AGL Energy has cut its dividends after first-half profits slid 41%, hit by a fall in wholesale electricity prices. But better times are expected ahead for the energy generator and retailer, with Morningstar analysts forecasting a rise in energy prices, with cost-cutting also expected to lift its profits and push shares back over $8.00.

AGL (ASX: AGL) announced on Thursday that its underlying profit after tax dropped 41% to $194 million, while earnings before interest, taxes, depreciation, and amortisation (EBITDA) fell 21% to $723 million. It slashed first-half dividends to 16 cents per share, down 61% from a year earlier. AGL shares ended the day down slightly at $7.27. But still, the shares are “significantly undervalued”, according to Morningstar's analyst Adrian Atkins.

Graeme Hunt, AGL Energy managing director and chief executive, said that rising energy prices across the globe would boost its earnings as hedged positions expire. "AGL Energy is well-positioned to benefit from improving wholesale electricity prices seen over the past six months, and if it is sustained, we expect to see this reflected in future earnings beyond FY22," he said.

AGL raised the lower end of its 2021-22 profit forecast to between $260 million and $340 million, from $220 million to $340 million previously.

AGL Energy HY22 Results Presentation

Source: AGL Energy HY22 Results Presentation

Favourable energy outlook  

In the second half of 2022, AGL earnings are expected to decline given the increased costs of capacity to cover periods of peak electricity demand, which are higher in the summer months. Wholesale gas consumption is also expected to be lower due to warmer months in the second half. 

But in the last six months, energy prices have surged. New South Wales wholesale electricity price futures have climbed to an average of $78 per megawatt-hour through to the end of 2025. In comparison, futures were less than $50 per MWh a year ago. Victorian and South Australian prices have also improved, though not by as much. 

“Higher electricity prices are a boon for AGL, given its cost of producing electricity is mostly fixed thanks to long-term coal supply contracts in New South Wales and owning its own mine in Victoria,” says Atkins. 

He says the stock has a favourable outlook over the medium-term. The global economic recovery is pushing up demand for energy while Covid-19 economic and social restrictions have disrupted global supply chains. That is likely to keep coal and gas prices elevated, supporting wholesale electricity prices, according to Atkins.

“Better operating conditions for the generation division means bigger profits and less risk,” he says. Atkins forecasts the company to post underlying profit after tax of $308 million for the full year 2022.

Looking at other financials, AGL’s operating costs fell across the business, and the company is on track to deliver its target of $150 million in cost savings by the end of FY2021-22 compared with FY2019-20. AGL is also on track to achieve a targeted $100 million reduction in sustaining capital expenditure by FY2022-23.

The company said it can withstand rising costs from higher commodity prices because it has long term gas and coal supply contracts and given its focus on costs and cash preservation, solidifying AGL's balance sheet. AGL plans to rebrand itself as Accel Energy after demerging its retail business--AGL Australia--by June 2022. Accel's main assets will be the coal-fired power stations and a 15% stake in the separately-listed electricity and gas retailer AGL Australia.

“Our aim, by transforming our business, is not only to better address our own climate-related risks but to also take a key leading role in enabling Australia’s energy transition, creating long-term value and sustainable investment opportunities as we do it,” Hunt said.

Demerger on target for June 2022

AGL said it is “well progressed” to achieve the proposed demerger by 30 June 2022, subject to board, shareholder and regulatory approvals. However, the demerger is costly, with expenses expected to total between $220 million and $260 million, AGL said.

AGL Australia said it will become a net-zero energy business by 2040 and Accel Energy will close all coal generation assets no later than 2045.

“Energy transition and the path to net-zero will be the defining challenge of our era. Companies that don’t adapt, don’t innovate, and don’t set themselves on this path will be left behind,” Hunt said.

“Moving early has meant that today we operate the largest portfolio of renewable and storage generation assets of any ASX-listed company. And it is this legacy that will shape the DNA of AGL Australia and Accel Energy, and their response to climate.”

However, Morningstar’s Atkins said while the demerger will help achieve climate goals, by separating AGL’s old fossil fuel assets and its energy retail business, it doesn’t necessarily make financial sense.

“The demerger seems to be about keeping the banks happy, as they don’t want to lend to coal power stations, so it seems to be a necessary evil. If it wasn’t for that, I’d probably say it doesn’t make sense because of the loss of scale, loss of vertical integration, duplication of costs and one-off demerger costs of up to $260 million,” Atkins said.

Accel Energy will repurpose AGL’s thermal generation sites as low emissions industrial energy hubs, as it brings forward its coal closure dates to no later than 2033 for Bayswater and 2045 for Loy Yang. With Liddell scheduled to close by April 2023, Accel Energy’s electricity generation portfolio’s annual Scope 1 and 2 emissions will reduce by 18% to 27% between FY2024-25 to FY2033-34, and by 55% to 60% between FY2034-35 to FY2045-46, compared a FY2018-19 baseline, the company said.

Brokers upbeat on AGL

A research note from Ord Minnett says the very strong outlook for AGL should drive a positive reaction from the market. The broker has a buy recommendation on the stock with a target price of $8.70.  “Reported NPAT was also very strong due to mark-to-market of contracts and derivatives at higher spot prices,” the note said.

Similarly, Morgans analyst Max Vickerson says overall, it is a “very strong result” for AGL, which will likely be well received by the market.

“The company’s cost out program appears to be driving better than expected results through with earnings guidance lifting 7%. The worst fears of the market regarding the demerger also appear to have been put to rest with an additional underwritten dividend the only additional equity capital needed,” said Vickerson.