Contact Energy - CEN Chart

[Snoopy]

Thanks for clarifying. I understand what you are saying 100% and that a return of capital via unimputed dividends is not income, and that then results in a real cash outflow for the shareholder. I agree a share buyback would make more sense. And in the absence of a share buyback, then debt reduction would also be beneficial. Unimputed dividends are not an efficient use of capital, nor are they tax efficient. There is no absolutely debate from me on that.

However, I guess I was looking at it from the angle that if we are going to exclude the unimputed cash given to the shareholder, then the payment of tax from those same proceeds should also be excluded. Why? Assuming:

1/ returning capital via unimputed dividends does not impact upon future profitability,
2/ returning capital via unimputed dividends does not impact on P/E ratio
3/ returning capital via unimputed dividends does not impact on SP,

then the overall

a/ personal and
b/ enterprise value

remain unaffected.

The funding of tax payments on imputed dividends is independent of all of these factors. Therefore by excluding the unimputed dividend from the valuation, then the tax payment on the unimputed dividend should also be excluded.

Ferg, I appreciate your wider thinking on this matter and it may take me a bit of time before all your comments sink in. What I can say now is that I was thinking along much more narrow lines when doing my capitalised dividend analysis. I was looking at Contact Energy as a 'black box', albeit a black box built with shareholder funds, with both an imputed and an unimputed dividend stream coming from it. Also I was looking at things from a purely personal (shareholder) perspective, and in particular the 'before' and 'after' position of the shareholder.

'Before' the unimputed dividend is paid, the shareholder has a certain slice of capital, a part of the total capital that they own, that I will call 'UD' (for unimputed dividend capital). After the unimputed dividend is paid our shareholder has a dividend 'UD' (less a tax deduction 'UDT' that has gone to Inland Revenue) that is now in the shareholder's bank account. The dividend 'UD' is paid from the company capital 'UD'. When the dividend is paid, the company capital goes down by an equal amount. I think that particular point is beyond argument.

If I may indulge you a bit further into my tunnel visioned dog brain thinking, 'Before' there was 'UD' capital within Contact Energy. 'After' that same 'UD' capital has been moved to my own shareholder bank account (less the UDT tax deduction that the Inland Revenue has taken). 'Before' I had this UD capital contained within the company courtesy of my shareholder interest. 'After' I have this same capital in my bank account (less UDT tax). My argument then is that the transfer of 'UD' capital is not a dividend, by any conventional 'transfer of declared earnings' measure. It is a transfer of capital and the capital really has been lost to the company that paid it out. And by dint of being a shareholder in Contact, I as a shareholder have lost my share of that capital from within the company. So it makes sense to remove the UD capital from the total 'dividend' payment, because there is in effect no net payment being made from a shareholder perspective. Giving shareholders their own capital back does not constitute a 'return' on the investment. It is a return of the investment, However, what has been lost to the shareholder, and is a real loss, is the part of the UD capital return that has been filtered off to Inland Revenue, the UDT. The UDT represents capital that the shareholder had 'before' the UD dividend was paid and does not have 'after' the UD dividend was paid. The UDT represents real capital that the shareholder had 'before' the UD dividend was paid and does not have afterwards. The company Contact has paid the UDT on your behalf before you get the balance of the UD dividend in your bank account. The UDT capital is real money, a slice of your UD capital , that has gone to the IRD and you will not see it again. Thus I would argue you have to make the UDT deduction from your dividend return calculation because you really are that much worse off in real dollars and cents.

At this point I return to your points 1/ 2/ and 3/ above.

I would argue that returning capital via unimputed dividends may indeed affect future profitability, because as a result the company will have less money to invest to improve the business going forwards. The PE ratio is probably more influenced by wider market interest rates in a utility type share so is probably not relevant to this discussion. The share price represents a short term 'voting machine' perspective of where the market judges the earnings capacity of Contact Energy is heading. The share price will very likely discount changes in the business that might occur two to three years down the track when the results of any capital investment made today start to come though. So while you are correct in saying the share price may not be affected in the short term by a defacto capital repayment, I am not sure you can say that when you look out at the share price in the medium to longer term.

