Contact Energy - CEN Chart

[Snoopy]

Now we come to a critical point in this analysis - the choosing of an 'indicative interest rate' that allows us to value Contact on the basis of being an ongoing income stream.

MacroEnvironmental Effect 1/ I have historically used an indicative interest rate figure of 5.5%. Since that time, interest rates have plunged to around 1%, before spiking sharply higher again (although not up to pre Covid-19 price expectations) in an effort to quell inflation.

MacroEnvironmental Effect 2/ Rapid rises in the price of aluminium has seen the Rio Tinto owned Tiwai Point aluminium smelter re-enter negotiations with Meridian and Contact. This will likely see aluminium smelting continue beyond the previously signalled FY2024 date for winding down of smelting in Southland. It will also likely see power price rises as alternative industries, like making hydrogen fuel, provide a competitive Southland based power hungry manufacturing alternative, should arrangements with Rio Tinto be unable to be concluded. Thus I see the future of electrical energy use in Southland as now being more certain, and continuing at an increased price. That will benefit the power industry in NZ generally, and Contact and Meridian, that currently have direct power supply contracts with Tiwai, in particular.

Considering these two macroenvironmental inflences, I have assessed that a gross return of 5.0% is an acceptable return from a shareholder perspective, investing in Contact Energy's assets today.

Post 2200 indicates that $43m worth of unused imputation credits may be on the Contact energy books going into FY2023. I have previously coined the term 'super-imputed' as describing future dividends that utilise such imputation credits. Imputation credits not earned during the year, but on the books to be used at some point nevertheless.

$43m represents $43m/0.28= $154m worth of profits before tax or $154m-$43m = $111m of net profit after tax. On a per share basis that represents

$111m / 776m = 'earnings per share' of 14.3cps

This is the quantum of dividend payment in the future that we shareholders can expect to be 'super-subsidized' above and beyond declared earnings. Once these excess imputation credits are used up, then I expect future tax credits to come out of this historical shadow and revert to reflecting operational performance (NPAT).

Valuing the Share

If we assume that a business cycle investment 'gross return' of 5.0% is required, then this equates to a CEN share price of no more than:

29.4c /0.05 = $5.88

So $5.88 is therefore 'fair value' on a 'whole of business cycle' dividend basis.

We need to discount from this $5.88 - by a factor - the earnings from the as yet uncompleted Tauhara geothermal power station. We need to discount these earnings back using an appropriate 'time value of money' factor. We need to remember that this discount only applies to the incremental value of the earnings from the new Tauhara project, not all of Contact's earnings. Tauhara is now expected to be operational in the second half of FY?2023 (08-02-2022 Press Release). This means it will be fully operational over FY2024. Taking an FY2021 perspective, FY2024 is three years into the future. Thus the discounting factor that I calculated back in post 2198 over 3 years -to be 0.8638- is appropriate.

EBITDAF-DA-I-T (Normalised NPAT) for the four years under consideration for dividend forecasting -excluding Tuahara- , (again from post 2198) were $131m, $175m, $127m and $183m. I make the four year average $154m. Tauhara is a geothermal station, and so will likely operate as base load generation, with energy output not varying much over the years. This means that over the business cycle, Tauhara should lift Contact Energy profits by:

$45m/$154m= 29.2%

Or looked at another way, from FY2024, Tauhara will be generating electricity supplying $45m/($154m + $45m) = 22.6% of Contact Energy profits (on average), compared to 77.4% of the .profits emerging from the rest of the Contact generation portfolio.

This means I need to adjust my fair value income yield valuation for Contact Energy as follows.

(0.774)($5.88) + (0.226)($5.88)(0.8638) = $5.70

The above valuation is effectively a 'no growth' valuation, that does not take into account any rises in value of the existing underlying power generation assets above book value. Increases in the value of power generation assets above book vale are a measure of the incremental discounted value of future cashflows, which feed from higher profits from existing generation assets. These higher profits are caused by legacy generation with low operating costs selling power into an ever higher average power price market. Contact Energy chooses not to increase the value of existing generation assets on the books annually (but competitor Mercury Energy does). However, I believe that to truly reflect the growth value of the Contact Energy generation portfolio, it is necessary to do this. So 'generation asset revaluation' is the next additive part of this Contact Energy share valuation exercise.

