Contact Energy - CEN Chart

[Snoopy]

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.

I have previously stated that I am not considering any thin air capital that may (or may not) arise from Contact's geothermal assets. Focussing on Contact's hydro assets only, requires us to look at what happened to the 'thin air capital' of Mercury's hydro assets only.

FY2014 was a significant year for Contact Energy, because it represented the last year in which they constructed a brand new geothermal power station, Te Mihi. Contact raised new capital for this project in FY2011, via a share issue, with a view to having the company in the right capital shape when Te Mihi construction came to an end. Contact's capital structure following that construction project can therefore be thought of as 'optimised'. It therefore makes sense to only consider the 'thin air' capital growth path from that Te Mihi construction completion date, starting with FY2015 and going forwards.

What does 'optimised capital position' mean in terms of numbers? The position at EOFY2014 was: Assets $6,183m, Shareholder Equity $3,582m

Equity Ratio as at EOFY2014 = $3,582m / $6,183m = 58%

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
Total	841

That $841m 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:

$841m x 784MW/1059MW = $623m

Debt can be borrowed against this 'thin air capital'. This means the total amount of investment capital (equity and debt) that can be utilised as a result of this 'thin air capital' is:

$623m / 0.58 = $1,074m

Now, what sort of power station could Contact build with that?

SNOOPY

[Snoopy]

Debt can be borrowed against this 'thin air capital'. This means the total amount of investment capital (equity and debt) that can be utilised as a result of this 'thin air capital' is:

$623m / 0.58 = $1,074m

Now, what sort of power station could Contact build with that?

Have just re-referenced my 28 April 2011 cash issue prospectus. On page 22 of that offer document is the following quote:

"The project is expected to cost $623m, which includes construction of the Te Mihi power station (including two steam turbine generators and associated equipment), electrical switchyard and transmission connection works, incremental steamfield works on the Wairakei geothermal system, including drilling of geothermal wells and other ancilliary works."

Conspicuous by its absence is any mention of buying outright or leasehold the underlying land.

For comparative purposes, the Ngatamariki 82MW geothermal power station, owned by Mighty River Power and under construction at the same time is forecast to cost $475m. On a Megawatt per dollar basis the Contact station is 54% more bang for the buck. I find it hard to reconcile this for two modern geothermal stations being built in the centre of the North Island at the same time. My only plausible explanation is that Ngatamariki is built on leasehold land and perhaps the extra money is related to buying a long term lease on this land?

Whatever the reason for the difference, my view has been strengthened that Te Mihi, built by Contact Energy is a good base figure to work from when estimating the replacement costs of other geothermal power stations excluding land costs.

Te Mihi has a design output of 166MW. FY2014 is six years ago. So I am going to allow for build inflation of 4% per year, about twice the inflation target, since that date to get FY2020 construction costs.

$623m x (1.04)^6 = $788m

The amount of construction capital available would suggest Contact can build its next geothermal station larger than Te Mihi.

166MW x($1,074m / $788m) = 226MW

If Contact constructed such a station today, how would that affect the size of their generation portfolio?

SNOOPY

[Snoopy]

Te Mihi has a design output of 166MW. FY2014 is six years ago. So I am going to allow for build inflation of 4% per year, about twice the inflation target, since that date to get FY2020 construction costs.

$623m x (1.04)^6 = $788m

The amount of construction capital available would suggest Contact can build its next geothermal station larger than Te Mihi.

166MW x($1,074m / $788m) = 226MW

If Contact constructed such a station today, how would that affect the size of their generation portfolio?

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
			Poihipi	65MW	Commissioned FY1997
			Te Mihi	166MW	Commissioned FY2014
Total	784MW		Total	452MW
Effective Capacity Factor	0.514		Effective Capacity Factor	0.940
Total Operationally Adjusted	403MW		Total Operationally Adjusted	425MW

Adding a new geothermal station of 226MW that would operate at 94% availability would lift Contacts expected operating generating capacity by:

(226MW x 0.94) / (403MW + 425MW) = +25.7%

SNOOPY

[Snoopy]

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 normalised earning valuation 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.

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)		71.70%

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

Adding a new geothermal station of 226MW that would operate at 94% availability would lift Contacts generating capacity by:

(226MW x 0.94) / (403MW + 425MW) = +25.7%

With the 'thin air capital' future earnings improvement factor now calculated, we can at last nail down a fair value for CEN shares, (according to this model at least.)

