The Airlie investment process weighs four factors when considering a company: financial strength, business quality, management and valuation. Our analysis recognises that industries and companies aren’t static, they are dynamic. As such, we are always looking for businesses where conditions (whether balance sheet, industry structure or management quality) have improved or will improve, and where this improvement isn’t yet reflected in the valuation.
We think Origin Energy fits this bill. In our view, Origin’s financial strength and business quality are set to improve, neither of which is reflected in the current valuation of 9.5x PE. Origin comprises 2 main businesses: an energy utility and gas producer via its stake in the APLNG project in Queensland.
1. Improving financial strength
While we have followed the Origin story very closely over the years since it was spun out of Boral in 1999, in recent years we have been unable to invest in the company as it failed our “financial strength” test. As per below, Origin’s net debt to EBITDA peaked at 7x in 2015, as the ill-timed APLNG project came online, just as oil prices fell from a peak of US$115/barrel in June 2014 to under US$30 by Feb 2016.
Since then, a combination of rising oil prices, improving energy earnings and the sale of non-core assets has put the balance sheet in much better shape, with net debt to EBITDA falling to 3.4x by FY18. While still elevated for our taste, we anticipate further balance sheet repair driving an equity re-rate as debt is paid down and dividends reinstated.
The business is entering a phase of significant free cash flow generation, driven by its interest in the APLNG project in QLD, which will return an increasing cash dividend to the group. While the share price has fallen with the recent 25% decline in oil prices, we are attracted to the cost out opportunity at the APLNG project, which means this asset is not solely reliant on the prevailing oil price. Origin and its partners are confident of attaining a 10-15% reduction in operating costs by June 2019. This further lowers the oil price at which the project is cash break-even to US$39/barrel, which management believe they can get to US$35/barrel long term. Current spot Brent oil prices are US$53/barrel. While we have no skill at picking where oil prices are going, we take comfort from the fact that Origin’s APLNG stake will be returning a cash distribution to the group at any price above US$39/barrel, a price at which most of the world’s oil producers are not making money.
On our estimates, the business could fund a c60cps dividend by FY20/21, which would put the current share price on >10% dividend yield.
2. Peak utility risk = improving business quality?
Origin generates the bulk of its EBITDA from its utility business. We would consider a vertically integrated energy wholesaler/retailer business such as Origin a pretty average business. While legacy wholesale assets are unique and expensive/difficult to replicate, it is unlikely that a utility business could earn a sustainable excess return above cost of capital through the cycle, given the political and social sensitivities. Put simply, high electricity prices are only good for shareholders, not consumers and definitely not governments. As such, periods of rising electricity prices are likely to lead to heightened political risk/negative sentiment weighing on the sector.
That has certainly played out in Australia, and throwing in a government focused on delivering lower electricity prices ahead of a 2019 election, we believe there is a possibility that government intervention into pricing could reduce earnings in the order of 10-15%. However, we would expect the industry would be able to mitigate some of these effects, and a more stable political environment post-election would also be a good thing. We think Origin is currently in the midst of peak political risk/ peak negative sentiment weighing on the utility business. Further, at its recent investor day, management announced intentions to reduce cost to serve in the retail business by $100m. As such, we think any price decline could largely be mitigated by lower cost to serve + reduced churn costs. With the balance sheet now strong enough to absorb these political risks, and with the valuation on a sub-10x P/E (vs 10 year average of 15x), we think the valuation is pricing in peak utility risk.