Contact Energy - CEN Chart

[Snoopy]

Below I present my corrected earnings picture for the last ten 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 100% of free cash flow being paid into the foreseeable future. However, in the two years this policy has been in existence, only 39cps has been paid out. So where the 100% of operating free cashflow exceeds that figure I have capped the dividend payout to 39cps.
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) difference is positive there is no extra tax bill. That's because in such a year, the dividend is fully imputed.
6/ The final column (Column D) represents the 'effective' dividend per share adjustment for any extra tax obligation from paying tax on unimputed distributions.

Scenario Basis Financial Year	eps (A)	Scenario dps (B)	Difference (A)-(B)	Divie Capital Component (C)	Unimputed Tax Bill (D)	Difference (B)-(C)-(D)
2011	21.7c	19.0c	+2.7c	0c	0c	19.0c
2012	24.7c	38.0c	-13.3c	13.3c	3.7c	21.0c
2013	28.1c	39.0c	-10.9c	10.9c	3.1c	25.0c
2014	27.7c	39.0c	-11.3c	11.3c	3.2c	24.5c
2015	22.4c	39.0c	-16.6c	16.6c	4.6c	17.8c
2016	22.1c	39.0c	-16.9c	16.9c	4.7c	17.4c
2017	18.7c	39.0c	-20.3c	20.3c	5.7c	13.0c
2018	18.2c	39.0c	-20.8c	20.8c	5.8c	12.4c
2019	24.3c	39.0c	-14.7c	14.7c	4.1c	20.2c
2020	17.7c	39.0c	-21.3c	21.3c	6.0c	11.7c
Total	225.6c (E)	369.0c (F)				182c
Business Cycle Imputation Rate (E)/(F)		61.14%

.

The expected average dividend per year, net of tax is therefore: 182 / 10 = 18.2cps (net)

Using a tax rate of 28c this is equivalent to a gross income of: 18.2cps /(1-0.28) = 25.3c

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, albeit not quite a 'bond equivalent'. I have previously used a figure of 5.5%. But that was in a climate of investment interest rates of some 3.5%. Interest rates have fallen by at least 200 basis points since then. OTOH the previously unthinkable is happening in that the Tiwai Point aluminium smelter is closing, and the power market is consequently in a state of flux as to how particularly Contact will be able to extricate the consequential surplus energy from their Clutha River power stations at Clyde and Roxburgh while transmission north is constrained. To balance these competing factors, I have assessed that a gross return of 4.5% iThe bulk of these tax credits came about in FY2016, because of $204m of impairments net of tax relating to the closure of the Otahuhu Power Station, an assessment that the Taheke Geothermal field is unlikely to be developed in the foreseeable future (from a June 2016 perspective) and a write down in the value of inventory gas. I have calculated above that $63m of those tax credits have been used up, which means that $97m - $63m = $34m are yet to materialise. That means there are probably two years worth of 'Superimputed dividends' for Contact Energy shareholders to come. What value of superimputation is appropriate? I am going with the average that I calculated in the first quoted post on this thread of 71.64%.s now appropriate for Contact Energy.

If we assume that a business cycle investment 'gross return' of 4.5% is required, then this equates to a CEN share price of:

25.3c /0.045 = $5.62

So $5.62 is therefore 'fair value'.

Readers should note that $5.62 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.

$5.62 x 1.2 = $6.74

Contact Energy is trading at $6.25 as I write this post. This technique would suggest that Contact Energy is now 11% overvalued (above fair valuation), not unexpected given the plunge in interest rates of late is probably worrying yield investors, and not out of line with the broad overvaluation of the NZX as a whole.

But does a 'capitalised dividend valuation' give the full picture?

Note: The incremental profit in the table below of 3.9cps, represents the change in gross profit spread out over ten years that would result if the business cycle imputation rate were to increase from 61.24% to 71.64% (ref Post 1820).

Scenario Basis Financial Year	eps (A)	Scenario dps (B)	Difference (A)-(B)	Divie Capital Component (C)	Unimputed Tax Bill (D)	Difference (B)-(C)-(D)
2011	21.7c+3.9c	19.0c	+6.6c	0c	0c	19.0c
2012	24.7c+3.9c	38.0c	-9.4c	9.4c	2.6c	26.0c
2013	28.1c+3.9c	39.0c	-7.0c	7.0c	2.0c	30.0c
2014	27.7c+3.9c	39.0c	-7.4c	7.4c	2.1c	29.5c
2015	22.4c+3.9c	39.0c	-12.7c	12.7c	3.6c	22.7c
2016	22.1c+3.9c	39.0c	-13.0c	13.0c	3.6c	22.4c
2017	18.7c+3.9c	39.0c	-16.4c	16.4c	4.6c	18.0c
2018	18.2c+3.9c	39.0c	-16.9c	16.9c	4.7c	17.4c
2019	24.3c+3.9c	39.0c	-10.8c	10.8c	3.0c	25.2c
2020	17.7c+3.9c	39.0c	-17.4c	17.4c	4.9c	16.7c
Total	264.6c (E)	369.0c (F)				226.9c
Business Cycle Imputation Rate (E)/(F)		71.64%

The expected average dividend per year, net of tax is therefore: 226.9 / 10 = 22.7cps (net)

Using a tax rate of 28c this is equivalent to a gross income of: 22.7cps /(1-0.28) = 31.5c

If we assume that a business cycle investment 'gross return' of 4.5% is required, then this equates to a CEN share price of:

31.5c /0.045 = $7.00

So $7.00 is therefore 'fair value'.

However, I am only predicting the 'superimputation' effect to last for two years. If we look out over ten years, then eight of those ten years will only have regular imputation. This means the business cycle value of Contact shares is actually a weighted average of the two parts of my valuation, calculated like this:

( 2($7.00) + 8($5.62) )/10 = $5.90

SNOOPY