$5.90 x 1.257 = $7.42

CEN are trading at $8.06 as I write this. I therefore consider CEN shares on the market today to be 8.6% overvalued.

SNOOPY

discl: hold CEN, but these are not overvalued enough for me to consider selling down. I won't be buying more at today's prices though

[Snoopy]

FY2017	Contact Energy	Mercury Energy
No. Shares	715.5m	1,400m
Share Price	$5.50	$3.39
Normalised eps	18.7c	12.0c
Normalised PE	29.4	28.3
Normalised NPAT Margin	6.4%	10.6%
ROE (Assets at Cost)	18.9%	55.6%
Bank Debt	$1,527m	$1,107m
Min. Debt Repayment Time	11.4 years	6.6 years
Snoopy's Fair Share Price Valuation	$5.58	$2.85
Market Premium or Discount to Fair Value	-5.2%	+19.0%

Notes:

1/ ROE for MCY of 55.6% not a misprint.
2/ CEN valuation does not contain an allowance for 'thin air capital', while MCY does. But now that CEN has closed down their baseload Otahuhu B station, the power stations that are left may start to develop 'thin air capital' as MRPs power stations do now. Nevertheless up until now it has been Contact policy not to create 'thin air capital'.
3/ Share prices taken from the market close on 30-09-2017.

The snapshot view shows a clear 'investor value advantage' for Contact Energy, although the PE ratio gap has now closed substantially. Could this still be a downstream effect of the discounted share placement from the Origin Energy sell down still affecting the market? This sale occurred early in the previous financial year (announced 4th August 2015) yet it still could be casting a very long shadow. More likely is the relatively poor operational result for Contact over FY2017. Note that the indicators of 'Net Profit margin' and 'MDRT' still favour Mercury Energy though. Yet despite being relatively weaker, Contact is still in a strong position given the relative security of cashflows in the energy markets in which it operates.

As I write this both shares are trading below their September 30th valuations ( CEN is $5.35 and MCY is $3.22. ) This means the the variations from my fair value are a 4.1% discount (CEN) and a 13.0% premium (Mercury). The Mercury premium is not sufficient to make me sell up though. I rather like the fact that of late when Mercury has had a good year it has not been so good and Contact and vica versa. Holding both seems to have given me a natural hedge against fluctuating values in the electricity market.

FY2020	Contact Energy	Mercury Energy
No. Shares	718.1m	1,400m
Share Price (17-12-2020)	$8.06	$6.18
Normalised eps	17.6c	11.7c
Normalised PE	45.8	52.8
Normalised NPAT Margin	6.1%	11.8%
ROE (Assets at Cost)	8.4%	9.2%
Bank Debt	$1,198m	$1,291m
Min. Debt Repayment Time	9.4 years	7.9 years
Snoopy's Fair Share Price Valuation	$7.42	$6.34
Current Market Premium or Discount to Fair Value	+8.6%	-2.6%

Notes:

1/ Both CEN valuation and MCY valuation contain adjustment factors to include the value of 'thin air capital' accumulated. For Mercury this is +23.4%. For Contact Energy the adjustment factor is +25.7% It is no longer Contact policy to revalue their assets annually. Hence Contact's balance sheet does not contain 'thin air capital', but Mercury's balance sheet does.

2/ The FY2020 financial statements of both companies were compiled on the assumption that the Tiwai Point Aluminium Smelter is to remain as a going concern.

My snoopshot view shows a clear 'investor value advantage' for Mercury Energy. Despite the stratospheric PE ratios now commanded by both companies, Mercury is trading modestly below fair value. My modelling shows that both companies are now in a position to build substantial new power stations at no additional cost to shareholders. In fact Mercury is doing this right now., and has the ability to build yet another similar sized wind power station when Turitea is finished. In the case of Contact, the new Tauhara Geothermal Station is fully planned (250MW output) and costed ($600m build cost) and consented, with the O.K. from head office all that is keeping construction starting. IMO these renewable energy projects are being priced by the market as already built and operating. Once they come on stream, those stratospheric market PEs for MCY and CEN should reduce.