SNOOPY

[Snoopy]

Yes unimputed dividends erode NTA but, in my opinion, NTA is the floor price for a share valuation and is not highly correlated to the share price or its movements for entities such as CEN. Such entities have a low ratio of capex to depreciation which generates FCF, and the non-retention of this cash erodes the NTA but not the share price or the shareholder wealth. Accordingly, the tax on the unimputed dividend should have no bearing on the overall share, or enterprise, valuation under this train of thought.

I have highlighted one of your sentences in bold. Read on its own it is a very odd thing to say, yet I think this sentence also highlights a crucial point in how we recognize earnings from the gentailers. What you are saying here is that there is little correlation between the value of the assets on the books and the capacity of those assets to generate shareholder wealth. Do you think you could go into a valuers office and say that and come out alive? Because what you are really saying here is that the 'valuation' of these long life generation assets has little value. Nevertheless, I think you might be right in this regard.

I am not sure that current accounting standards can cope with the gentailer earnings model. If you look at AR2019 p76, you will see that under 'Depreciation & Amortisation' that Generation and Plant Equipment will depreciate by between 1 and 33% over the year. So with those long lived generation assets, the accounting standards are telling us that even using the most sympathetic view, a civil structure of a hydro dam will depreciate by 1% per year and will be fully depreciated in 100 years. I don't believe that is in any way realistic or accurate.

1/ Earthquakes aside, I would estimate the lives of these hydro dam to be measured in several hundred and maybe even thousands of years, So the annual depreciation charges in the Contact accounts are way too high, and consequently real profit each year is significantly understated.
2/ I would further argue that for certain long lived assets, their value should be 'appreciated' each year, not 'depreciated'. This is a consequence of the power pricing model the NZ electricity market operates under. New generation is added on the understanding that returns will be based on the marginal cost of building that new generation. But by charging for all generation at the current marginal cost, this can allow enormous profit margins for older generation assets that are on the books at historical cost. The way to get around this is for frequent revaluation of your generation assets. Mercury Energy routinely does this but Contact Energy does not.

I ended my capitalised dividend valuation post with a rather cryptic comment

"Does a 'capitalised dividend valuation' give the full picture?"

My comments 1 and 2 above were really what I was getting at here. I think there is some adjustment factor needed to make the capitalised dividend valuation analysis complete for the gentailers.

Another angle was that if the share price is $6.25 and CEN is returning capital of say $0.20c per share per annum via unimputed dividends, then after 31 years you have all your capital back (admittedly before tax), plus an ongoing imputed dividend flow and an unimputed payment ad infinitum. Shouldn't that be worth something over above the imputed dividends...?

I don't think you would get an unimputed dividend at infinitum. You would get the same as now. An imputed dividend payment from accounting standard recognised earnings and an unimputed payment from the excess cashflow. But the excess cashflow above earnings would have to be accounted for. So the unimputed dividends would still have to come out of the accounts and Contact would start to build up negative assets once the book asset base went below zero. It sounds like a silly concept but that is exactly what will happen if the current accounting policy is continued. So in 31 years time the accounting rule makers will finally realise how silly the current accounting rules at Contact Energy are.

SNOOPY

[Ferg]

Hey Snoopy, interesting discussion and I appreciate the replies. I think you may have misinterpreted my statement about the linkage between NTA and wealth. I was referring to a point in time value for wealth, rather than the ability to generate wealth in future. But it leads to some other interesting points nonetheless.

Picking up on your point about revaluing generation assets versus historical cost. You are right in that historical cost methods start to look ridiculous over the longer useful lives of generation assets. At some point they will be fully depreciated and if unimputed FCF is regularly distributed instead of going into capex, growth projects or debt reduction, then you will end up with negative NTA.

