Contact Energy - CEN Chart

[BlackPeter]

The above is an issue I have documented on the changing treatment of the Taranaki Combined Cycle power station at Stratford in year to year accounts.

There will be other issues regarding actual changes in the asset portfolio going forwards. Negotiations were well advanced (subsequently concluded) on the sale by Contact of the 'Rockgas' retail LPG supply business and the 'Ahuroa' gas storage facility. This raises the question: Should I try to 'back out' the associated free cashflows of both of these business units in my 10 year operating cashflow picture above? The rationale for doing this is that if I am using my 'free cashflow' table that I have generated above as a forecasting tool for future dividends, would it not be sensible to take out the cashflow from business units that I know will not be there in the future?

I guess it depends on whether you want to draw up a very detailed (and normally wrong) financial design - or the big picture. Obviously - if you take the cash flow for these business units out, than you must as well predict what they do with the money the get (or got) for them. Better polish your crystal ball ... ;

[Snoopy]

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.

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.
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 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	36.0c	-13.8c	13.8c	3.9c	18.3c
2010	21.4c	33.0c	-11.6c	11.6c	3.2c	18.2c
2011	21.8c	19.0c	+2.8c	0c	0c	19.0c
2012	24.7c	38.0c	-13.3c	13.3c	3.7c	21.0c
2013	28.2c	40.0c	-11.8c	11.8c	3.3c	24.9c
2014	27.8c	45.0c	-17.2c	17.2c	4.8c	23.0c
2015	22.5c	46.0c	-23.5c	23.5c	6.6c	15.9c
2016	22.2c	51.0c	-28.8c	28.8c	8.1c	14.1c
2017	18.7c	42.0c	-23.3c	23.3c	6.5c	12.2c
2018	18.3c	41.0c	-22.7c	22.7c	6.4c	11.9c
Total	227.8c	391.0c				178.5c

The expected average dividend per year, net of tax is therefore: 178.5 / 10 = 17.5cps (net)

Using a tax rate of 28c this is equivalent to a gross income of: 17.5cps /(1-0.28) = 24.3c

If we assume that a business cycle investment 'gross return' of 5.5% is required, then this equates to a CEN share price of:

24.3c /0.055 = $4.42

So $4.42 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 $4.42 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.

$4.42 x 1.2 = $5.30

Contact Energy is trading at $6.79 as I write this post. This technique would suggest that Contact Energy is now significantly overvalued (28% above fair valuation). But does a capitalised dividend valuation give the full picture?

SNOOPY

[Snoopy]

My post on the Mercury thread, post 1076, gives the background information required for this calculation. Sadly with the balance sheet of Contact 'optimised' at the FY2014 balance date, we probably should only consider the thin air capital created over FY2015, FY2016 and FY2017 when assessing how much hidden value has accumulated within Contact's Generation Portfolio. For comparative purposes, I list the relevant Mercury figures, grabbed from Mercury posts 1003 and 1076, below:

Mercury Energy	Total Revaluation ($m)	Pre Tax Revaluation ($m)
FY2015	356	497
FY2016	100	137
FY2017	38	52
Total	494	686

Observant readers will note that in the case of Mercury I subsequently took off all the special dividends paid. This is because I judged the Mercury special dividends were being paid to optimise the capital structure of Mercury. Contact shareholders will remember that they were paid a special dividend of 50cps just before Origin Energy quit its Contact stake. However, that payment was made for quite different reasons, to utilise imputation credits that would otherwise be lost. Since the Contact special dividend was not a capital structure optimization exercise, I propose to make no capital optimisation adjustment for that!

Using the scaling factor I derived in post 1514, we can now work out the 'thin air capital' that should now be 'off the books' at Contact Energy:

$494m x 0.74 = $366m

If we assume 45% gearing then Contact could borrow 0.45 x $366m = $165m against that sum.

This means the the money available to construct a new power station, using Contact's off balance sheet funds, is:

$165m + $366m = $531m

Why am I about to quote a whole lot of Mercury Energy information on the Contact Energy thread? A very good reason: Mercury chooses to recognise the changes in the valuations of their power stations each year whereas Contact Energy do not. This doesn't mean that the value of those Contact Energy hydro stations in particular isn't going up though. So if we truly want to know the underlying increase in Contact Energy assets that are hidden on the books, we need to glean information from a company that does do this, then transfer that information over.