Mercury Energy currently owns a strategic stake in 'Tilt Renewables', a listed entity that develops and operates wind farms in New Zealand and Australia. 'Tilt Renewables' is currently the subject of undisclosed market interest, that may result in Mercury's interest being sold at a good profit. I have not included any speculation from such a deal in my valuation for Mercury directly. However I have included the capital currently committed to Tilt as 'spent;' on construction of Puketo wind farm (still on the drawing board). So in my judgement ascribing any extra value to the Tilt renewable stake now would be both speculative and also double counting the capital I have already modelled as committed to Puketo.

Important profitability indicators of 'Net Profit margin' and the debt risk indicator of 'MDRT' continue to favour Mercury Energy.

As I write this, both shares are trading above their September 30th 2020 market valuations ( CEN $6.65 and MCY $5.10.) The recovery in share price since that date is primarily because of the political will shown to accommodate an extension to the time frame of the Tiwai Point closure. However, as I write this, the official position remains that the Tiwai Point aluminium smelter will cease production by August 2021. This means there is a substantial downside risk for both share prices if an extension to the Tiwai Point closure date cannot be negotiated,

The current Contact Energy market price premium is not sufficient to make me sell up. I rather like the fact that of late when Mercury has had a good year it has not been so good and Contact and vica versa. Holding both seems to have given me a natural hedge against fluctuating values in the electricity market.

SNOOPY

[Snoopy]

Contact Energy Hydro	Station Generation Capacity	Contact Energy Geothermal	Station Generation Capacity	Contact Notes
Clyde	464MW	Ohaaki	48MW
Roxburgh	320MW	Te Huaka	28MW	Completed FY2010
		Wairakei	145MW
		Poihipi	65MW
		Te Mihi	166MW	Completed FY2014
Total	784MW	Total	452MW
Effective Capacity Factor	0.514	Effective Capacity Factor	0.940
Total Operationally Adjusted	403MW	Total Operationally Adjusted	425MW

An issue has emerged on the MCY thread regarding Mercury claiming a high capacity utilisation of their geothermal power generation stations of 95%. Yet when actual figures are calculated from operational data , the utilisation never rises above 70%, a huge difference. One theory I have to explain this is that Mercury does not fully own all of their geothermal power stations. Therefore the maximum amount of power that can be generated reflects the equity percentage ownership of the of those power stations, not the total power station output. One way to check this theory is to look at Contact Energy. Contact is also a significant operator of geothermal power generation in the volcanic plateau of the North Island. However, unlike Mercury, Contact fully owns the output of all their geothermal power stations. So if Mercury is correct in their 95% capacity utilization claim, this kind of capacity utilisation figure should apply to Contact Energy as well. Let's see if it does.

Let's run the calculation for FY2020 using the reported 'equity accounted generation base', which in this instance is the same as the whole generation base.

https://contact.co.nz/-/media/contac...020.ashx?la=en (See page 7)

The geothermal generation capacity at Contact is 452MW (table above). If run at 100% capacity for twelve months those five geothermal stations can generate

452MW x 24 hrs/day x 365 days/quarter = 3,959,520 MWh/year

So the Contact geothermal stations, over FY2020, operated at: 3,333,000 / 3,959,520 = 84.2% capacity

As a check, I shall do the same calculation for the FY2019 year

3,256,000 / 3,959,520 = 82.2% capacity

That is consistent with the following year. But why is the capacity utilisation a full ten percentage points lower than Mercury has been achieving?

SNOOPY

[Jantar]

…...
That is consistent with the following year. But why is the capacity utilisation a full ten percentage points lower than Mercury has been achieving?

SNOOPY

Perhaps MCY are not reporting their NCF (Nett capacity factor) correctly. Contact's geothermal used to make an error in their reporting. It could be that there was a problem in the steam field that caused a loss of generation even though the generator itself was still available. As the Operation Manager had his bonus linked to NCF, he would report the plant as fully available, and so claim a high capacity factor. It took some convincing before geothermal separated availability from NCF.

[Snoopy]

Why is the capacity utilisation a full ten percentage points lower than Mercury has been achieving?

Perhaps MCY are not reporting their NCF (Nett capacity factor) correctly. Contact's geothermal used to make an error in their reporting. It could be that there was a problem in the steam field that caused a loss of generation even though the generator itself was still available. As the Operation Manager had his bonus linked to NCF, he would report the plant as fully available, and so claim a high capacity factor. It took some convincing before geothermal separated availability from NCF.

Interesting possibility there Jantar. I have had some thoughts of my own on this matter.