SNOOPY

[Snoopy]

(0.774)($5.88) + (0.226)($5.88)(0.8638) = $5.70

The above valuation is effectively a 'no growth' valuation, that does not take into account any rises in value of the existing underlying power generation assets above book value.

Increases in the value of power generation assets above book vale are a measure of the incremental discounted value of future cashflows, which feed from higher profits from existing generation assets. These higher profits are caused by legacy generation with low operating costs selling power into an ever higher average power price market. Contact Energy chooses not to increase the value of existing generation assets on the books annually (but competitor Mercury Energy does). However, I believe that to truly reflect the growth value of the Contact Energy generation portfolio, it is necessary to do this. So 'generation asset revaluation' is the next additive part of this Contact Energy share valuation exercise.

Contact Energy generation assets that have a significant unbooked premium on their book value are the hydro assets at Clyde and Roxburgh. We can estimate the quantum of this from similar increases in hydro station value that were booked by competitor Mercury Energy (see post 1878). The rising value of future cashflows, that increase the relative worth of long lived legacy power generation assets is an additional 'return' for which I have previously coined the term 'thin air capital'. That sounds ethereal, and is to the extent that this 'capital' appears solely on the expectation of power prices rising. However, although the short term power prices at the wholesale level go up and down, long term power prices go up and up. So in practice I have never seen any of the Mercury Energy declared new 'thin air capital' on their hydro generation assets ever vanish, even if theoretically it could.

The 'thin air' capital growth for Mercury hydro assets is shown below. Both Mercury and Contact operate in the same electricity market. That is why I consider the thin air capital accumulated by Mercury as an indicative factor to use for the thin air capital accumulated (but not recognised) by Contact management over that same period. Information in the table below is derived from posts 1349 and 1308 in the Mercury thread.

Mercury Energy	Reval. Hydro & Thermal Assets ($m)	Reval. Geothermal & Other Generation Assets ($m)	Total Revalued Generation Assets
2015	355	142	497
2016	82	55	137
2017	0	52	52
2018	0	55	55
2019	151	99	250
2020	253	43	296
2021	550	388	938
Total	1,391

That $1,391m of thin air incremental capital raised was based on a total hydro generating capacity of 1059MW (Post1347, Mercury Thread). The total Contact Energy hydro electric generation capacity is 784MW (my post 1514). So I can determine my 'best guess' at the thin air capital accumulated by Contact Energy subsequent to the FY2014 balance date by ratio:

$1,391m x 784MW/1059MW = $1,030m

New Capital projects are funded by a combination of debt and equity. If we take a 54% equity ratio going forwards as 'acceptable' (see post 2205), then this $1,030m of new 'thin air' equity could in theory fund capital projects to the tune of:

$1,030m / 0.54 = $1,907m

Take the project capital needed to complete Tauhara out of that total, and new incremental project capital is reduced to:

$1,907m - $818m = $1,089m.
Now 1,089/818= 1.33. And 168MW x 1.33 = 223MW

Theoretically, add in a new companion bond program, and it means I can see equity capital for another Tauhara sized field geothermal station (actually a geothermal station 33% bigger) as being available right now.

A new 223MW power station would lift operational generating capacity by 22.5% (ref post 2206)

This raises my 'fair value' of Contact Energy, based on my steady state income valuation, by 22.5%

$5.70 x 1.225 = $6.98

CEN closed on the market on Friday at $7.68, which makes it 10% overvalued by my way of looking at things. None of this takes account any sentiment that will flow from the imminent announcement of the FY2022 results and dividend to be announced.

SNOOPY

discl: holder

[nztx]

1. approx 12 months ago - wasn't there something that looked likely to affect forward earnings - Snoopy?

2. I note you state Mercury is booking revaluation gains - but they are 100% fully imputed on dividends (since 2013) by my notes.

Whereas Genesis are 80% imputed in their distributions, since early 2016 by my notes. Is there some other reason why GNE don't have tax credits to fully impute their distributions ? (ie amortisation / depreciation rates differing for tax & accounting purposes or something else ?)

[alokdhir]

CEN is underperforming the electric basket of MCY / MEL / GNE etc by a wide margin

Hopefully it will catch up around its results time .

