Contact Energy - CEN Chart

[Snoopy]

Still difficult to store wind energy - however, it does make a lot of sense for wind generators to stop their generators when the power price is too low. At current they tend to run losses when their cost (due to maintenance and wear) are higher than the price paid.

Makes sense to turn off the turbine if you aren't making money BP. But I still don't get the principle of :

"allowing wind to offer into the market in a similar manner to all other generators"

Let's say you offer a whole lot of wind energy to the market next winter and the wind doesn't blow. What do you do? Buy the energy you have contracted to sell on the market? Sounds a very risky proposition!

SNOOPY

[Snoopy]

I don't think there is a risk to the current 26cps annual dividend payout, even if a lack of imputation credits reduces this dividend net value to less than 26cps. Therefore my valuation of Contact Energy remains largely unchanged. But if the dividend is not fully imputed in FY2017, then my $5.50 'fair value' will reduce a bit. Yet I don't expect that reduction be be significant because 'this year' will only provide 1/9 th of my company valuation data.

The above was written back in July. Contact have subsequently announced a change to dividend policy. From p33 of the annual result presentation:

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Contact will target distributions of between 80 – 90% of operating free cash flow as an ordinary dividend, on average over time, once the S&P net debt / EBITDAF ratio is below 2.8x

Contact will provide the market with the targeted distribution for the following financial year
» Distributions are expected to be split into an interim dividend paid in April, targeting 40% of the total expected
dividend, with the remainder paid as a final dividend in September
» Imputation credits will be attached to dividends to the extent they are available.

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The projected increase in gross dividend, based on gross profits being constant from FY2017 onwards is:

Financial Year	Projected Gross Dividend
2017	26 cps
2018	32 cps
2019	34-38 cps

But there is the very important 'key rider' about imputation credits being available. My normalised result for NPAT for FY2017 was as follows:

EBITDAF	$494m
less Depreciation & Amortisation	($204m)
less Interest	($92m)
equals Underlying NPBT	$228m
less tax at 28%	($64m)
equals Underlying NPAT	$134m

Divide NPAT by the 715m of shares on issue and I get an earnings per share figure of:

$134m/715m = 18.7cps

It looks like only just over half of the dividend will be imputed from now on! This makes the 'fully imputed' 15c dividend that we shareholders have just received look like a manipulation from prepayment of tax. How can a company pay 23c of imputed dividend (Full year dividend was 26c, but the interim 11c dividend was only imputed to 8c) when underlying earnings look to be 19c in round figures? If Contact really are able to pay a 13c interim dividend followed by a 19c final in FY2018, something approaching half of that could be shareholders being paid their own capital back, with the tax man taking his slice on the way!

SNOOPY

[BlackPeter]

Makes sense to turn off the turbine if you aren't making money BP. But I still don't get the principle of :

"allowing wind to offer into the market in a similar manner to all other generators"

Let's say you offer a whole lot of wind energy to the market next winter and the wind doesn't blow. What do you do? Buy the energy you have contracted to sell on the market? Sounds a very risky proposition!

SNOOPY

Not a specialist for our very own electricity market ... but my understanding is that according to the rules of the game wind generators in NZ are required to offer all the electricity they think they can provide in the next 30 min slot for $10 per MWh. All other suppliers may ask for a higher price - reflecting as well their higher reliability. Obviously - at the end all generators get the price which was asked for by the dearest generator who's offer was still taken.

The network can cope with demand changes as well as with supply changes - wind generators don't have to provide or offer power they can't deliver (i.e. if the wind stops, this is fine and somebody else will supply more). The price wind generators pay for their unreliability is that they always need to offer their power at the lowest price.

Just my limited understanding of our power market. Can any of the power gurus around here confirm or amend?

[Snoopy]

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Contact will target distributions of between 80 – 90% of operating free cash flow as an ordinary dividend, on average over time, once the S&P net debt / EBITDAF ratio is below 2.8x

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What does Contact's new dividend policy really mean in dollar terms? To answer that question I have overlaid the new dividend policy on the actual results over the last nine years.