My post on the Mercury thread, post 1076, gives the background information required for this calculation. Sadly with the balance sheet of Contact 'optimised' at the FY2014 balance date, we probably should only consider the thin air capital created over FY2015 to FY2018 (inclusive) when assessing how much hidden value has accumulated within Contact's Generation Portfolio. For comparative purposes, I list the relevant Mercury figures, grabbed from Mercury posts 1003 and 1076, below:

Mercury Energy	Total Revaluation ($m)	Pre Tax Revaluation ($m)
FY2015	356	497
FY2016	100	137
FY2017	38	52
FY2018	40	55
Total	534	741

Using the scaling factor I derived in post 1514 (this shows the relative size of Mercury's and Contact's generation portfolios), we can now work out the 'thin air capital' that should now be 'off the books' at Contact Energy:

$534m x 0.74 = $395m

If we assume 45% gearing (actual gearing at EOFY2018 is slightly higher than this), then Contact could borrow 0.45 x $395m = $178m against that sum.

This means the money available to construct a new power station, using Contact's off balance sheet funds, is:

$178m + $395m = $573m

SNOOPY

[Snoopy]

The following information I have taken from FY2016. I have chosen this as a representative year because:

1/ It is the first year in which the closure of Otahuhu was expected, so is more likely indicative of future station use patterns than previous years.
2/ The hydrological conditions appear more 'normal' than FY2017.

<snip>

Thus we have a representative grand total generation figure of:

3297GWh + 1061GWh + 4091GWh = 8449GWh

The budget for constructing Te Mihi (166MW) back in FY2013 was $623m (refer to my post 617).



It doesn't look like Contact have accumulated enough thin air capital to construct another Te Mihi. But I reckon there might be enough in the kitty to build a 100MW geothermal station. Assuming that station had a utilisation rate of 85%, by how much would the power generating capacity of Contact Energy increase?

Energy Generated by New Station Over one year:

(100MW x 0.85) x 25 x 365 x (1/1000) = 776GWh

776GWh / 8449GWh = 9.2%

So this is the multiplication factor we need to increase the value of CEN shares by if we are to include in that the earnings value of the new station that 'could be built', without recourse to raising new capital from shareholders.



Note the above normalised earning valuation of the previous post does not make any allowance for off balance sheet 'thin air capital' that has been accumulated by Contact Energy. Making this adjustment I get a fair value for Contact Energy of:

$5.58 x 1.092 = $6.09

Given that Contact is trading well below that figure, it looks like an 'accumulate' at current market prices. Yet, ever the bargain hunter, I would be on the look out for 20% discount to fair value. That equates to $4.87. I say Contact would be a 'strong buy' should the current market volatility see the share price drop to that level.

The following information I have taken from FY2016 (my post 1523). I have chosen this as a representative year because:

1/ It is the first year in which the closure of Otahuhu was expected, so is more likely indicative of future station use patterns than previous years.
2/ The hydrological conditions appear more 'normal' than FY2017 and FY2018 (being the second successive year of hydro inflows 10% below average).

<snip>

Thus we have a representative grand total generation figure of:

3297GWh + 1061GWh + 4091GWh = 8449GWh

The budget for constructing Te Mihi (166MW) back in FY2013 was $623m (refer to my post 617).

It doesn't look like Contact have accumulated enough thin air capital to construct another Te Mihi (refer to my post 1583). But I reckon there might be enough in the kitty to build a 150MW geothermal station. Assuming that station had a utilisation rate of 85%, by how much would the power generating capacity of Contact Energy increase?

Energy Generated by New Station Over one year:

(150MW x 0.85) x 24 x 365 x (1/1000) = 1117GWh

1117GWh / 8449GWh = 13.2%

So this is the multiplication factor we need to increase the value of CEN shares by if we are to include in that the earnings value of the new station that 'could be built', without recourse to raising new capital from shareholders.

