AGL Energy (ASX: AGL) has two large batteries under construction in the Hunter Valley, which management expects to offset the headwind from costlier gas and coal supply. AGL has another four batteries close to final investment decisions across New South Wales and Queensland.

Why it matters: With the market fixated on earnings headwinds from the expiry of cheap fuel supply contracts in fiscal 2028 and the closure of coal power stations in the 2030s, we think it is missing the big opportunity in batteries.

  • Battery developments are highly accretive. AGL says its first two batteries are generating ungeared returns of about 13%, well above our estimate of its cost of capital of 7.5%. Competition is limited, and the need for batteries is large, which should support excess returns in the medium term.
  • Competition is limited because nonutility battery owners receive much lower returns, and the transition to intermittent renewable energy requires a huge number of batteries to store energy and stabilize the grid.

The bottom line: We maintain our $12 per share fair value estimate for no-moat-rated AGL Energy. We think it is attractively priced, trading on a P/E of 10 and offering a fully franked yield of 5%.

  • We have increased our medium-term capital expenditure and earnings forecasts to reflect an acceleration of investment in batteries. We now forecast a five-year EBITDA compound annual growth rate of 4.6%, while earnings per share is likely to be flat because of growing depreciation and interest costs.
  • We lower AGL’s Morningstar Uncertainty Rating to Medium from High. We think AGL is on a steadier footing, with elevated electricity prices, lenders’ support, and a solid strategy to offset earnings headwinds.

Long view: We expect the two batteries under construction and four close to final investment decisions to add nearly $400 million to EBIT by fiscal 2030. We expect ongoing investment in batteries and renewables into the 2030s at a reduced pace.

AGL Energy’s battery and renewable energy developments to offset headwinds

AGL Energy is one of Australia’s largest integrated energy companies. Earnings are dominated by energy generation (wholesale markets), with energy retailing contributing just a fifth of operating earnings. Strategy is heavily influenced by government energy policy, such as the renewable energy target.

AGL Energy’s consumer market division services over 4 million electricity and gas customers in the eastern and southern Australian states, representing roughly a third of available customers. Retail electricity consumption has barely increased since 2008, reflecting the maturity of the Australian retail energy market and declining electricity consumption from the grid. Despite deregulation and increased competition, the market is still dominated by AGL Energy, Origin Energy, and Energy Australia, which collectively control three fourths of the retail market.

AGL Energy’s wholesale markets division generates, procures, and manages risk for the energy requirements of its retail business. Exposure to energy-price risks are mitigated by vertical integration, peaking generation plants and hedging. More than 80% of AGL Energy’s electricity output is from coal-fired power stations. AGL Energy has the largest privately owned generation portfolio in the National Electricity Market.

Bulls say

  • As AGL Energy is a provider of an essential product, earnings should prove somewhat defensive.
  • Its balance sheet is in relatively good shape, positioning it well to cope with the renewable transition.
  • Its low-cost coal-fired power stations underpin solid earnings for the group.

Bears say

  • The regulatory environment is unpredictable and has a significant impact on AGL Energy’s earnings.
  • AGL Energy’s gas costs are rising as cheap legacy supply contracts end.
  • Banks plan to phase out lending to coal power stations in the 2030s.

Get Morningstar insights in your inbox

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.