But revaluing generation assets will result in higher depreciation charges (and a lower earnings and EPS) resulting in surplus ICs versus reported EPS given the extra depreciation charges will not be tax deductible. However, given capex is still less than depreciation (with a higher nett FCF contribution than previously given cash capex has not changed but depreciation has increased) this will still result in excess FCF above EPS and the final nett position for FCF and IC's does not actually change. I know that sounds weird, but model the scenario and you will see it. So either way we are back to making what are effectively capital distributions if, as you point out, the funds are not used for funding more productive uses within the business.

Speaking of which, I would also question the reasoning behind making such unimputed payments - do the directors think the shareholders can get a better return than they can? Or is it done to prop up the SP by investors who don't use your valuation methods and don't realise they are only getting some of their capital back less tax? Or is there some other reason for the dividends policy? I don't know.

As for your other question about which % to use for imputation modelling, I suspect the answer lies in the historical relationship between taxable profit versus FCF times the % dividend policy. I can look into that tonight.

Cheers, Ferg.

[Snoopy]

As for your other question about which % to use for imputation modelling, I suspect the answer lies in the historical relationship between taxable profit versus FCF times the % dividend policy. I can look into that tonight.

Here are my thoughts on the two goes I had at calculating a suitable imputation rate for calculating gross returns.

My Post 1795

This approach takes a ten year history of 'normalised earnings' which I define as:

EBITDAF - DA - I - T = Normalised Net Profit After Tax.

EBITDAF means Earnings Before Interest Tax Depreciation Amortisation and Financial Instruments - and Significant Items

That means 'Normalised Net Profit' is based on a 'stay in business' earnings profile, which is exactly what we want. The curse of using a multi year averaged earnings profile is that the further back you go, the less likely yesterday's market is a true alternative reflection on what could conceivably be a picture of trading today. How far back you should go depends on how dynamic the market is. By starting in FY2011 we leave behind the HVDC transmission constraints that affected the distribution of energy nationwide particularly in FY2009. But it does take in the construction of Contact's Te Mihi $623m geothermal power station project, which wasn't fully on song until FY2014, and the associated $351.4m FY2012 capital raising,

Te Mihi ended up effectively replacing the Otahuhu gas power station that closed in FY2016. Contact still has Taranaki Combined Cycle Gas Turbine, but is now less dependent on gas than it once was. So things have changed over the last ten years. But enough of the core business from ten years ago remains and the market that Contact operates in has been relatively stable. One area I did modify when using the historical data as an indicative alternative scenario for today is that I assumed a significantly higher dividend payout ratio, That's because it was announced at the of FY2018 that Contact was looking to give back to shareholders 100% of operating cashflow from then on. Note that whether earnings are paid out as dividends or not makes no difference to the tax paid by Contact Energy as a company. The other factor I calculated was my estimate of tax paid each year using the formula: 0.28 x (EBITDAF-DA - I). Imputation credits are generated by the actual tax paid. So it might be useful to compare the actual tax paid against the figure(s) I calculated (see table below).

We do know that the imputation credit balance held on the Contact Energy books was reduced to zero by a special dividend of $367m, (not in the table below), that was paid just prior to Origin Energy selling their controlling stake in the company. The special dividend was paid on 25th June 2015, just days before the end of FY2015.

Scenario Basis Financial Year	Modelled Income Tax Paid	Actual Income Tax Paid	Modelled Income Tax Paid	Actual Income Tax Paid
2011	$61m	$60m
2012	$69m	$65m
2013	$78m	$64m
2014	$78m	$94m
2015	$62m	$29m
2016	$62m	($40m)	$62m	($40m)
2017	$64m	$59m	$64m	$59m
2018	$51m	$41m	$51m	$41m
2019	$68m	$69m	$68m	$69m
2020	$49m	$46m	$49m	$46m
Total	$642m	$487m	$294m	$175m
Business Cycle Imputation Rate (modelled)	61.1%
Business Cycle Imputation Rate (implied actual)		46.3%

I would not expect these figures to line up exactly year by year. That is because there are timing issues with real tax payments relating to provisional tax and terminal tax. But I would expect that over a longer period that the total tax payments, modelled verses actual, should converge. I find it startling that they haven't. And the sub-totals from FY2016 onward (after the imputation credit balance was exhausted at EOFY2015), make the difference between modelled tax paid and the actual tax paid hard to explain. This could imply two or three things.

