Contact Energy - CEN Chart

[Snoopy]

The second point I struggle with a bit is the treatment of revaluation of generation assets. Part of the issue here is how power stations and their plant are treated for devaluation purposes.

Thermal plant has a finite life of 25 - 30 years. Very few thermal generators ever go beyond 30 years. Genesis' Rankine units are a very good example of 4 units built in 1982 - 1986. Two of these units were shut down in 2007 when they were 25 years old, and put into a mothballed stage while the other two units were kept running. Over the years as the other two units have become uneconomic they have been swapped out and the mothballed units brought back online. Parts are now being cannabalised from one of those shut down units to keep the present two running units going, but even these are now close to the end of their time. So the value of a $300 M thermal unit after 30 years is $0. Easy to value.

Hydro Plant is the complete opposite. It almost never devalues, but actually appreciates in value over time. A $100 M hydro plant built in 1950, would have required $8 M spent in refurbishment in 1980 - 1990, and $64 M in refurbishment in 2010 - 2030. But today that station would have a value of around $900 M and probably another few hundred years of life to go.


Geothermal plant is different again. The individual units are valued in the same way as thermal units, and these units must be rebuilt completely every 25 - 30 years. But the station, steamfield, and associated infrastructure is a bit like hydro with a relatively long life. Not hundreds of years, but probably closer to 100 years. Waiarakei is valued a lot more today than when it was first built, but probably only has a maximum life of a further 20 - 30 years, taking it close to 100 years of usable time. This becomes very difficult to value at any point in time.

The net result of all the changes in asset valuations was indeed to reduce the return on equity for the years going forward, but showed a massive increase in return on equity for the year in which the revaluations took place. I know all the energy companies treat their revaluations differently. Perhaps there is a case for requiring them to do so at regular intervals like the retirement sector has to do with their property valuations.

Jantar, as you probably know, there was a change in Asset Revaluation Policy at Contact from FY2010 ( AR2010 p60 ). Assets were, at that time, written back to book value at EOFY2004 which was when IFRS accounting rules became the standard in New Zealand. Up until EOFY2004 the asset revaluation policy at Contact Energy was as follows (from p50 AR2003):

"Contacts accounting policies require the valuation of all generation assets on three yearly intervals, with interim revaluations where there is deemed to be a significant change to the valuation of these assets. Due to the policies all generation assets were revalued to the net present value of future earnings of the assets, on an existing use basis,"

I believe that almost all revaluations up until EOFY2004 - the revaluations that were not written back- were Clyde and Roxburgh hydro dam related. Contact's other Crown jewel renewable plant, the Te Mihi geothermal station, was not commissioned until FY2014. And the original Wairakei geothermal generation was 40 year sold, even back then. Of the other geothermal stations on the books at EOFY2004, Poihipi was small. And Ohaaki may have, even then, looked like running into capacity problems. None of those three geothermal plants scream 'revaluation' to me.

What I have done in my ROE calculations is reverse the revaluations of, most likely, Clyde and Roxburgh up until EOFY2004. These days any such revaluations would flow straight through to the bottom line as 'bumper profits' in the year of revaluation, as you rightly note above. However, back then, in pre-IFRS days, this didn't happen. So my act of reversing these one off windfall gains does not impact on the reported profit history of Contact. What it does do though, is increase the calculated 'Return on Equity' of Contact shares. I make no apologies for this. I believe that the true measure of profitability of Contact's assets must be based on the original book value. 'Deciding that your assets are worth' more will consequently decrease the company ROE for no good reason.

Jantar, I don't believe you should have an issue with revaluation of assets in the Contact context. There haven't been any (lasting) revaluations for sixteen years. By undoing the revaluations prior to FY2004, I am effectively seeing those hydro dams as more valuable than the end of year accounts record. From what I have read in your post, I don't think you have any issue with recognising the high inherent earnings value of hydro assets that are not reflected in the earnings results as presented. I will happily try to calm any qualms you have on the subject if you can tell me where you can see a problem. I don't see a problem myself, but maybe you are seeing something that I don't?.

