Contact Energy - CEN Chart

[Snoopy]

Since I wrote the above post, Contact has paid a special dividend of 50c per share. So my equivalent purchase price for that last parcel of shares is now $5. As I write this, the share price is $4.90, so even cheaper!

When purchasing shares I always like to stack up any potential purchase with any alternative that is out there. Genesis Energy is also an electricity gentailer that, like Contact, has natural gas interests. So how do the two stack up?

Dividends are all fully imputed.

	Contact Energy	Genesis Energy
Share Price	$4.90	$1.41+31c(Kupe)
Projected eps (FY2015)	26.2c	6.4c+2.6c(Kupe)
Projected dps (FY2015)	11c+15c=26c	8c+8c=16c
Gentailer PE	18.7	22.0
Earnings Yield Gentailer (FY2015)	7.4% (gross)	6.3% (gross)
Share Price for 6% yield (fair value)	$6.04	$1.48+$0.31
Discount from fair value	19%	4%
My Investment Response	Buy	Hold

This table is behind the reason that I added to my CEN holding today. Most of the extra discount is I believe rated to the uncertainty surrounding Origin's controlling stake. But what a wonderful opportunity that gives for we value investors to top up!

I wrote the above post on 31st July 2015. In today's context it is historical. However for comparative purposes I wish to bring it up to date. Since I made that post I have changed my mind on how Kupe should be valued. Back then I thought Kupe should be valued on an 'after tax' basis'. Now I consider valuation on a 'before tax' basis more appropriate. So how does this one small change affect my valuation of Genesis Energy?

	Contact Energy	Genesis Energy
Share Price	$4.90	$1.29+43c(Kupe)
Projected eps (FY2015)	26.2c	6.4c+2.6c(Kupe)
Projected dps (FY2015)	11c+15c=26c	8c+8c=16c
Gentailer PE	18.7	20.1
Earnings Yield Gentailer (FY2015)	7.4% (gross)	6.9% (gross)
Share Price for 6% yield (fair value)	$6.04	$1.48+$0.43
Discount from fair value	19%	10%
My Investment Response	Buy	Hold

Result: No effect on the decision I made to invest more in CEN at that time. However, it does show that the gap between my perceived market value of GNE and CEN at the time was not as great as I had thought.

SNOOPY

[Bobdn]

I have both CEN and GNE but because GNE has a geoss dividend yield almost twice as much as CEN, I like GNE better. This is how sophisticated my investing is.

[Snoopy]

CEN values SAP at 265 million with a 15 year lifetime, I don't really see how the change to SAP will increase earnings.
At the stations it is just a hinderance because no-one knows where the spares are anymore.

Page 38 of the 23-11-2106 presentation gives some detail of what the Contact SAP system is scheduled to do.

Pre November 2015

SAP Go-live
SAP stabalization
SAP release 1 adds credit checking
SAP release 2 resolves billing issues

Progress since November 2015

SAP release 3 adds billing capability
SAP driven cost reduction
SAP release 4 adds new products
Leverage SAP data and insight

Go to page 39 and you can see how the customer statistics are measuring up:

Average number of bills paid more than 30 days late has plummeted to one tenth of what it was only two years ago. Yet overall bad debt expense hasn't decreased significantly (0.55% two years ago, 0.5% today). One factor could be that the number of retail customers on more than 10% discount have increased from 63% two years ago to 82% now. Myself, as a recent sign up, make sure that I keep a positive balance on my power bill about a month ahead of the bill cycle to be absolutely sure I don't miss that 20% discount which hooked me a new customer.

Slide 24 shows the cost of energy for FY2016 was just over $30/MWh, down from just under $40/MWh in FY2015. I presume a major contributor to this is becasue of the closure of Otahuhu. So even with more customers moving to a 20% discount on their power bills, there is enough cost reduction there for Contact to be increasing their profits while offering customers better deals

I see that "Digital customer Interaction' is a must have. So it looks like more 'apps' are under development. Contact are embracing mobile devices as a customer interaction tool if you can believe the presentation graphics. The graphics also say that 'Home Generation' will be embraced. That includes 'backup power' (that means battery storage) and time of use billing. Even "horus1" will be feeling all warm and fuzzy with that revelation!



SNOOPY

[Snoopy]

I made the above estimate with the Contact Energy August market update. But now we have the actual figures it is time to tidy my estimate up.

1/ Take EBITDAF.

$525m

2/ Remove one off profit effects.

+0.72x$24m (Add back one off cost from retail transformation project)

3/ Less Depreciation and Amortization

-$204m

4/ Less annual interest charge.

-$98m

5/ Less tax payable at 28%

-$67m

6/ Calculate NPAT (normalised estimate).