	FY2009	FY2010	FY2011	FY2012	FY2013	FY2014	FY2015	FY2016	FY2017
Cashflows from Operating Activities	$425m	$368m	$379m	$440m	$469m	$446m	$490m	$556m	$502m
less Stay in Business CAPEX	($103m)	($76m)	($180m)	($98m)	($116m)	($46m)	($63m)	($87m)	($75m)
less Net Interest Costs	($63m)	($56m)	($62m)	($72m)	($66m)	($77m)	($98m)	($101m)	($92m)
equals Operating Free Cashflow	$259m	$236m	$137m	$270m	$287m	$323m	$329m	$368m	$335m
Operating Free Cashflow x 0.8	$207m	$189m	$110m	$216m	$230m	$258m	$263m	$250m	$228m
Dividend per Share (based on 715m shares on issue)	29cps	26cps	15cps	30cps	32cps	36cps	37cps	35cps	32cps

Those calculated dividends are rather higher than what was actually paid out in the past, with one exception: FY2011. Why was the operating cashflow over FY2011 anomalously low? In that year Contact built both the Stratford Peaker station, and commissioned the Ahuroa gas storage site. Both of these additions were not to add to the normal portfolio of generation assets. They were to enable the existing generation assets to be utilized more effectively. It looks like Contact may have classified any associated expenditure as 'stay in business' Capex, because of this.

I intend to use the above table as 'input information' into my 'capitalised dividend' valuation model, which is one window as to what Contact Energy shares might be worth today.

Another point of note is that I am assuming exactly 715m shares were on issue at the end of each year over the last nine years. In fact the number of shares issued varied with share issues and share buybacks. However the purpose of the table is not an historical retrospective. The purpose of the table is to answer the question:

"What would happen if we imposed the the weather events and demand from the last nine years over the current capital structure. Effectively we are modelling an array of nine possible demand and generation variability events over today's Contact Energy, to see what kind of dividend variability going forwards we might expect.

One more point to notice is the very last figure in the bottom RH corner of the table. That figure - 32cps - happens to be exactly the targeted dividend figure that Contact is looking to achieve for FY2018 assuming debt has been brought down to an acceptable level. By implication, debt was not at an acceptable level at the end of FY2017. But if the debt had been brought down, that means we might have expected that level of dividend from the year just gone, had today's dividend policy applied. The fact that the retrospectively calculated dividend for FY2017 aligns with the forecast dividend of FY2108 gives me confidence in the dividend numbers rolling out from this modelling.

SNOOPY

[blackcap]

Not a specialist for our very own electricity market ... but my understanding is that according to the rules of the game wind generators in NZ are required to offer all the electricity they think they can provide in the next 30 min slot for $10 per MWh. All other suppliers may ask for a higher price - reflecting as well their higher reliability. Obviously - at the end all generators get the price which was asked for by the dearest generator who's offer was still taken.

The network can cope with demand changes as well as with supply changes - wind generators don't have to provide or offer power they can't deliver (i.e. if the wind stops, this is fine and somebody else will supply more). The price wind generators pay for their unreliability is that they always need to offer their power at the lowest price.

Just my limited understanding of our power market. Can any of the power gurus around here confirm or amend?

John Worth at NWF AGM was saying that they had to supply all power at $.01 (ie 1 cent) and were not allowed to curtail under the current regime. But that is likely to change very soon.... (he said that some of the companies like CEN et al have weather forecasters in their team so they can work out when the wind generators are likely to start producing power and thus be able to "game" the bidding system. Very clever. But if curtailing is going to be allowed and if the wind generators can offer in 5 bands rather than at 1 cent as is suggested this will change the game.

This is how I understood his explanation in lay mans terms. I am not trying to mis-quote or put words in his mouth. This is my interpretation of what the NWF CEO said to us after the meeting in informal talks.

[Snoopy]

Actual FY2016 results are out, so time to update my valuation model.

First a few words for those who joined the Contact Energy (CEN) party late.

