CFA Society New Zealand University of Otago
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CFA Institute Research Challenge Hosted by CFA Society New Zealand University of Otago This Report is published for educational purposes only by students University of Otago—Student Research Competing in the CFA Institute Research Challenge Industrial Sector, Utilities Industry fgjhjgh New Zealand Stock Exchange (NZX) MERIDIAN ENERGY ` Date: 23/09/2016 Current Price: $2.85 Recommendation: BUY Ticker: MEL.NZSE Target Price: $3.16 Market Profile Executive Summary Closing Price $2.85 52-week Range $2.10-$3.05 We issue a BUY recommendation on Meridian Energy (MEL) with a one-year target Share Outstanding 2,561,300,000 price of $3.16 which offers a 16.3% total return, including dividends, on the closing price Market Capitisation (000s) $7,304,550 of $2.85 on the 23rd of September, 2016. Our recommendation is driven by: Forward P/E 24.15 EV/Forward EBITDA 11.27 Electricity Demand Growth – Growth in 2015 national electricity demand coupled with Dividend Yield 6.67% forecasted increases in GDP and population growth provides a positive outlook for increases in future demand. As a generator MEL would benefit from the associated Source: Bloomberg, NZX, Team Estimates increase in wholesale spot prices. Recommendation Rule Current Price $ 2.85 Positive Generation Outlook – MEL is New Zealand’s largest electricity generator Market Return Assumption 8.28% producing approximately 34% of national electricity generation FY2016. Large capital Sell Expected Return less outlays provide barriers to entry to the generation industry, solidifying MEL’s than -8.28% competitive position. As a predominately hydro generator MEL has the lowest short-run Hold Expected Return between -8.28% and marginal cost amongst its competitors, therefore, barring adverse hydro conditions MEL Buy Expected Return would be expected to generate cash strong flow in perpetuity. greater than 8.28% Source: Team Estimates Stable Retail Position – Despite increased retail competition, MEL has maintained a Valuation Summary consistent market share of approximately 13% and has the second lowest net switch rate Method Price Weight Weighted Price since 2012 amongst the big five gentailers. Smart meter rollout and a strong customer FCFF $3.42 0.5 $1.71 base from MEL’s Powershop brand suggest a stable retail outlook, with the firm’s retail DDM $3.37 0.25 $0.84 segment providing a natural hedge against falling wholesale prices. EV/EBITDA $2.55 0.25 $0.64 No Closure Price $3.19 Strong Cash Flows and Shareholder Return – MEL has seen growth in EBITDAF of Tiwai Risk-Adjustment -$0.03 12% in the past four years primarily driven by solid generation inflows and improving Target Price $3.16 retail performance. Dividend increases in each of the past four years and forecasted Source: Team Estimates – Further details in sustainable dividend growth signals continued high shareholder return. Appendix G Bull and Bear Scenario Analysis Valuation – Our target price of $3.16 per share was obtained using a combination of FCFF, DDM and Relative Valuation analysis, as well as incorporating a 10% possibility Bull Case Price Weight Weighted Price of a Tiwai closure. FCFF $ 3.54 0.5 $ 1.77 DDM $ 3.37 0.25 $ 0.84 Investment Risks – New Zealand Aluminium Smelters (NZAS) closure and adverse EV/Fwd EBITDA $ 2.57 0.25 $ 0.64 hydrological conditions remain the two largest risks to MEL’s short to medium-term Target Price $ 3.26 earnings. Additional risks to MEL are: power station production risk, and regulated Bear Case Price Probability Weighted Price market structure changes in both New Zealand and Australia. 2019 Closure $ 2.89 0.5 $ 1.45 2020 Closure $ 2.94 0.3 $ 0.88 Bear and Bull Case – We also consider a best and worst case scenario for MEL, in 2022 Closure $ 3.01 0.2 $ 0.60 addition to our base valuation. Our bear case presumes a 100% probability of a Tiwai Target Price $ 2.93 closure, reducing our target price to $2.93. A Tiwai closure is incorporated into our base Source: Team Estimates case with a 10% probability of closure weighting. Our bull case presumes a 0% probability of a Tiwai closure as well as allowing retail prices to rise by 2% per year, Share Price Movement assuming retail competition would fall with rising wholesale prices squeezing profit 7500 $3.50 margins of pure retailers. This scenario produces a target price of $3.26. 