Note the above capitalised earning valuation of post 1582 does not make any allowance for off balance sheet 'thin air capital' that has been accumulated by Contact Energy. Making this adjustment I get a fair value for Contact Energy of:

$5.30 x 1.132 = $6.00

Given that Contact is now trading well above that figure ($7.14 as I write this), it looks like an 'reduce' at current market prices. But my valuation does not include an effect that a more permanent change in discount rates might have on the valuation of the company's power stations. Today's cut in wholesale interest rates announced by the Reserve Bank. A 0.5% cut in discount rate could increase the value of Contact's power stations (Again using Mercury as a reference point) by $534m x 5.5/5 = $587m:

$587m x 0.74 = $434m

With 716m shares on issue, this could increase the underlying value of each Contact share by:

$434m/716m = 61c

That gives a new 'fair value' of: $6.00 + $0.61 = $6.61

For the bargain hunter, like me, I would be on the look out for 20% discount to my unadjusted for discount factor fair value. That equates to: $6.00 x 0.8 =$4.80. I say Contact would be a 'strong buy' should any market volatility see the share price drop to that level.

SNOOPY

[SilverBack]

I see today's big increase in CEN's SP as the consequence of lowering the OCR. CEN is a yield play as much as anything and lowering interest rates generally, naturally raises the SP.

[Beagle]

Good luck getting them for $4.94 Snoopy lol

[Snoopy]

Good luck getting them for $4.94 Snoopy lol

The last lot I bought I paid rather less than $4.94 Beagle. Admittedly that was a few years ago!

SNOOPY

[Beagle]

You're as cunning as a hungry Beagle Might as well bury that bone for years more, I think its going higher.

[dreamcatcher]

The last lot I bought I paid rather less than $4.94 Beagle. Admittedly that was a few years ago!

SNOOPY

I also bought around $4.60 but those pricess are well and truly gone now feel SP heading to $8 - $9 ..........

[Snoopy]

You obviously only pay tax you expect to use. They have obviously done the modeling and decided they needed to skip imputation for one dividend as that would result in paying too much tax. Why they didn't skip the dividend entirely is obviously for marketing purposes, especially since they announced a bond issue at the same time - they are effectively borrowing money to return capital to existing shareholders.

Change in divvy policy to drive a re-rating ? Lots of people use these companies as bond proxies apparently.
Divvy going up and interest rates going down. Hmmm Gross yield inclusive of about 2/3rd's imputation credits looks like 7.5% to me. Not too shabby.

I am concerned that Contact is inappropriately manipulating their imputation credit balance to produce a superficial gross yield that is attractive to investors, but that is in reality not sustainable. Manipulation of imputation credits is an easy game to play. All a company must do is to pay tax in advance to a rate of 28%, regardless of how much tax is actually due, then the subsequent dividend can be paid out as 'fully imputed'.

Contact Energy cleared out their imputation credits with a special dividend, paid in the second half of CY2015 (which was also the first half of business year 2016). That meant the first subsequent regular dividend paid in 1HY2016 of 15cps carried no imputation credits. This is the dividend that Harvey referred to above as a 'marketing exercise'. A dividend that is 'fully imputed' means that tax at the company tax rate of 28% has already been deducted before it appears in shareholders bank accounts. The imputation rates of all CEN dividends paid since, prior to the last full year reporting date, I have tabulated below:

Date	Dividend	Cumulative Normalised Profit for Year	Base Witholding Tax Rate	Imputation Already Paid	Imputation Rate
1HY2016	15cps (NI)		28%	0%	0%
2HY2016	11cps (PI)	22.2cps	7.63%	20.37%	73%
1HY2017	15cps (PI)		14.41%	13.59%	49%
2HY2017	11cps (PI)	18.7cps	7.63%	20.37%	73%
1HY2018	15cps (FI)		0%	28%	100%
2HY2018	13cps (FI)	18.3cps	0%	28%	100%

The interesting thing to compare is the 'cumulative normalised profit' and the 'cumulative dividends' paid each year. During FY2018, for example, the 'cumulative normalised profit' fell short of the 'cumulative dividends' paid that year by:

28.0cps - 18.3cps = 9.7cps

Yet somehow the dividends paid during that financial year were 'fully imputed'. This could have been caused by one off factors (because tax is paid on actual profits not normalised profits). I will have to investigate. But to the set and forget shareholder, it does give the impression that 28cps of the dividend could be thought of as a yardstick to measure what level of dividend might be payable, fully imputed, into the future. I would argue that the real yardstick is only 18.3cps: a massive difference.

SNOOPY