=$173m

From this the actual normalised earnings per share are:

$173m / 733m = 23.6cps

To my surprise the final dividend of 15cps was retained from last year (albeit this time unimputed). Coupled with the 11cps interim dividend, the normal dividend from FY2015 of 26cps represents 110% of net profit.

I am sad to report I have to make a correction to the reference calculation below. I had added back the one off effect of $24 because of costs associated with the retail transformation project. However, on inspection of the segmented results, it seems these costs were never incorporated into the EBITDAF earnings figure to start with. So I should not have added them back in after all!

1/ Take EBITDAF.

$525m

2/ Remove one off profit effects.

nil

3/ Less Depreciation and Amortization

-$204m

4/ Less annual interest charge.

-$98m

5/ Less tax payable at 28%

-$62m

6/ Calculate NPAT (normalised estimate).

=$161m

From this the actual normalised earnings per share are:

$161m / 733m = 22.0cps

SNOOPY

[Snoopy]

I am sad to report I have to make a correction to the reference calculation below. I had added back the one off effect of $24 because of costs associated with the retail transformation project. However, on inspection of the segmented results, it seems these costs were never incorporated into the EBITDAF earnings figure to start with. So I should not have added them back in after all!

1/ Take EBITDAF.

$525m

2/ Remove one off profit effects.

nil

3/ Less Depreciation and Amortization

-$204m

4/ Less annual interest charge.

-$98m

5/ Less tax payable at 28%

-$62m

6/ Calculate NPAT (normalised estimate).

=$161m

From this the actual normalised earnings per share are:

$161m / 733m = 22.0cps

Updating the normalised profit figure for FY2016:


1/ Take EBITDAF.

$523m

2/ Remove one off profit effects.

nil

3/ Less Depreciation and Amortization

-$201m

4/ Less annual interest charge.

-$101m

5/ Less tax payable at 28%

-$62m

6/ Calculate NPAT (normalised estimate).

=$159m

From this the actual normalised earnings per share are:

$159m / 715.1m = 22.2cps


SNOOPY

[Snoopy]

Updating the normalised profit figure for FY2016:

<snip>

6/ Calculate NPAT (normalised estimate).

=$159m

From this the actual normalised earnings per share are:

$159m / 715.1m = 22.2cps

The gentailers have a reputation for being 'yield' shares. The sort of thing you want to have in a portfolio if you want a steady income. Over the last couple of years the trend has been towards paying dividends out of cashflow, rather than earnings. This in turn means that most of the dividends from gentailers going out into the future will not carry full imputatiuon credits. Paying out dividends without imputation credits is nothing new. One example that comes to mind is the former Dorchester Pacific (now renamed Turners). Like other NZ finance companies, immediately post GFC, they got into terrible trouble and booked huge losses. Unlike most other finance companies they recovered and recouped their tax loss position over many years. During these years of recuperation, Dorchester paid out modest unimputed dividends. The gentailer position, as regards imputation credits on dividends , though, is quite different.

None of the big gentailers have ever been in the kind of trouble that almost sunk the entire finance industry in NZ. But most of the gentailers are coming out of a period of investment in new power stations that is now finished. Thus they have high depreciation charges (non cash) that will not require a corresponding reinvestment in new power plant in the medium term. These depreciation charges effectively become extra free cashflow. And that extra cashflow is being passed on to customers through 'top up' unimputed dividends.

Contact Energy has its own unique take on the imputed dividend issue. For many years they had been building up imputation credits on the books. Just before Origin Energy relinquished their controlling stake in Contact, these imputation credits were released in the form of being attached to a special dividend. The downstream effect of this was that due to tax payment timing issues, the following normal dividend, paid from normal business operations, was paid with no imputation credits at all! Shareholders should be assured that this is a temporary situation. With the settling down of the Contact share register, imputation credits will be resumed. Yet Contact suffers from my previously discussed point of having high positive cashflow that is in part not taxed as a result of the recent power station building program (Te Mihi Geothermal in the case of Contact) being completed. Like the other gentailers it is unlikely that dividends going forwards will be fully imputed. So an important question arises: How do you value a dividend that is only partially imputed?

My position is that the unimputed part of these gentailer dividends should not be counted in an investors return. Unimputed dividend are in effect a return of cash assets already held by the company and already owned by shareholders. Thus when Contact pays an unimputed dividend, what they are really doing is just paying your own share capital, that you already own, back. Unfortunately for shareholders, capital returned by the unimputed dividend method is taxed. I would argue that this capital tax, paid as income tax, should be taken off the investors return for the year. My position then is that unimputed dividends are not even neutral but negative for shareholders.