CEN operates in an industry where the weather plays a big part. No-one can predict for sure what the weather, and hence resultant rainfall, and consequently inspired power demand will be on the overall network. In addition there are competitive market pressures which see customers happy to flip flop between different retailers at regular intervals. However, Contact have been operating in volatile weather and consumer markets for many years. Furthermore, the energy market is relatively mature. Rather than try and guess what the weather and consumer market share for Contact in the future might be, I prefer to use 'actual data' from the last eight years, and superimpose the current forward dividend policy on that data. Because I am considering eight years of data, this will produce an 'averaging effect'. Thus, although I predicting a particular 'fair share value' for Contact, we can expect the market value of CEN shares to fluctuate both above and below that figure.

Gentailers have a lumpy demand for investing in new power stations. Right now we are at the bottom of the lump. Generally a gentailer must keep reinvesting in their generation plant to keep viable. But right now we are in a place where the big reinvestment is done. This means that the annual depreciation and amortization charges on assets do not need to be reinvested right now. That means 'extra cashflow' for Contact Energy, and 'extra money' that is available to pay out to shareholders, over and above earnings? How much extra money?

In FY2016 the depreciation and amortisation charge was $201m, and the offsetting capital expenditure was $128m. There are currently 715.5m Contact shares on issue. So the 'windfall cashflow' per share in FY2016 amounts to:

($201m-$128m)/ 715.5m = 10cps

Of course not all of this is available to be paid out. Contact currently has a relatively high debt load. Management have indicated that they wish to use some of that cashflow to pay down debt. But add 10cps to last years earnings of 22cps and you get 32c. There is plently of headroom there to indicate paying a cash dividend of 26cps per year going forwards will not be a problem.

Below I present my corrected earnings picture for the last eight years. You will note that:

1/ I have deleted last year's 50cps special dividend from the record, because it will not be possible to repeat that into the future.
2/ The 'Scenario Dividend Per Share Column' represents a prediction of an ongoing dividend of 26cps being paid into the foreseeable future.
3/ The (A) - (B) difference column, if negative, represents the amount of the projected dividend not covered by imputation credits. This is important, because a dividend paid without imputation credits is in accounting terms, equivalent to giving shareholders their own capital back (equal to the amount of the unimputed dividend) complete with a tax bill. This is generally bad for investors. It is necessary to make a negative adjustment to account for any expected tax to be paid on the unimputed dividend component.
4/ The capital component of the dividend is the portion of shareholder equity being returned to shareholders. This will need to be removed from the dividend return calculation. Because to pay it is to return to shareholders money on the balance sheet that they already have, so it isn't a shareholder benefit.
5/ The unimputed component tax bill column, represents the income tax charged on share capital that is expected to be paid by the shareholder. A 28% tax rate is assumed. Note that if the (A)-(B) differnce is positive there is no extra tax bill. That's because in such a year, the dividend is fully imputed.
6/ The final column represents the dividend per share adjusted for any extra tax obligation.

Scenario Basis Financial Year	eps (A)	Scenario dps (B)	Difference (A)-(B)	Divie Capital Component (C)	Unimputed Tax Bill (D)	Difference (B)-(C)-(D)
2009	27.0c	26.0c	+1.0c	0c	0c	26.0c
2010	25.3c	26.0c	-0.7c	0.7c	0.2c	25.1c
2011	22.4c	26.0c	-3.6c	3.6c	1.0c	21.4c
2012	24.6c	26.0c	-1.4c	1.4c	0.4c	24.2c
2013	27.5c	26.0c	+1.5c	0c	0c	26.0c
2014	27.1c	26.0c	+1.1c	0c	0c	26.0c
2015	22.0c	26.0c	-4.0c	4.0c	1.1c	20.9c
2016	22.2c	26.0c	-3.8c	3.8c	1.1c	21.1c
Total	198.1c	208.0c				190.7c

The expected average dividend per year, net of tax is therefore: 190.7 / 8 = 23.8cps (net)

Using a tax rate of 28c this is equivalent to a gross income of: 23.8cps /(1-0.28) = 33.0c

If we assume that a business cycle investment 'gross return' of 6% is required, then this equates to a CEN share price of:

