opponent of wind power and has pledged to “wield a stick” against electricity companies to bring down rates. The closer the election gets, the more likely he is to take dramatic action.

AGL Energy’s (ASX: AGL, OTC: AGLXY) replacement of CEO Andy Vesey this week with the less controversial CFO Brett Redman seems like an attempt head off such a blow.

Tensions between Vesey and the government had escalated over the past year. That was in part because of AGL’s record profits. Its decision to replace the 50-year-old Liddell coal-fired power plant with a combination of natural gas, renewables, and energy storage also played a role.

AGL’s underlying strategy, however, seems unlikely to change much.

One big reason is Labor’s “Climate Change Action Plan,” calling for 50% renewables by 2030. Another is Australia’s states are empowered to set their own energy policies.

Liberal Party-controlled Southern Australia, for example, has a 75% renewable target by 2025. That’s even more ambitious than Victoria, where the Labor Party government is aiming for 40% by 2025.

New South Wales reached its official target of 20% in 2016; it’ll bring another 5,000 megawatts of solar on line this year.

Labor-controlled Queensland says it’s on track to meet its official renewable target of 50% by 2030.

Together, these four states account for 85% of Australians. That makes them arguably as important as the federal government to energy policy.

Power Politics

Australia’s power sector is caught in a political crossfire.

The failure of the Turnbull plan demonstrated once again how difficult it is to reach consensus, particularly with the country’s influential coal mining business fighting for its life.

And approaching elections make compromise unlikely.

The political risk basically overshadows everything else at this point.

Earlier this month, for example, AGL posted a 28% boost in its underlying profit for fiscal 2018. It also raised its semi-annual dividend by 29%.

And AGL generated over $1.4 billion in free cash flow after all capital spending, more than twice what it paid out in dividends.

Such powerful results should have pushed AGL shares higher. But the stock actually careened lower following the announcement, as investors worried that big numbers would invite more political fallout.

The stock now trades for just 8.5 times trailing-12-month earnings. And its pre-tax dividend yield is very high at 7.6%.

Is Australia’s power sector is still a worthwhile investment in light of these headwinds? Analysts tracked by Bloomberg are split.

AGL, for example, draws three “buy” ratings, seven “holds,” and two “sells.”

Origin Energy (ASX: ORG, OTC: OGFGY), Australia’s second-largest power company, is slightly better at six “buys” and six “holds,” with no “sells.”

Victoria power grid operator AusNet Services (ASX: AST, OTC: SAUNF) has two “buys,” six “holds,” and two “sells.”

The Opportunity

We come down on the side of the bulls for three main reasons:

  • Low valuations equal low expectations.
  • Politics notwithstanding, meeting Australia’s long-term energy needs requires a massive investment that only the country’s power companies can make.
  • The Australian dollar is likely to rebound to the neighborhood of $0.80 in the next 12 months, pushing up the value of Australian stocks dollar-for-dollar.

There’s some risk government policies will compress sector earnings in the coming year, no matter who wins the election.

This risk, however, is reflected in the rock-bottom expectations behind power companies’ low valuations. And they may be a lot easier to beat than most expect.

For example, AGL achieved its fiscal 2018 results despite a 53% decline in margins at its consumer business, as it elected to eat wholesale price increases. Results could therefore improve nicely next year if AGL continues to hold its industry-low customer attrition rate.

Management is also executing AUD120 million in cost reductions, which will go a long way toward offsetting expected lower margins in wholesale generation.

Cash flow could get a further boost from AUD2 billion in renewable energy investment and the company’s expansion in Western Australia.

These developments and/or any sign of progress on the regulatory front would likely rally AGL shares. As for the Australian dollar, whenever it’s lagged oil prices this long and dramatically, it’s always gained value in the following 12 months.

Those are good reasons why the best-in-class Down Under are still worth our investment dollars.

Lance Gaitan

Lance Gaitan graduated from Franklin University in Columbus, OH with a degree in Finance. After graduating, Lance worked as an auditor for an insurance administrator and later attained his securities license and then went to work as a broker for a small firm.Full Bio