1/ Contact was sitting on a large pile of imputed tax credits before FY2011 that it was able to add those to dividend payments (up until June 2015 at least) to make the imputation on dividends higher than they otherwise would have been (certainly true until EOFY2015).
2/ I have been too generous with my imputation credit tax assumptions.
3/ Contact Energy have paid a lot of tax before it was due to inflate their imputation credit account before certain dividends were payable to shareholders. This would, IMO, be tantamount to an attempt to deceive shareholders about the real tax paying status of the company.

In case you were wondering, the income tax refund in FY2016 came about 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. The tax effect of this refund is the substantial difference between the modelled tax paid and the actual tax paid.

SNOOPY

[blackie]

and who said accounting wasn't riveting?
not I, thats for damn sure

[Snoopy]

Here are my thoughts on the two goes I had at calculating a suitable imputation rate for calculating gross returns.

My Post 1795

Here is the second half of my imputation credit hunt. In this post my 'modelled' payments are actually the real payments that must have been handed over to IRD allow to allow a dividend to be paid with a specified level of imputation credits attached. The actual tax declared I have taken from the representative 'Statement of Comprehensive Income'. I am reporting in half year periods. The tax declared in the second half (calendar year period from 1st January to 30th June) has been worked out by taking the tax paid for the full year and subtracting that paid in the first half.

My Post 1799 covers the period after the imputation credit balance was exhausted by the paying of a special dividend. The following table has evolved from information presented in that post. It should be no surprise to see the first dividend to be paid after the imputation credit clean out, the first line in the table, has no imputation credits attached as a result. Not only was no income tax paid by Contact Energy over that period. The company received a $51m income tax credit.

The second line of the table shows a dividend being paid with $19m of imputation credits attached, against an actual tax liability over the period of only $11m. I don't understand how attaching such a large imputation credit to the dividend payment is possible, unless Contact have stumped up with a $9m 'tax paid in advance' payment to the IRD to make up the difference. The only other explanation I can think of is that part or all of that declared in the prior period $51m tax credit has found its way into Contact's imputation account. The second explanation looks more likely because the sum of imputation credit tax paid from 23-06-2016 onwards greatly exceeds the declared income tax liability for the same period. And $51m would go a long way to making up the difference. However, if my second explanation is correct, why was the dividend declared on 23-06-20!6 not fully imputed (that $51m tax refund should have ensured there were plenty of imputation tax credits available in the tax credit bucket)? An unsolved mystery?

If indeed the tax refund from HY2016 has been treated as a 'tax credit' for imputation purposes (I still have my doubts about that because imputation credits are normally only issued for actual tax paid) then the deficit over the ten half year period listed comes down to:

$289m - ($226m + $51m) = $12m

It is at least conceivable that Contact may have overpaid their tax by $12m over the last five years.

Dividend Payment Date	Net Amount	Dividend Imputation Rate	Gross Dividend Divisor	Imputed Dividend Tax Paid {A}	Half Year Income Tax Declared {B}	Tax paid less Tax Declared {A}-{B}
25-09-2015	$110m	0%	1.0	$0m	($51m)	$51m
23-06-2016	$79m	70.9%	0.8015	$19m (2)	$11m	$8m
23-09-2016	$107m	54.9%	0.8463	$19m	$38m	($19m)
17-03-2017	$79m	78.7%	0.7796	$22m	$21m	$1m
19-09-2017	$107m	100.0%	0.72	$42m	$24m	$18m
06-04-2018	$93m	100.0%	0.72	$36m	$17m	$19m
18-09-2018	$136m	100.0%	0.72	$53m	$43m	$10m
09-04-2019	$115m	69.8%	0.8046	$28m	$26m	$2m
17-09-2019	$165m	72.3%	0.7976	$42m	$26m	$16m
07-04-2020	$115m	69.8%	0.8046	$28m	$20m	$8m
Average		71.64%
Total 23-06-2016 Onwards				$289m	$226m	$63m

Notes


1/ The 'gross dividend divisor' column is calculated according to the method explained in my post 1796.

