AGL hitches future fortune to cleaner & greener renewables

Strip out the write-downs on the value of its gas assets from AGL Energy Ltd's (ASX: AGL) interim result and the energy utility's actual performance for the six months ending 31 December 2015 look a lot more respectable than it initially appeared.

It was an above-par performance and a full-year contribution from its recently acquired Macquarie Generation coal project – plus higher gas volumes and prices – that saw underlying profit after tax rise 24% to $375 million, which was 2% above the consensus estimate.

Equally pleasing, revenue rose 8% to $5,601 million, with an interim dividend of 32 cents – up 7% on previous year.

Subject to normal conditions for the rest of 2015-16, AGL expects full-year core net profit to be within the upper half of the $650 million and $720 million range it announced at its AGM last September.

While the company struggles to attract and retain consumers, with total customer churn up by 0.5%, acquisitions and retentions actually increased by 5%. Overall, average customer numbers declined by 0.9%, but gross margin per account improved by 12%.

Where the rot set into the result was the company's decision to withdraw from gas exploration and production. What followed were impairments of $640 million (after tax) to value of these gas exploration and production assets, and this resulted in a statutory loss after Tax of $449 million.

Meantime, the weaker gas market remains a lingering nemesis for AGL, and lower-than-expected productivity from the Gloucester Gas project hasn't helped.  But this has made it easier for AGL to commit to abandoning gas exploration and production, and at some future point it will offload these assets.

While the company will continue to struggle to grow revenues faster than consumer demand for electricity, it's hoped that over time, AGL's renewables segment will replace its outgoing gas and coal assets.

Admittedly, it's still heavy going for the company's renewables portfolio with an Earnings Before Interest and Tax (EBIT) loss of $37 million, compared to $40 million in the prior comparable period. However, in an attempt to gradually move away from coal-based power generation over time, AGL is launching a renewable energy business to develop large-scale projects.

Part of major push into lower-carbon fuels, the new fund – the Powering Australian Renewables Fund – will hold AGL's recently completed solar power projects in western NSW and will be partly owned by AGL.

CEO Andy Vesey expects the strong performance of AGL's core business to ideally place the company to capitalise on the evolution occurring within the energy sector.

Part of that evolution involves supporting the country's transition to a lower carbon generation portfolio and the launch of the renewables fund, which will develop at least 1000 megawatts of large-scale renewable energy projects at a cost of $2 billion to $3 billion, with AGL contributing about $200 million.

By cleverly cutting AGL's balance sheet commitment to the sector to just $200 million, the renewables fund is able to diversify away from generation and into more consumer oriented products.

It's understood a small number of parties will be invited to partner AGL in the fund, with a broad mix of funds – especially Australian infrastructure funds – and banks to contribute debt. However, the jury's out on whether potential partners have the appetite for a greater share of the risks than they're used to.

What may worry potential partners is the tail risk on 20-25 year assets that only have 5-10 year revenue contracts.

But given that long-term power purchase deals no longer work in today's uncertain market, Vesey is urging potential partners to take a more innovative approach to funding renewables projects.

He hopes risks will be mitigated by the fund's diversification across different forms of energy and the participation of AGL as an experienced renewable energy project developer.

Plans to sell its two solar projects into the fund – built at a cost of about $300 million – helps AGL towards its target of $1 billion asset sales. With the Macarthur wind farm sale having already raised half the total, this leaves only around $200 million to be raised from the sale of gas assets.

While AGL does have a $4.8 billion funding gap and a rising net-debt to equity (2016 43.40%), and earnings per share (EPS) growth over the last five years has been excellent.

Equally encouraging, cash flow from operations remains strong, despite AGL's heavy debt load and low cash, virtually all of its debt is non-current, requiring repayment in future periods.

With Vesey making it very clear to the market that AGL will not use coal for its base-load electricity requirements beyond 2050, the company's business model is arguably in transition.

This bring with it myriad threats and opportunities, plus an as yet unproven expectation that much needed partners are willing to commit to greater degrees of uncertainty than they're traditionally comfortable with.

Those who believe in AGL's renewable energy story need to take a long-term view. A share price under $18 makes for a more attractive entry point.