CEN dividend is lopsided towards this distribution while others have equal distributions ....so it should be doing better in anticipation of 21 cents payout

Last week electric utility stocks were up 4.1 % while CEN was flattish ....MCY was the leader

[Snoopy]

With interest rates headed for unprecedented lows, I may have to revise my opinion on what equity ratios that I think of are acceptable, Yet the picture at Contact over the last eleven years has been unexpectedly consistent.

	Equity (A)	Assets (B)	Equity Ratio (A)/(B)
FY2010	$2,777m	$5,148m	0.5394
FY2011	$3,236m	$5,643m	0.5735
FY2012	$3,418m	$6,112m	0.5592
FY2013	$3,537m	$6,197m	0.5708
FY2014	$3,582m	$6,186m	0.5790
FY2015	$3,171m	$6,089m	0.5208
FY2016	$2,823m	$5,652m	0.4995
FY2017	$2,778m	$5,455m	0.5093
FY2018	$2,727m	$5,311m	0.5135
FY2019	$2,782m	$4,954m	0.5616
FY2020	$2,621m	$4,896m	0.5353
FY2021	$2,927m	$5,028m	0.5821
FY2021.5	$2,951m	$4,978m	0.5928

It is interesting to once again review the equity ratio of Contact Energy over the years. The improvement in the last two table entries above can be put down to the cash issue of 12th March 2021. Co-incidentally, that time also corresponded to the nadir point of NZ interest rates. So it makes sense to have a bit more equity on hand, in relative terms, as interest rates start to rise again. But the likelihood of interest rates rising was not the reason for the cash issue. I quote from the cash issue retail offer document p5.

"On 15th February 2021, Contact announced its commitment to developing the 152MW Tauhara Geothermal Project (Tauhara) as well as plans to raise approximately $400m of new equity."

On 8th February 2022 we got a Tauhara project update

"Contact Energy says the development of the new Tauhara geothermal power station near Taupō is progressing well and is now expected to generate 168 megawatts, up from 152 megawatts when the investment was announced a year ago.
Contact CEO Mike Fuge said Tauhara would generate more renewable electricity than was initially forecast. “The way the power station has been designed means there is flexibility to deliver a higher generation capacity. Given that the reservoir of geothermal fluid is more productive than initially anticipated, we now expect to be able to deliver to the full design potential.”

"He said the “excellent news” about the increased capacity was tempered by an increase in the overall costs of the Tauhara development, with project costs now expected to total $818m, up $140m from the initial estimate of $678m.
“Obviously there are increased costs associated with the expansion in capacity and some of the complexities associated with delivering this increased capacity, but like every project across New Zealand we have some serious headwinds from the Covid19 pandemic to navigate which have impacted project costs." "

These numbers lead me to a couple of 'back of the envelope' calculations:

$400m (new equity)/ $678m (new assets) = an incremental Tauhara equity ratio of 59.00%

$400m (new equity)/ $818m (new assets) = an incremental Tauhara equity ratio of 48.90%

This means that with the original project costings, the overall company equity ratio remains steady. But with the new costings, the overall CEN equity ratio goes down.

CEO Mike Fuge noted in AR2021 (page 6) that:
"The capital raise gives us the flexibility to execute on up to $800m in additional projects beyond Tauhara."

The $140m cost increase at Tauhara presumably means the 'flexibility to fund additional capital projects' is now reduced to $800m - $140m = $660m

SNOOPY

[Snoopy]

Contact Energy Hydro	Station Generation Capacity	Notes	Contact Energy Geothermal	Station Generation Capacity	Notes
Clyde	464MW	Commissioned FY1992	Ohaaki	48MW	Commissioned FY1989
Roxburgh	320MW	Commissioned 1956	Te Huaka	28MW	Commissioned FY2010
			Wairakei	145MW	Commissioned 1958, Modified FY2005
			Tauhara	168MW	Commissioned 2023 (hopefully)
			Poihipi	65MW	Commissioned FY1997
			Te Mihi	166MW	Commissioned FY2014
Total	784MW		Total	620MW
Effective Capacity Factor	0.514		Effective Capacity Factor	0.850
Total Operationally Adjusted	403MW		Total Operationally Adjusted	527MW

Notes

(1) With a new geothermal station, I would expect somewhere near a 94% capacity utilisation factor. However I have chosen overall capacity utilisation factor at 85% for existing plant, because I expect the capacity utilisation of some of the older geothermal plant to decline.




