Long term outlook for AGL is positive

Lewis Jackson: Hello, and welcome to Morningstar. I'm Lewis Jackson, a reporter in the editorial team. And today we're sitting down with Adrian Atkins to talk about AGL.

Adrian, welcome.

Adrian Atkins: Hi Lewis.

Jackson: Let's start with the share price. AGL (ASX: AGL) has been undervalued since March last year and Morningstar best ideas since May this year. With the share price still down, what are markets missing and why are you so optimistic about AGL?

Atkins: Well, I think it comes down to different time frames. At Morningstar, we try and take a long-term view and look through the cycle. Whereas the stock market typically just looks ahead by a year or two, and the next year or two for AGL will be pretty tough. But we expect earnings to improve over the longer term, and that should be driven by higher wholesale electricity prices. In fact, if you look at this chart, you can see wholesale electricity prices have already risen quite significantly from the bottom earlier this year. But that's going to take a little while to flow through to AGL's earnings. Because of multi-year hedging and sales contracts. There's a few key reasons for electricity prices to trend higher. Firstly, we've got large coal fired power stations closing as they reach the end of their useful lives, reducing electricity supply. We've got new wind and solar farm additions probably going to slow because the electricity grid is struggling to accommodate them. And then last, but not least, we've got high gas prices pushing up running costs for gas fired power stations and putting upward pressure on electricity prices. And we expect that to continue. So despite the tough near-term outlook, we think the longer-term outlook is positive for AGL.

Jackson: So at the end of June, AGL's management confirmed the details of the upcoming demerger, can you give us a quick overview of what's happening and what it means for investors.

Atkins: Yeah, sure. So management plans to separate the coal power stations from the retail business. And that's basically just to ring fence the ESG risks. Both of these businesses will be listed on the ASX and AGL investors will get shares in both of them. In terms of the individual businesses, we think the retail business should be fairly stable. While the earnings in the generation business will fluctuate more with the wholesale electricity price. And because we're positive on wholesale electricity prices, we think that that generation business actually has the better growth potential. From what we've seen so far from management, we think there are pros and cons with this demerger plan. The negatives include that there's going to be a loss of scale and duplication of a lot of head office costs, such as staff costs, and IT systems. But there is a positive and that is that the retail business should remain well supported by its banks, because banks at the moment are trying to reduce their exposure to coal, and that's making life a bit difficult for AGL. So with the retail business, getting better treatment from the banks, then that allows it to take on most of AGL's debt, and therefore the the generation side of the business will not have to carry much debt at all. It'll have a small amount of debt, and we think it could probably repay that pretty quickly over the next few years anyway.

Jackson: And for AGL shareholders today, what will they get when the demerger happens?

Atkins: Shareholders will get a share, for every share they have in AGL, they get one share in the the two separate businesses.

Jackson: Fantastic. And when AGL reports Thursday, what are you looking for? And are there any announcement that investors should stay alert for?

Atkins: Look, I think most people watching the stock are going to be looking at fiscal '22 profit guidance that will give a good idea of operating conditions now. But for me, I'll be looking for evidence that our thesis is starting to play out essentially that higher gas and electricity prices are going to flow through to earnings over the medium term.

Jackson: Great. Adrian, thanks for your insights today.

Atkins: No problem, Lewis.

Jackson: I'm Lewis Jackson with Morningstar. Thanks for watching.