SNOOPY

[Jantar]

Thank you for those explanations Snoopy. As I commented I am not an accountant so had difficulty seeing where you were coming from. I still can't say I fully understand it all, but obviously you had correct reasons for treating the numbers as you did.

With the metering costs, as they are already incorporated into the gross revenue, I still think you are double counting them by adding them back in again.

[Snoopy]

Thank you for those explanations Snoopy. As I commented I am not an accountant so had difficulty seeing where you were coming from. I still can't say I fully understand it all, but obviously you had correct reasons for treating the numbers as you did.

With the metering costs, as they are already incorporated into the gross revenue, I still think you are double counting them by adding them back in again.

Perhaps you are thinking that I have already worked out a profit, and that profit has already had expenses (including metering costs) deducted from it. So it is therefore 'double counting' to add back in the metering costs from revenue. And you would be right. Except that is not what I am doing.

We are looking at a ratio of profit to revenue in this exercise. The profit is on the top half of the fraction, and the revenue is in the bottom half. So altering the revenue in the denominator of the fraction by adding back in metering costs isn't doing anything -directly- to the profit which is in the numerator of the fraction.

I suppose thinking about this more carefully that strictly, because I have taken the lines revenue out of the denominator, I should also take the lines profit out of the numerator. But we do not know how much 'clipping the ticket' that Contact does in passing the lines charges onto the customer. I would guess it does the same 'cliipping the ticket' that all the other retailers do. And if that is the case, and the real object of this exercise is to be able to compare the net profit margin of one gentailer with another, then the actual 'lines profit' clipped and booked by Contact doesn't matter. Because exactly the same proportion of lines profit will be in the accounts of competitor retailers as well. In any event because Contact is simply 'clipping the ticket' for someones else's lines service, I don't expect the 'lines profit' booked by Contact will be very much.

Thanks for your prodding Jantar, because sometimes I do make mistakes and sometimes I find these by going over my working again. But I don't think this is one of those times.

SNOOPY

[Snoopy]

The second point I struggle with a bit is the treatment of revaluation of generation assets.

This is a big topic that I struggle with myself. But I will try to explain my thoughts on adjusting asset values when calculating ROE and readers will have to see if it makes sense to them.

The following is an excerpt from AR2010 p60, which was the year that Contact decided to stop revaluing it's generation assets

-------

"Contact adopted a policy of revaluing its core generation plant and equipment from the commencement of the Group. Contact has relied upon an independent valuation of such assets as determining fair value. As there is a limited market for trading comparable generation assets in New Zealand, the valuation has primarily relied upon the discounted cashflow analysis of the estimated long term cashflows from generation plant and equipment. Given the long life (up to 100 years) of such assets, the valuation is very sensitive to any variation in assumptions. Events like the global financial crisis have added increased uncertainty to the independent valuation assumptions. The range in the current independent valuation has correspondingly increased compared with prior valuations, such that a single point fair value within the valuation range is difficult to determine."

"In the alternative, the cost valuation basis is considered a reliable basis for measurement of generation plant and equipment. Cost also provides relevant information about the long term cash generating performance of the core generation plant and equipment. For example core metrics such as return on capital invested in plant and equipment can be calculated without adjustment to the return or the investment for the impact of asset revaluations."

<snip>

"Fair value is at 1st October 2014 is considered deemed historical cost owing to the impracticality of determining actual cost back to the original purchase date"

---------

Going back to the original purchase date may be a problem, as Contact's assets came from what was ECNZ 'way back when'. But is is relatively easy to go back to the floating of Contact itself and the historic asset revaluations made prior to 1st October 2014.

FY1999	$673m
FY2002	$843m
FY2004	$550m
Total	$2,066m

Having made the argument for using historic cost, I find it very odd that Contact has chosen not to unwind the prior to 1st October 2014 asset revaluations that are readily accessible via their own annual reports. All I am advocating here is the extension of Contact's own current asset revaluation policy back to the float of Contact Energy incorporating the extra asset revaluations recorded in the published accounts.