Adding a new geothermal station of 223MW (beyond the Tauhara station) that would operate at 94% availability would lift Contacts expected operating generating capacity by:

(223MW x 0.94) / (403MW + 527MW) = +22.5%

In case you are wondering whether future growth is just 'pie in the sky', it is modern practice to contract out generating capacity before a new plant is built. In the case of Tauhara (yet to be commissioned) half of the output is already sold to Genesis Energy and various PPAs (Power Purchase Agreements).

Also the limited carbon emissions from geothermal are usually pure, which means carbon capture technology is looking very promising in geothermal applications.

SNOOPY

[Snoopy]

1. approx 12 months ago - wasn't there something that looked likely to affect forward earnings - Snoopy?

While preparing my posts of the last few days, I went through Contact's presentations to look for their NPAT and EBITDAF earnings projections. They seemed very coy about what was happening in FY2022. They mentioned movements in depreciation charges and other costs, but nothing that spelt out a forecast bottom line for FY2022.

Perhaps you were thinking about the Tiwai point power contract? Or maybe it was the costs incurred with getting Tuahara underway?

2. I note you state Mercury is booking revaluation gains - but they are 100% fully imputed on dividends (since 2013) by my notes.

Whereas Genesis are 80% imputed in their distributions, since early 2016 by my notes. Is there some other reason why GNE don't have tax credits to fully impute their distributions ? (i.e. amortisation / depreciation rates differing for tax & accounting purposes or something else ?)

[cynic mode]
Genesis do not have the capability to fund the building of new power stations themselves, because the government will not tip any more money into a Genesis investment pot. So rather than 'plan to reinvest' in their own assets as they depreciate, they have 'given up' and are feeding that 'depreciation money' straight to shareholders as an unimputed dividend instead. This placates investors into thinking they are 'getting a good yield' and that this dividend policy is sustainable. When the last of Genesis's own power stations wear out and Kupe has run dry, they will have fully transformed into being a 'middle man' in the power market system.

Genesis will buy power from power stations that are owned by others, and battle in the market to match those fixed power purchase deals to the demands of the increasingly fickle consumer. The fixed price deals on the purchase side will see them become increasingly uncompetitive with the remaining gentailers that can adjust their generation to market demand. Thus we will see the slide of Genesis Energy into oblivion.

I would give Genesis ten years before the Genesis rump becomes an unsustainable business. So I would say if Genesis is trading at a PE of more than 10, then they are trading on future earnings that will likely never exist. Be careful out there if you hold Genesis Energy shares.
[/cynic mode]

SNOOPY

[Snoopy]

Snoopy

Here's an interesting thought experiment.

IF EV = MC + D - C
but for a shareholder:
Investment Value = MC% - Debt + Cash

where MC% is the % of the business they own x MC which = Number of shares x SP;
Debt is any debt used to fund the purchase of the investment (hopefully nil for sensible shareholders!), and
Cash is what is in the investors pocket from (nett) historic dividends.

Notice EV has +D-C and IV has -D+C.

So to my point in my previous post, whatever method you use depends on the viewpoint and agenda.

The post above is the tail end of a discussion that I was having with Ferg in February 2021 about the different ways of valuing Contact Energy, from a 'company' and from an 'investor' perspective. The result of this discussion is that we both agreed there are different approaches to valuing Contact Energy and the most important thing is to be consistent in your valuation approach.

From the 'Company perspective' we might consider 'Enterprise value' as a suitable measuring stick:
Enterprise Value = Market Capitalisation - Company Debt + Company Cash On Hand

From an individual shareholder perspective, a better measure might be:
Investor Value = % Market Capitalisation - Investor Debt + Cumulative cash from all dividends received

Here '%Market Capitalisation' represents the current value of an investors individual shareholding, and 'Investor Debt' is debt taken on to buy that shareholding (if any).

Fergs observation

"Notice EV has +D-C and IV has -D+C."

is an interesting juxtaposition of stakeholder viewpoints. However, writing in that glib shorthand has lost an important part of the message. Namely that the 'D' and the 'C' from the 'Enterprise Value' perspective and 'Investor Value' perspective are not the same thing.

