1 Meridian Energy EQUITY RESEARCH – New Zealand ANALYST FIRST NZ CAPITAL SECURITIES LIMITED IS A NZX FIRM Jason Lindsay +64 4 496 5338 [email protected] 29 October 2010 A valuation perspective PG 1 TABLE OF CONTENTS TABLE OF CONTENTS ....................................................................................................................................................... 2 EXECUTIVE SUMMARY...................................................................................................................................................... 3 Recent Performance .................................................................................................................................................................................3 Earnings Outlook ......................................................................................................................................................................................3 Base Case Valuation .................................................................................................................................................................................3 Key Assumptions.......................................................................................................................................................................................3 Sensitivity Analysis....................................................................................................................................................................................3 COMPANY PERFORMANCE ............................................................................................................................................... 4 Trends .......................................................................................................................................................................................................4 Sector Outlook ..........................................................................................................................................................................................4 Company Outlook.....................................................................................................................................................................................7 EARNINGS MODEL ........................................................................................................................................................... 8 Earnings estimates....................................................................................................................................................................................8 Cash Flow Estimates ...............................................................................................................................................................................10 Balance Sheet .........................................................................................................................................................................................10 ASSUMPTIONS ADOPTED............................................................................................................................................... 13 Economic Assumptions ..........................................................................................................................................................................13 Sector Assumptions.................................................................................................................................................................................13 Specific Assumptions ..............................................................................................................................................................................14 Capex Assumptions.................................................................................................................................................................................15 DISCOUNTED CASH FLOW VALUATION .......................................................................................................................... 16 Cost of capital assumptions....................................................................................................................................................................16 Summary of DCF valuation.....................................................................................................................................................................17 Cash Flows for forecast horizon .............................................................................................................................................................17 Key Assumption Sensitivity.....................................................................................................................................................................18 COMPARISON OF DCF VALUATION WITH ALTERNATIVE VALUATION METHODS ............................................................ 19 Peer Company Analysis ..........................................................................................................................................................................19 Peer Company Analysis Commentary ....................................................................................................................................................20 APPENDIX 1................................................................................................................................................................... 21 PG 2 EXECUTIVE SUMMARY Recent Performance Meridian Energy’s underlying profit after tax increased by 29% in FY10 to NZ$251.9mn (from NZ$195mn) primarily as a result of an improved LWAP/GWAP factor, and above average storage and high inflows combined with some significant thermal plant outages resulting in a short period of higher wholesale electricity prices. EBITDAF increased by 25% in FY10 to NZ$641.7mn (from NZ$512.4mn). We estimate the lower LWAP/GWAP (load weighted average price to generated weighted average price) factor in FY10 (1.13x versus 1.24x in FY09) added close to NZ$70mn to EBITDAF (although this was mitigated by a return to more normal levels of constraint rental rebates). The full commissioning of the 143MW West Wind project added a further circa NZ$15m to EBITDAF (and would have been more under more normal wholesale electricity prices). Benefits from the cost out programme were also seen. EBITDAF/MWh increased 10.6% from NZ$41.87 to NZ$46.29. Earnings Outlook A large portion of the forecast EBITDAF growth in FY11 and FY12 is as a result of acquisitions/capex (primarily Mt Millar and Te Uku) in FY10 and FY11. A full year contribution from Mt Millar wind farm is expected in FY11 with first turbine commissioning of Te Uku wind farm expected late calendar year 2010 (partial contribution in FY11 and full contribution in FY12). The new NZAS agreement takes effect from 1 January 2013. We forecast a significant lift in earnings as a result (partially reflected in FY13 and the full impact in FY14). Meridian Energy faces a significant increase in HVDC charges as a result of the Transpower Pole 3 project costing up to NZ$670mn due for completion in 2012 (although they will benefit from a lower location factor). We forecast the construction of Central Wind (which is consented) in FY13 and FY14 with commissioning from FY15. We do not forecast any further developments beyond what has been consented. Base Case Valuation Our DCF valuation is based on forecasting Meridian Energy’s cash flow for a 10 year period. This derives an enterprise valuation of NZ$7,495mn and an equity value of NZ$6,276mn using a WACC of 8.6% and a terminal growth rate of 2.5%. Key Assumptions Our retail price path effectively preserves the current profitability of the retail division. We assume the first leg of carbon pricing (from 1 July 2010) is reflected in FY11 (first half) with the removal of the 50% free allocation on emissions from 31 December 2012 causing a further leg up in tariffs FY13 (back half). Intense retail competition and softer wholesale electricity prices in the short term (meaning retail is currently quite profitable) may result in a delay in processing the forecast tariff increases giving rise to downside risk to our forecasts. After lowering our short term wholesale price path to reflect softer hedge data, our wholesale price forecasts are now in line with Energy Hedge and ASX data through to FY15. MED forecasts are higher than our forecast price path in later years. We assume HVAC and HVDC percentage increases in line with Transpower forecasts and CPI and distribution system growth (1.5%) increases to lines company charges. Our long run generation assumptions are based on the 13 year average per Energy Link with 3% efficiency gains on Manapouri and Benmore following recent capital expenditure. Line losses and LWAP/GWAP are forecast in line with historic levels with an improvement the the LWAP/GWAP factor from FY13 following the commissioning of the upgraded HVDC link (Pole 3). We have attempted to unwind the NZAS estimated cash flows liability with reference to wholesale price path forecasts. Our analysis suggests the tariff is at a 19% discount to the forecast wholesale price path. Sensitivity Analysis Relative to others in the sector Meridian Energy is less sensitive to moves in retail tariffs (as a result of their smaller residential book relative to