Having $2,066m in revalued 'phantom assets' on the books is pretty substantial. Particularly so in the EOFY2020 context of Contact having $4,896m of total assets (including those just described phantom assets) on the books. Net assets at EOFY2020 were $2,621m. ROE is calculated on 'net assets', the end of period 'shareholder equity'. So what to do about it?

A company's assets are funded by a combination of equity and debt. This also applies to those $2,066m in phantom assets included on the Contact books. Removing those phantom assets from the books means removing both the 'debt funded component' and the 'equity funded component'. From an ROE perspective, we are only interested in the 'equity funded component'.

As at EOFY2020, Contact $2,621m worth of shareholder equity and $2,275m of liabilities funding total assets of: $2,621m + $2,275m = $4,896m

This means we can consider any asset the company owns (including the $2,066m of phantom assets I have identified) as funded:

$2,621m/$4,896m = 53.53% by equity

From that figure we can work out the underling equity at EOFY2020 removing the $2,066m of phantom assets from the equity picture:

$2,621m - 0.5353 x $2,066m = $1,515m

Using a normalised profit figure of $127m for FY2020, I calculate a 'Return on Equity' figure for FY2020 of:

$127m / $1,515m = 8.4%

The final question to ask here is, does removing the phantom equity from the picture matter? I argue that it does because if I didn't do it, the ROE calculated for FY2020 would be very different:

$127m / $2,621m = 4.8%

That figure is little more than half my revised ROE figure! I would argue that a figure of 4.8% gives a very false picture on how efficiently Contact Energy are using their equity to generate a return for shareholders. Because that $2,621m of shareholder equity on the books contains:

$2,621m - $1,515m = $1,106m of shareholder equity that was created, from pre 1st October 2004 generation asset revaluations out of thin air.

SNOOPY

[dreamcatcher]

Probably helping SP same as MEL ............aluminum prices strong

[Snoopy]

Probably helping SP same as MEL ............aluminum prices strong

At the end of year FY2020 result brokers briefing one analyst asked about negotiating with Tiwai. CEO Mike Fuge's response was that although they had put some money in the negotiating pot with Meridian, Contact was a passenger in the process. The exact words he used talked about being a 'contractor' to Meridian. So I don't think anyone inside Contact is on the negotiation hotline. This was before all the pre-election promises of NZ First, National and Labour on government involvement for a medium term more managed exit for Rio Tinto. When asked about a 2-4 year managed exit time frame that he had previously spoken about, Fuge said that time frame was the reality in terms of getting alternative uses for that power consented and built. IIRC Fuge also said that a five year exit plan would be better for NZ Inc.

SNOOPY

[Snoopy]

After I started on my Buffett test evaluation of Contact Energy, I remembered why I hadn't been through the full Buffett test performance before. I knew it would fail! However to those followers of Buffett this shouldn't have come as a surprise. The Buffett tests reward growing companies with expanding profit margin potential and a high return on shareholder equity. That last hurdle was never going to be easy with a highly capital intensive business like electricity production. The New Zealand electricity market is mature with limited growth potential, not helped by the pending departure of the Tiwai Point aluminium smelting plant. And that is just the highest profile industrial looking to downsize or leave NZ entirely. Furthermore unexpected changes in catchment inflow can make profit margins volatile.

Nevertheless the failure was spectacular, with the only success being the significant business size test (BT1). I didn't write up this series of posts to beat up Contact investors though. After all I am a CEN shareholder myself. What this conclusion shows is that if you want to invest in Contact, then you need other reasons to do it. The buffettology book must be put away.

Instead investors should look back to my post 1821:

"Valuation: From a FY2020 projected dividend 'capitalised valuation' perspective."