The 'Ds' have no connection at all. The debt that a company takes out to build their business is completely unconnected to the amount of money a shareholder might borrow to acquire the same company shares 'on market'.

The 'Cs' are connected in that they come from the same source - the cash generating activity of the company. But if you imagine all the cash generated by a company going into a bucket, the 'C' from an Investor value perspective is the amount of cash that has been tipped out of the bucket, where as the C from an Investor Perspective is the amount of cash that remains inside the bucket.

Ferg is looking at 'Investor Value' from an individual investor perspective. But I think for comparative purposes it is more useful to look at the 'Investor value' of all investors in the company, brought together as a group.

With all of this in mind, I have rewritten Ferg's two algebraic equations as below:

From the company perspective:
EV = MC + CD - CC (where CD = Company Debt and CC = Company Cash)

From the collective shareholder perspective:
IV = MC - SD + SC (where SD = Shareholder Debt and SC = Shareholder Cash)

And we have an implied third equation as well:
SGC = CC + SC (where SGC = Shareholder Generated Cash)
(Shareholder generated cash is all the cash that ever went into the 'cash bucket' in my bucket analogy.)

Using that third equation, and assuming no shareholder debt, I can rewrite the first two equations as follows:

EV = MC + CD - (SGC-SC) = MC +SC + CD - SGC

IV = MC + SC

From that, I think it is obvious there are two fundamental differences between 'Enterprise value' and 'Investor value'

1/ Company debt does not have any direct effect on 'Investor value'.
2/ Total cash generated over the time a company has existed does not have any direct effect on 'Investor Value'.

In fact from an 'Investor Value' perspective, the only two things that matter are the 'share price' and the 'dividend stream'. Some would say that the 'share price' is merely a present day representation of the discounted valuation of future cashflows anyway.

If we accept that gentailer dividends are based cashflows rather than earnings in the traditional sense, we can then make a 'grand aggregation conclusion'. Namely that the total 'Investor Value' of Contact Energy is based entirely on cashflows, and nothing else. If that is true, then it follows that from an 'Investor Value' perspective we must take account of 'tax paid' when doing our company valuation. That is because 'tax' is that part of the cashflow from Contact Energy that we shareholders do not get.

SNOOPY

P.S. Sorry for the long algebraic rant. But it was necessary to prove to myself that treating tax as I do, as in post 2199, is necessary to obtain a correct 'Investor Value' valuation of Contact Energy.

[Snoopy]

[cynic mode]
Genesis do not have the capability to fund the building of new power stations themselves, because the government will not tip any more money into a Genesis investment pot. So rather than 'plan to reinvest' in their own assets as they depreciate, they have 'given up' and are feeding that 'depreciation money' straight to shareholders as an unimputed dividend instead. This placates investors into thinking they are 'getting a good yield' and that this dividend policy is sustainable. When the last of Genesis's own power stations wear out and Kupe has run dry, they will have fully transformed into being a 'middle man' in the power market system.

Genesis will buy power from power stations that are owned by others, and battle in the market to match those fixed power purchase deals to the demands of the increasingly fickle consumer. The fixed price deals on the purchase side will see them become increasingly uncompetitive with the remaining gentailers that can adjust their generation to market demand. Thus we will see the slide of Genesis Energy into oblivion.

I would give Genesis ten years before the Genesis rump becomes an unsustainable business. So I would say if Genesis is trading at a PE of more than 10, then they are trading on future earnings that will likely never exist. Be careful out there if you hold Genesis Energy shares.
[/cynic mode]

Finally got around to listening to the March 2022 Mike Fuge Sharsies interview that has been referenced on this thread before.

https://www.youtube.com/watch?v=KwNjqt704jI

Explaining why things are going to get difficult for thermal power generation plant, selective quotes are below:

**From 21 minutes into the interview and talking about power input prices, and how they have changed since the Russian Ukranian invasion.**

"The most interesting thing is the spike in price of coal from $US100/ton plus carbon charges to $US400/ton (edit price has fallen back to around $US320/ton as at early August). In the NZ energy system, normally coal gets dispatched after renewables and gas provides the marginal pricing. Now coal has flipped over the top of that and that $US400/ton is the marginal dispatch cost. That could lead to quite a bouncy winter."