2/ A sample calculation to derive the amount of tax that has to have been paid to satisfy the imputation credit attached to the dividend paid on 23-06-2016 is shown below.

Imputation tax payment = ($79m / 0.8105) - $79m = $18.5m

SNOOPY

P.S. This post is based on actual declared dividend payouts, and the tax paid implications from those payouts and company declared tax (not the derived tax from my 0.28x (EBITDAF - DA -I) calculation in post 1804, referred to in part 1). However, actual earnings are subject to various one off earnings blips (both up and down) from non core transactions that are not reflective of core business activity into the future.

[see weed]

A good dividend payer. The yld on ASB site is showing 6%. Started buying in early July around the smelter closure. I think it was a bit over sold, but was only buying in for the div. Am in the process of selling 82% of my holding, to chase other div stocks. Will start buying back in again early next year if price is right.

[Snoopy]

Fair enough guys.

For those interested in the maths here's what it looks like for CEN.
I have used the average forecast figure of 33 cps future dividends off market screener and assumed 65% imputation credits and that an investor looking at this now is treating the almost imminent dividends of 23 cps as a partial return of the purchase price.

Looking at the medium term yield.

$6.38 - 23 cents = $6.15 net purchase price on a medium term view.

33 cps per annum in dividends with 65% imputation credits = 33 / 0.818 = 40.34 cps gross. 40.34 / 615 = 6.56% Gross Yield

I can't wind up my analysis without mentioning the third option as espoused by Beagle. I don't know where Beagle pulled his 65% imputation figure from. Maybe he will explain? But Beagle does have a good nose for getting a dividend feed. And whether he is actually feeding on CEN or not, you have to respect his numbers. It might be telling that his 65% is right near the middle of my 61% and 72% guesses.

IMO the important factor in the variation of my two imputation credit rate guesses is the difference between basing earnings on EBITDAF and profit derived from that (which is the internal performance measure preferred by Contact management since FY2006) and NPAT. In both cases I do take into account 'net interest payments' and 'depreciation and amortisation'. I also take into account tax in both cases, although with EBITDAF this is my own calculation that will produce a slightly different figure depending on what NPBT figure you start with and the timing of certain tax payments. Nevertheless tax is always a derived figure determined by other inputs. So in this post I want to look further at the factor that is clearly different between my two approaches and that is 'F' (for financial instruments). It is all very well to say that 'F' could be behind any differences. But what does that statement actually mean?

'Financial Instruments' are a way Contact can gain certainty over areas of future spending that are material to the business but are not under management's influence. There are four general categories listed in AR2006 p68.

1/ Cross Currency Interest Rate Swaps
2/ Interest Rate Derivatives
3/ Forward Foreign Exchange Rate Hedges
4/ Electricity Price Hedges

These hedges may be further classified as 'Cash Flow Hedges', which are used to deliver certainty on interest rate payments and 'Fair Value Hedges' which are used to deliver certainty around 'bond capital repayments'. It is easy to forget that Contact Energy has significant debt that is funded by the USPP (United States Privately Placed) Debt Market of $US340m (AR2020 p79) and also local bonds CEN030, CEN040 and CEN050 listed on the New Zealand debt market summing to $NZ350m (AR2020 p79). The former can be hedged three ways ( 1/, 2/ and 3/) whereas the latter category can be hedged around point 2/. The fair value adjustments on these borrowings over the last five years make interesting reading.