7000 $3.00 Key Financials and Ratios: No Closure Scenario 6500 $2.50 As at 30/6 2015 2016 2017F 2018F 2019F 2020F 2021F 6000 $2.00 Total Energy Margin $ 954 $ 1,009 $ 1,104 $ 1,082 $ 1,105 $ 1,163 $ 1,185 5500 $1.50 Total EBITDAF $ 618 $ 650 $ 743 $ 714 $ 768 $ 846 $ 863 5000 $1.00 NPAT $ 247 $ 185 $ 302 $ 280 $ 315 $ 361 $ 363 4500 $0.50 Debt to Equity 23.8% 25.0% 26.5% 28.4% 31.1% 35.6% 36.4% Return on Equity 5.2% 3.6% 6.2% 5.9% 7.0% 8.3% 8.6% 11/15 03/14 08/14 01/15 06/15 04/16 10/13 EBITDAF per Share $ 0.24 $ 0.25 $ 0.29 $ 0.28 $ 0.30 $ 0.33 $ 0.34 NZX50 MEL Payout Ratio 1.56 2.72 1.62 1.79 1.62 1.47 1.21 Dividend per Share $ 0.15 $ 0.20 $ 0.19 $ 0.20 $ 0.20 $ 0.21 $ 0.17 Source: Bloomberg Source: Company Data, Team Estimates Figure 1. MEL’s percentage of NZ Business Description Total Generation Meridian Energy Limited (MEL.NZSE) is a majority state-owned, vertically integrated electricity generator and retailer. MEL began operations in 1999 with the breakup of the 35.00% 33.8% 33.2% 33.0% Electricity Corporation of New Zealand (ECNZ) into three separate businessesi as the New Zealand electricity market began deregulation. In October 2013, MEL was publicly 30.5% listed on the NZX and ASX, with The Crown retaining 51.02% ownershipii. 30.00% With the breakup of the ECNZ, MEL was granted control over the Waitaki hydro scheme 27.2% and the Manapouri hydro station, both of which are located in the central South Island. Currently, MEL owns and operates seven hydro stations in the lower South Island, five 25.00% wind farms throughout New Zealand and two wind farms in Australia. Accounting for approximately 34% of total generation FY2016, the firm is New Zealand’s largest electricity generator. (Figure 1). As a predominately hydro generator MEL benefits from 20.00% a low-cost structure relative to its competitors dependent on higher cost thermal. Wind 2012 2013 2014 2015 2016 generation provides some protection against adverse hydrological conditions, however, Source: Energy Link MEL’s earnings can be volatile due to its dependence on consistent levels of rainfall and snowmelt. Figure 2. Segment Proportion of MEL’s operations can be broken down into several segments: NZ generation; which NZ Contracted Sales (GWh) comprises the sale of the firms hydro and wind generation into the spot market; NZ wholesale contracted sales, encompassing sales to the New Zealand Aluminium Smelter (NZAS) and net derivative contract sales; NZ retail contracted sales; and International th 10% generation and contracted sales. As at 30 of June 2016, the NZAS accounts for 41% of MEL’s NZ total contracted sales volume and consumes between 13-15% of national generation annually (Figure 2). Weak global aluminium prices and a strong New Zealand 49% dollar have decreased the profitability of the smelter, threatening its viability. As the smelter comprises such a large proportion of MEL’s contracted sales and NZ generation 41% as a whole, its failure is a key risk to the generation industry. Company Strategy MEL’s company strategy is to operate as an efficient, vertically integrated electricity generation and retail companyiii. Total Retail NZAS Financial Contracts Vertical integration – Operating as a vertically integrated business provides a natural hedge against periods of high wholesale prices which are typically Source: Company Data, Team associated with low hydro levels as decreasing retail margins are countered with Estimates increases in generation prices. This gives MEL a competitive advantage over pure retailers who face declining overall margins in times of increasing wholesale prices. Figure 3. MEL Dividend Payout Shareholder return – With a period of flat electricity demand and low short-term growth opportunities MEL has committed to returning a high proportion of cash flow to shareholders over the next several years. FY2016 MEL declared an ordinary 20.00 dividend of 13.50cps with a special dividend of 4.88cps (Figure 3). This represents 18.00 a 5% growth in ordinary dividends for the past year and a 33% total shareholder return compared with 20% return in the NZX top 50 companiesiv. 16.00 5.35 4.88 Renewable energy – MEL generates 100% of its electricity from renewable 14.00 sources, benefiting from a combination of hydro stations and wind farms. While 12.00 2.00 both wind and hydro generators are heavily reliant on weather conditions they 10.00 provide MEL with lower operating costs than thermal and geothermal generators 8.08 8.40 v 8.00 and have long operating lives . Additionally, this aligns MEL with the government’s 6.82 goal of 90% renewable electricity generation by 2025 and provides the firm a 6.00 reputational advantage over fossil fuel reliant companies. 4.00 Shareholder Structure 2.00 4.19 4.80 5.10 MEL is a mixed-ownership, majority state-owned enterprise with The Crown owning 0.00 51.02% of total shares outstanding and all minority owners restricted to a maximum 10% 2014 2015 2016 ownership interest. Institutions and individual investors own the remaining stake in the firm, with National Nominee New Zealand Limited recording the next largest ownership Interim Final Special stake at 4.89% as at 30 June, 2016 (Figure 4).