"For oil we are going to be in for an extended period of high prices. For us if we are dispatching gas and even coal which has rocketed through the roof, it is going to put a strong incentive to really accelerate those renewable energy projects which we have., which is a good thing in the longer term. It is just going to be a bit painful in the shorter term."

"Retail electricity prices will plateau as more renewable energy generation is built and the wholesale market has a chance to stabilize again."

"In the wholesale market some industries have been caught out. I tend not to have a lot of sympathy for them for two reasons.

1/ We have been offering long term tenure PPAs (Purchase Power Agreements) at very sharp prices, in that same period of the rapid spike in wholesale prices.
2/ A lot of those wholesale customers, on the other side of the ledger are experiencing a boom in commodity prices."

"If your marginal coal is $400,the if you are having to dispatch oil or diesel generated electricity, it is going to be expensive. The best thing you can do is to respond to that price signal and build more renewable generation."

"If you were just squirreling the energy profits away, there might be a slight ethical issue there"
"But if you are taking windfall energy profits and investing it as we are, in new renewable energy projects, that is a very virtuous cycle."

"Our earning performance over the next three years, particularly as Tuahara comes on, we expect to remain very strong. We are effectively replacing our thermal fleet with a cost between $90-$150/MWh (monthly average) and replacing that with a geothermal generation that has a marginal cost of $18/MWh (monthly average). That underpins profit growth"

Note that $100/MWh = 10c/kWh

SNOOPY

[Snoopy]

"The most interesting thing is the spike in price of coal from $US100/ton plus carbon charges to $US400/ton (edit price has fallen back to around $US320/ton as at early August). In the NZ energy system, normally coal gets dispatched after renewables and gas provides the marginal pricing. Now coal has flipped over the top of that and that $US400/ton is the marginal dispatch cost. That could lead to quite a bouncy winter."

"Our earning performance over the next three years, particularly as Tuahara comes on, we expect to remain very strong. We are effectively replacing our thermal fleet with a cost between $90-$150/MWh (monthly average) and replacing that with a geothermal generation that has a marginal cost of $18/MWh (monthly average). That underpins profit growth"

Note that $100/MWh = 10c/kWh

The above from Mike Fuge is a bit technical. So for those who don't have an intimate knowledge of how the power delivery system works in NZ, I am going to try to give a slightly less technical run down on the financial implications of the above.

In recent years, the marginal cost of generating 'renewable energy' has been 'very very cheap', the marginal cost of 'coal generated electricity' has been 'very cheap' and the cost of 'gas generated electricity' has not been so relevant, because more important has been the ability to relatively quickly to fire up a gas turbine to plug holes in the power generation picture, when generation from other sources fall short.

The other point to note is that natural gas is more often than not a by product of oil production. So while our Taranaki basin is exporting oil for 'good dollars', the associated natural gas retrieved is not exported. For that to happen, we would need special port storage facilities and specialised ships to take the product overseas. Over 2021, the average gas wholesale price in NZ was just over 3.0c per kWh. This is a 'domestic by product price' that bears little connection to the price of natural gas in other countries, because natural gas out of a well in New Zealand is a 'stranded asset'.

The power system in NZ is run so that for a given demand, the market invites bids from alternative suppliers of 'power available' to meet that demand. The price bid that gets the incremental supply offered over the demand hump is the price that all power suppliers get, no matter what their actual cost of power production is. Thus the profit that 'our generator' makes is the difference between the highest marginal power price bid accepted by the power market and our generators cost of production.

What Mike Fuge is saying is that, in the past, there was a good margin between 'the cost of thermal power generation by coal' and 'the cost thermal power generation by gas'. So the power generated by gas determined the power price received by the coal fired Rankine units at Huntly, operated by Genesis Energy. But a less reliable gas supply and the cost of coal going up by up to 400% have combined to make coal 'the new marginal price point setter' for all the generating companies. This means you can look at one of those websites that shows power generation over half our periods in the NZ market, and it might show Genesis's Huntly pumping out the power to keep the lights on. But profits for Genesis going forwards will not be aligned with past low hydro years. Because the profit margin is reduced to the mark up on the coal price only, not the difference between the formerly price determining gas price and the much lower imported coal price that was available prior to the Putin invasion of Ukraine. The international coal price going up and down is I believe what Mike Fuge is talking about when he suggests NZ is in for a 'bouncy winter'.

SNOOPY