The best investment strategy I can come up with, taking shorter term view is to seek out a share purchase price of no more than $7. With the shares closing at $8.06 today, we are trading north of where I see fair value. But in this generally overvalued market, $8.06 is not grossly overvalued. And with an average buy price of $4.81 and a median holding period of 7 years I am 'sitting pretty' on what for me has been a very successful investment.

The next opportunity to enter at a good price may be when the freshly evaluated Tauhara geothermal field gets a turbine stuck on top of it. At the FY2020 result briefing, CEO Mike Fuge reminded analysts that Tauhara is sitting 'ready to go'. And that Contact Energy management believe it will be the next big power station development off the block. More capital will be required to build Tauhara, and that may mean a short term fall in dividend. Then again, the new power station may be able to be funded with a hybrid equity bond, without any new shares having to be offered. The general message from the analysts briefing was that all options are on the table and Tauhara will be first out of the blocks, whenever the Tiwai wind down determined race start happens to be.

For now I will continue to hold and watch.

SNOOPY

discl: shareholder

[Snoopy]

Jantar kindly identified some errors in my first version of this table. Time to put in his corrections

Mercury Energy Hydro	Station Generation Capacity	Mercury Notes	Contact Energy Hydro	Station Generation Capacity
Aratiatia	78MW	Upgrade by FY2020
Atiamuri	74MW		Clyde	464MW
Waipapa	51MW		Roxburgh	320MW
Ohakuri	112MW
Whakamaru	100MW	Upgrade to 124MW by FY2020
Arapuni	196MW	Received 12MW upgrade in FY2011
Maraetai 1 & 2	352MW
Karapiro	96MW
Total	1059MW		Total	784MW

Mercury Energy Geothermal	Station Generation Capacity	Mercury Notes	Contact Energy Geothermal	Station Generation Capacity	Contact Notes
Kawerau	100MW		Ohaaki	48MW
Mokai (25% owned)	112MW		Te Huaka	28MW	Completed FY2010
Rotokawa	34MW	Refurbished FY2015	Wairakei	145MW
Nga Awa Purua (65% owned)	138MW	Completed FY2010	Poihipi	65MW
Ngatimariki	82MW	Completed FY2014	Te Mihi	166MW	Completed FY2014
Total	466MW		Total	452MW

The first purpose of this comparison is to show how similar the renewable generation of each company is.

The second purpose of this comparison is to come up with a 'quantitative factor' that shows how we can estimate any undeclared 'thin air capital' on the Contact balance sheet. Competitor Mercury are very forthcoming with their 'thin air capital', regularly upgrading the value of their generation assets on an annual basis. Contact do not follow this policy, but that doesn't mean that no thin air capital is accumulating at Contact. It just means they are not trumpeting it in the annual accounts. Sniffing out hidden value is this hound dog's specialty, so this is why I remain 'on the case'.

I was a bit disturbed by Jantar's opinion that there is no fix for Contact's Ohaaki. The required water re injection rate quenching the field looks to be a long term death sentence for Ohaaki, and no doubt would require an annual write down in the value of that station should Contact adopt the policy of revaluing their generation assets each year. There is also a 'field risk' with most of the rest of the Contact geothermal portfolio all plugged into the Wairakei field. It is still possible that long term wholesale price increases over the geothermal portfolio will cancel out any production deterioration at Ohaaki though. Given this, I would suggest that for 'valuation purposes' we should assume that it is only the South Island hydro assets that are accumulating thin air capital. But even then with climate change changing the snow melt in the South, there could be some long term valuation adjustments to be made as a result.

Clearly there is not as much 'thin air capital' being accumulated at Contact than is being accumulated at Mercury. Also. I don't believe it is prudent that in a market with electricity wholesale prices largely flat, that we can assume any thin air capital accumulated in the past is a pointer to more of the same happening in the future. I do believe we investors can bank the thin air capital that has already been accumulated though, even if it hasn't been recorded in Contact's books.