33.0/0.06 = $5.50

So $5.50 is therefore 'fair value'. Naturally this valuation assumes no gross disruption to the market, i.e. Tiwai Point remains a going concern

Below I present my corrected earnings picture for the last nine years. You will note that:

1/ I have deleted the FY2015 50cps special dividend from the record, because it will not be possible to repeat that into the future.
2/ The 'Scenario Dividend Per Share Column' represents a prediction of an ongoing dividend of 80% of free cash flow being paid into the foreseeable future.
3/ The (A) - (B) difference column, if negative, represents the amount of the projected dividend not covered by imputation credits. This is important, because a dividend paid without imputation credits is in accounting terms, equivalent to giving shareholders their own capital back (equal to the amount of the unimputed dividend) complete with a tax bill. This is generally bad for investors. It is necessary to make a negative adjustment to account for any expected tax to be paid on the unimputed dividend component.
4/ The capital component of the dividend is the portion of shareholder equity being returned to shareholders. This will need to be removed from the dividend return calculation. Because to pay it is to return to shareholders money on the balance sheet that they already have, so it isn't a shareholder benefit.
5/ The unimputed component tax bill column, represents the income tax charged on share capital that is expected to be paid by the shareholder. A 28% tax rate is assumed. Note that if the (A)-(B) differnce is positive there is no extra tax bill. That's because in such a year, the dividend is fully imputed.
6/ The final column represents the dividend per share adjusted for any extra tax obligation.

Scenario Basis Financial Year	eps (A)	Scenario dps (B)	Difference (A)-(B)	Divie Capital Component (C)	Unimputed Tax Bill (D)	Difference (B)-(C)-(D)
2009	22.2c	29.0c	-6.8c	6.8c	1.9c	20.3c
2010	21.4c	26.0c	-4.6c	4.6c	1.3c	20.1c
2011	21.8c	15.0c	+6.8c	0c	0c	15.0c
2012	24.7c	30.0c	-5.9c	5.9c	1.7c	22.4c
2013	28.2c	32.0c	-3.8c	3.8c	1.1c	27.1c
2014	27.8c	36.0c	-8.2c	8.2c	2.3c	25.5c
2015	22.5c	37.0c	-14.5c	14.5c	4.1c	18.4c
2016	22.2c	35.0c	-12.8c	12.8c	3.6c	18.6c
2017	18.7c	32.0c	-13.3c	13.3c	3.7c	15.0c
Total	209.5c	272.0c				182.4c

The expected average dividend per year, net of tax is therefore: 182.4 / 9 = 20.3cps (net)

Using a tax rate of 28c this is equivalent to a gross income of: 20.3cps /(1-0.28) = 28.1c

If we assume that a business cycle investment 'gross return' of 6% is required, then this equates to a CEN share price of:

28.1/0.06 = $4.69

So $4.69 is therefore 'fair value'. Naturally this valuation assumes no gross disruption to the market, i.e. Tiwai Point remains a going concern

Readers should note that $4.69 represents 'business cycle neutral' fair value. We could argue that we are currently at the top of a low interest rate inspired valuation cycle. My rule of thumb would suggest a 'top of cycle' value some 20% higher than my calculated fair value.

$4.69 x 1.2 = $5.62

This isn't too far removed from the $5.54 Contact is trading at as I write this post. However, I would suggest that if Contact breaks out of this trading range (towards $6), that might be an appropriate time to look at lightening your shareholding.

SNOOPY

[tobo]

Contact dropped yesterday and Genesis today.

[Arbitrage]

The trend is my friend. The last 12 months have been kind to shareholders.

[fish]

Is there a trend?

[Hectorplains]

Operating report out. Electricity customer numbers are still drifting down. LPG customer base continues slow growth though - how 'sticky' are these customers?.

It doesn't appear that the fuel loyalty scheme is doing much to retain or attract customers? The recent announcement of bundling internet (but only for current customers) feels like a belated 'me too' response to Trustpower's success in this.

How important is the customer base as a metric for CEN?