	FY2020	FY2019	FY2018	FY2017	FY2016	Reference
Fair Value Adjustments on Hedged Borrowings	$144m	$86m	$52m	$11m	$72m	(Refer Note B4, respective Annual Report)
Movement in Hedged Reserve	($10m)	($46m)	$14m	($15m)	$2m	(Refer Statement of Comprehensive Income, respective Annual Report)

I am not clear on how these above two table lines are related. In AR2019 p79 there is a suggestion that on the adoption of IFRS9 (from July 1st 2018) a new 'cost of hedging reserve' was established. There is a cost to convert foreign currency cash flows into New Zealand under cross currency interest rate swaps. This cost can change from year to year (I do not understand why) and this change is recorded in the relatively new 'Cost of Hedging Reserve'.

It is only the second line that appears in the 'Statement of Comprehensive Income'. There is no separate tax entry relating to these 'Items that may be reclassified to 'profit and loss' (in particular 'movement in hedged reserve'). So I am not sure if tax for this has already been accounted for in the only 'Tax Expense' entry, or if there is no tax effect.

Here is what investopedia

https://www.investopedia.com/ask/ans...ive-income.asp

says about taxes on 'Other Comprehensive Income'.

"In regards to taxes, it is permitted to report other comprehensive income after taxes, or one can report before taxes as long as a single income tax expense line item is included at the end of the statement. Conversely, this can also apply to a tax benefit."

In the case of Contact Energy, there is no single income tax line at the end of the income statement. I therefore conclude that 'Other Comprehensive Income' is reported 'after taxes' and there is no 'extra tax' to report that would increase the amount of imputation credits available.

SNOOPY

[Snoopy]

One star remains out of line, and it is a big one. The overall electricity market is just as likely to shrink as it is to grow, as 'economic growth' now seems decoupled from power consumption. And short of selling Tiwai to the Chinese and bringing in billions of Chinese national capital and labourers, the inevitable corollary to no new investment is that the aluminium smelter will close.

I think that going forward from here, the sensible investor must view the NZ power market as a static one in terms of demand. On the customer side, power company switching will ebb and flow. But I think the big five are large enough to survive and customers swings are likely to be balanced by customer roundabouts in the longer term.

For me then the key factor in the profitability of power companies going forwards comes under the heading "resilience". It will be the companies who are best prepared to fill holes in the power production line that will prosper. 'Holes' might mean a drought. But it also might mean a spike in gas prices. It looks like those reasonably strategically located geothermal power stations are the most hole-proof going forwards.

As for the CEN share price going forwards. I agree $6 is possible. $9 occurred when power was a 'growth' market and Origin didn't have any gas field development in Australia and when there were far fewer CEN shares on issue. I do think CEN will eventually get back to $9. But sadly I don't think anyone on the share register now will still be alive at that point. Except perhaps for you fish, as I believe the Orange Roughy can live for a couple of hundred years.

Quite a prophetic post of mine from seven years ago. The only bit I really got wrong is the bit about all of us on the forum being dead (except for fish who I picked as a survivor). The share price closed at $9.03 on 9th October 2019 (the only day the share price did close at over $9) thus releasing the rest of us from our own death warrants. Don't thank me for you all still being here though, you probably should thank bull and his "get your income while you can" campaign from last year. On 30th September 2013, the share price closed at what I thought was a high $5.41, implying an historical normalised profit PE ratio of 19.7 for a boring utility! Heady stuff I thought at the time. Yet on 9th October 2019 the $9.03 closing price implied an historical PE ratio of 37, a figure that would have blown me off the doghouse in 2013. But somehow, as with the best Sopwith Camel pilots, I have managed to hold on. At $6.33, the Friday close we are on an historical PE of 36. With the pending closure of the Tiwai Point smelter, this $6.33 price looks very toppy still, As one of the few companies still paying dividends, I wonder if investors, including me, are now suffering a blindness caused by 'dividend shortage sickness'?

SNOOPY

[RTM]

....... As one of the few companies still paying dividends,......

SNOOPY

Really Snoopy ? While my dividend payers have shrunk slightly, way less than I thought it might.
So far.