Mercury has already calculated how much thin air capital they have accumulated over the last few years. I think it is a fair assumption that if we take this figure for any time period, then multiply it by a factor of:

784/1059 = 0.74

Or if you consider that the Mercury Geothermal power stations have increased in value over time, unlike their Contact counterparts, the multiplication factor might be:

784/(1059+466) = 0.51

One of those fractions will allow us to make an approximation of how much thin air capital has been accumulated by Contact over the same period. Once we know that figure, we can work out what size new power station that Contact can build, without going back to shareholders for more capital.

Jantar has previously told us of the technical issues at Ohaaki. That strictly should be written down in value due to what appear to be permanent operational constraints (Contact's policy is not to annually review the value of its generation assets so it hasn't been). He has also spoken of the risks of Contacts geothermal generation largely being dependent on the health of a single geothermal field: Wairakei. I have therefore decided to set aside any 'thin air capital' that may be raised from any underlying increase in Contact Energy's geothermal assets (if indeed there is any) and concentrate on calculating thin air capital that has likely been raised from Contact's hydro generation assets.

Mercury Energy Hydro	Station Generation Capacity	Mercury Notes	Contact Energy Hydro	Station Generation Capacity
Aratiatia	78MW	Upgraded FY2020
Atiamuri	74MW		Clyde	464MW
Waipapa	51MW		Roxburgh	320MW
Ohakuri	112MW
Whakamaru	124MW	Upgraded from 100MW FY2020
Arapuni	196MW	Received 12MW upgrade in FY2011
Maraetai 1 & 2	352MW
Karapiro	96MW
Total	1083MW		Total	784MW

Clearly there is not as much 'thin air capital' being accumulated at Contact than is being accumulated at Mercury. Also. I don't believe it is prudent that in a market with electricity wholesale prices largely flat, that we can assume any thin air capital accumulated in the past is a pointer to more of the same happening in the future. I do believe we investors can bank the thin air capital that has already been accumulated though, even if it hasn't been recorded in Contact's books.

Mercury has already calculated how much thin air capital they have accumulated over the last few years. I think it is a fair assumption that if we take this figure for any time period, then multiply it by a factor of:

784/1083 = 0.72

then this will give us an estimate of the thin air capital accumulated, but not booked, by Contact Energy over the same period.

SNOOPY

[BlackPeter]

Jantar has previously told us of the technical issues at Ohaaki. That strictly should be written down in value due to what appear to be permanent operational constraints (Contact's policy is not to annually review the value of its generation assets so it hasn't been). He has also spoken of the risks of Contacts geothermal generation largely being dependent on the health of a single geothermal field: Wairakei. I have therefore decided to set aside any 'thin air capital' that may be raised from any underlying increase in Contact Energy's geothermal assets (if indeed there is any) and concentrate on calculating thin air capital that has likely been raised from Contact's hydro generation assets.

Mercury Energy Hydro	Station Generation Capacity	Mercury Notes	Contact Energy Hydro	Station Generation Capacity
Aratiatia	78MW	Upgraded FY2020
Atiamuri	74MW		Clyde	464MW
Waipapa	51MW		Roxburgh	320MW
Ohakuri	112MW
Whakamaru	124MW	Upgraded from 100MW FY2020
Arapuni	196MW	Received 12MW upgrade in FY2011
Maraetai 1 & 2	352MW
Karapiro	96MW
Total	1083MW		Total	784MW

Clearly there is not as much 'thin air capital' being accumulated at Contact than is being accumulated at Mercury. Also. I don't believe it is prudent that in a market with electricity wholesale prices largely flat, that we can assume any thin air capital accumulated in the past is a pointer to more of the same happening in the future. I do believe we investors can bank the thin air capital that has already been accumulated though, even if it hasn't been recorded in Contact's books.

Mercury has already calculated how much thin air capital they have accumulated over the last few years. I think it is a fair assumption that if we take this figure for any time period, then multiply it by a factor of:

784/1083 = 0.72

then this will give us an estimate of the thin air capital accumulated, but not booked, by Contact Energy over the same period.