One issue may be that the geothermal generation portfolio at Contact is on average significantly older than that of Mercury. As equipment gets older there may be need for either more maintenance or more frequent maintenance. Any incremental downtime will reduce the capacity utilisation of the installation. Of course an 'old' installation is not necessarily static. Although Wairakei has been producing power since 1958 (rating 165MW), an additional 16MW was extracted from the field with the construction of the Wairakei Binary Plant in June 2005. This is an addition and has not directly replaced older equipment. There are three types of geothermal power plants: dry steam, flash steam, and binary cycle. A binary cycle plant can operate on cooler geothermal reservoirs than the others. Heat from the geothermal fluid causes the secondary fluid to flash to vapor, which then drives the turbines and subsequently, the generators.

Yet even with new equipment any turbines will be operating on a 'design curve'. A certain pressure differential will be designed for. If the input temperature and volume of the geothermal liquid harvested changes, then the turbine will still operate. But it may not operate at its optimum efficiency. So when compared with its original design specification, the maximum energy output has not changed. But due to changed input conditions, the turbine can never run at its design output.

Such efficiency constraints will definitely be manifesting themselves at Ohaaki (commissioned 1989) because of steam availability (Contact have had several attempts at drilling new wells to improve this but I think they have given up). Furthermore another modern plant at Poihipi Road (commissioned 1997, also tapping into he Wairakei field) had been restricted by resource consent restraints (Not sure of the current state of these) . According to AR2006 p15 the combined design capability of Ohaaki and Poihipi Road was 160MW. The 2004 target Company Statement in response to the Origin Energy takeover, states the design capability of Ohaaki is 104MW. That means the design capability of Poihipi Road must be 56MW. The latest figure I have seen is that their combined output is rated at no more than 113MW. This indicates that one or both will be operating at a sub-optimal point on the turbine design curve. We think of these plants as 'new' compared to Wairakei. But at 30 and 20 years old respectively, in mechanical terms, I guess they are getting quite elderly!

The other issue is the Wairakei geothermal field itself. After being 'mined' for energy for 62 years, it is possible that drilling new bores to keep up the design turbine pressure is becoming an issue ( I think this is the point that Jantar was making). However, I see the new proposed Tauhara geothermal station is tapping into a source contiguous with the Wairakei field. This would indicate Wairakei has a whole has another 50 years life left in it, in its current tapped form.

Just sharing these thoughts, because I think a lower geothermal field capacity utilisation at Contact verses the apparently comparable situation at Mercury does make sense. And it isn't due to any incompetence of those operating the geothermal fields at Contact!

SNOOPY

[Snoopy]

Just sharing these thoughts, because I think a lower geothermal field capacity utilisation at Contact verses the apparently comparable situation at Mercury does make sense. And it isn't due to any incompetence of those operating the geothermal fields at Contact!

I want to wrap up this topic by focussing on what a pointy headed techno-splurge into the minutiae of power station operation at Contact has to do with investment returns for CEN shareholders. Fortunately, for those who are already lost, you don't need to know anything about the minutiae of operating geothermal power stations to appreciate this point.

I have previously brought up the idea of 'thin air capital' increasing the value of certain power companies above what seems to be sensible when measured in PE or earnings yield terms. How effective 'thin air capital' is at raising the value of an investment depends on the value of the base (existing) assets it is bouncing off. If the value of the base generation assets is less (and that is what a power station operating at a lower capacity utilisation factor means), then it follows that the incremental effect of a fixed amount of 'thin air capital' is worth more (in relative terms, which is what matters in a comparison like this). It appears that for its geothermal assets at least, Contact Energy is operating those assets at a lower efficiency than that I have modelled. That means the 'thin air capital' appreciation factor will be greater than the one I calculated. And that means that the underlying fair value value of Contact shares will be slightly greater than the value which I calculated previously ($7.42).

Redoing the calculation (for original, refer to my post 1883):

0.94 x 226MW / (0.514x784MW + 0.84x452MW) = 0.271

So my multiplication factor to allow for 'thin air capital' changes from 1.257 to 1.271

My new Contact Energy 'fair value' share price valuation is now: $5.90 x 1.271 = $7.50 (up from $7.42 before)

Not a huge difference. It doesn't change any of my conclusions from previous posts. But the extra 8cps is worth having nonetheless.

SNOOPY

[Simsee]

My word. What’s up with Contact? Not at all unhappy as it’s my largest holding but jeepers!