AGL rejects second lowball bid: Morningstar view

AGL Energy (ASX: AGL) directors knocked back a slightly improved takeover offer from the Brookfield consortium of $8.25 per share (up from $7.50 per share initial proposal) on Monday. We strongly agree with the board. We maintain our fair value estimate and believe narrow-moat AGL is significantly undervalued. Our view is unchanged on the original bid except that operating conditions have further improved since.

The world was already scrambling for energy before the tragic events in Ukraine and the sanctions on Russia. Now global prices for coal and gas have risen to extreme levels, which puts upwards pressure on Australian electricity prices. Since we published our original view in February, baseload wholesale electricity price futures in New South Wales have increased 12% to an average of $93 per megawatt hour for the next few years. That's an attractive price and our conviction in an AGL earnings recovery continues to firm. Broker earnings forecasts likely have further upside.

We understand the suitors have walked away after the latest rejection. That doesn't worry us. If the business is to be sold, we think the board should at least wait for two key catalysts:

1. First, the demerger as this should increase the number of suitors for the retail business and ensure a fair price.
2. Second, wait for the earnings recovery as high wholesale gas and electricity prices flow through to earnings with a lag.

A year ago, the market got carried away with fears that new renewable energy supply was depressing electricity prices and that this would continue indefinitely because of ambitious government plans to decarbonise. Our position is that gas prices remain an important driver of electricity prices, and rising gas prices are likely to support electricity prices.

There is also an increasing risk that supply chain disruptions, shortages, and skyrocketing input prices cause the renewable rollout to fall short of official projections. Rising bond yields and the potential for more difficult credit conditions could also make it harder to finance these projects. AGL is well placed as it continues to produce electricity cheaply using its own coal in Victoria and cheap contracted coal in New South Wales until 2028.

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