SNOOPY

Interesting exercise, but not sure I would put too much emphasis on "thin air capital" for valuing the assets of Gentailers. At the end - there is not a thriving market place for large electricity generating assets (i.e. its not really capital, but just not realizable paper gains or losses) and the respective value of these assets is solely dependent on their future capacity to generate money.

Latter is dependent on

- future (unknown) electricity prices and
- future (unknown) electricity demand and
- future (unknown) competing electricity supplies and
- future (uncertain) ability of above assets to generate electricity at a time when the markets needs it and
- future (unknown) decisions of market regulators and
- future (unknown) climatic or seismic events

Lots of unknowns ... and while it is probably a fair assumption that most of the gentailers assets might still be around and operational in a handful of years or decades - I don't think that anybody is able to predict with any certainty how profitable they will be at that stage. And this is exactly what we would need to know to calculate a net present value with or without thin air :

[Snoopy]

Interesting exercise, but not sure I would put too much emphasis on "thin air capital" for valuing the assets of Gentailers. At the end - there is not a thriving market place for large electricity generating assets (i.e. its not really capital, but just not realizable paper gains or losses) and the respective value of these assets is solely dependent on their future capacity to generate money.

Thanks for those comments BP, and yes that is a legitimate alternative viewpoint. In fact that is Contact's own viewpoint. However, although it appears there is no ready market for these long lived generation assets, I will bet you that if some of those assets were 'put on the block' then buyers would suddenly appear. The other point is that there are no plans to sell any of these long lived assets. So the lack of a readily identifiable daily market for them is not an issue. The fact that they are saleable is all that matters. Finally the incremental increase in equity values are based on their ability to generate money.

Latter is dependent on

- future (unknown) electricity prices and
- future (unknown) electricity demand and

Those are unknowns in the sense the that future is always unknown. But there are full time boffins within the industry whose full time job is to forecast demand, and forecast what is happening to price. Furthermore they can influence the wholesale price by determining which of their generation assets to operate. Furthermore they can also put their money where their mouth is by participatng in the power futures market. So I would argue there is a lot of predictability in both pricing and demand that can be locked in as a certainty by signing up to short and long term supply/demand contracts.

- future (unknown) competing electricity supplies and

I can't really agree with that. Everyone knows Contact has a new consented geothermal power station with the build set to go at short notice. Everyone knows that Mercury and Genesis are currently building new wind power stations, the capacity of those and what the likely generation profiles will be. Everyone knows that Huntly will be used less as a commitment to a less carbon intensive power generation base ramps up. There are no real supply surprises.

- future (uncertain) ability of above assets to generate electricity at a time when the markets needs it and

Gentailers that are lucky enough to have significant hydro generation assets are re-purposing their hydro assets as hydro batteries to get around exactly this problem.

- future (unknown) decisions of market regulators and

Always a risk. But the current system has survived the 'threat' of various coalition governments and has not been changed.

- future (unknown) climatic or seismic events

Lot's of seismic design expertise has gone into these geothermal and hydro assets. That is never a guarantee in the face of 'the really big one'. But if that was the critical factor in operating a business, there would be no businesses operating at all. I am not sure you can model against events with an expected return period of more that 100 years.

Lots of unknowns ... and while it is probably a fair assumption that most of the gentailers assets might still be around and operational in a handful of years or decades - I don't think that anybody is able to predict with any certainty how profitable they will be at that stage. And this is exactly what we would need to know to calculate a net present value with or without thin air :

If forecast prices and demand go down then the market value of those power generation assets goes down. Then the thin air capital disappears just as easily as it arrived. However, with almost zero fuel costs, those long lived power generation assets benefit hugely from even tiny price rises that go straight to the bottom line. The rising population would suggest that power prices will continue to go up in the long term, despite the one off loss of big industrial users. The conversion of the vehicle fleet from fossil fuels to an electric power base over the next 30 years will underpin that electric power demand trand. Over my many years of paying power bills, and renegotiating my power pricing along the way, I can't recall the price of power ever falling!

SNOOPY