Companies never like reducing dividends paid to shareholders. Even if they have a poor year, they can often 'look through' that result to next years recovery and maintain their dividend. So the company 'dividends stream' is often more stable than the 'earnings stream'. In the case of Contact they have paid out an 11cps interim dividend and a 15cps final dividend in recent times. Cashflow forecasts indicate they will not need to reduce these payments, even if tax paid earnings fail to match the annual dividend payment of 11cps + 15cps = 26cps. My normalised earnings calculations show that in FY2015 eps was 22.0cps and in FY2016 is was 22.2cps. If we regard an eps of 22cps are the 'present market norm', and assume Contact do not reduce their annual dividend payment of 26cps, this points to future annual dividends of 26cps being made up of a 22cps imputed dividend component and a 4cps unimputed dividend component. Using this breakdown, we can calculated a forecast 'gross dividend' for Contact Energy going forwards as follows:

22cps/0.72 + 4cps = 30.5cps + 4cps = 34.5cps.

From this we must remove from shareholder 'return' the negative capital effect of paying tax on capital shareholders already own (the tax effect of the unimputed dividend), and the neutral effect of paying back capital that shareholders already own (the unimputed dividend itself).

34.5cps - 4cps - 0.28( 4cps ) = 29.4cps

Using a reference price of $4.73 per Contact Energy share this equates to a gross yield of:

29.4c / 473c = 6.2%

If we assume that in these days of low interest rates a 6% gross yield is an acceptable return, this leads to the fair value of a CEN share to be:

$4.73 x ( 6.2/6.0 ) = $4.89

SNOOPY

[Arbroath]

Hi Snoopy,

You raise a good point - I'd rather Contact reduced the dividend to 17-18cps that it can pay fully imputed and used the surplus free cash flow to conduct share buy backs annully over the next 3-4 years. That would have the effect of reducing shares on issue by up to 20% (if all surplus FCF above NPAT is spent - projected c. $200m+ each year for a few years). The reduced shares on issue will then enable a higher fully imputed dividend per share to be paid as the NPAT (assume flat around $160m) is spread over less shares on issue. By 2020 they could be paying 30cps fully imputed if they pursued that strategy which brings the gross yield up to near 9%.

[Snoopy]

Hi Snoopy,

You raise a good point - I'd rather Contact reduced the dividend to 17-18cps that it can pay fully imputed and used the surplus free cash flow to conduct share buy backs annully over the next 3-4 years. That would have the effect of reducing shares on issue by up to 20% (if all surplus FCF above NPAT is spent - projected c. $200m+ each year for a few years). The reduced shares on issue will then enable a higher fully imputed dividend per share to be paid as the NPAT (assume flat around $160m) is spread over less shares on issue. By 2020 they could be paying 30cps fully imputed if they pursued that strategy which brings the gross yield up to near 9%.

Arbroath, I do not disagree with any of your suggestions as regards managemnt of the cashflow of Contact in the best interest of shareholders. However, there is one more use of the unimputed earnings cashflow that Contact managment should consider. Paying down debt! If you go to section B4 of AR2016, you will see that in April 2017 $100m in 'Wholesale bonds' are maturing. At the moment Contact are paying an interest rate of 7.86% on those bonds. Pay that off and you get nearly $8m of savings on interest paid. This is not insignificant when your normalised profit is $161m. In fairness I believe that management are actively pursuing a debt reduction program.

SNOOPY

[Snoopy]

Using a reference price of $4.73 per Contact Energy share this equates to a gross yield of:

29.4c / 473c = 6.2%

If we assume that in these days of low interest rates a 6% gross yield is an acceptable return, this leads to the fair value of a CEN share to be:

$4.73 x ( 6.2/6.0 ) = $4.89

Medium time readers will notice a difference betweem the fair valuation that I have given above, $4.89 (post 1328) , and the $5.50 valuation I came to detailed in post 1288. So which of my two 'fair value' calcluations am I backing: $4.89 or $5.50?

Personally I do not like to make valuations made on the basis of a single year, or in the case of my $4.89 valuation just a couple of years. Granted these years are the most recent, and therefore most closely represent 'current market forces'. But personally I prefer to use the averaging effect that using eight years of market data brings. So I am sticking to $5.50 as my estimate for 'fair value'. Having said this, I do not dismiss my $4.89 valuation entirely. If you believe that current market forces are entrenched, then $4.89 could be taken to be a more current, and pessimistic 'fair value' view.

My investment philosophy is always to buy at 'below fair value', not 'fair value'. So in current market conditions I would consider up to $4.89 as an appropriate price to buy in Contact Energy from a new to the company investor perspective.

SNOOPY

[Arbroath]

Agree entirely although the actual saving is more like $3m to the bottom line as they can roll those bonds at c. 4.5% in the current market and the interest is a pretax expense.