Contact Energy - CEN Chart

[Snoopy]

Below I present my corrected earnings picture for the last ten years. You will note that:

1/ I have deleted the FY2015 50cps special dividend from the record, because it will not be possible to repeat that into the future.
2/ The 'Scenario Dividend Per Share Column' represents a prediction of an ongoing dividend of 100% of free cash flow being paid into the foreseeable future. However, in the two years this policy has been in existence, only 39cps has been paid out. So where the 100% of operating free cashflow exceeds that figure I have capped the dividend payout to 39cps.
3/ The (A) - (B) difference column, if negative, represents the amount of the projected dividend not covered by imputation credits. This is important, because a dividend paid without imputation credits is in accounting terms, equivalent to giving shareholders their own capital back (equal to the amount of the unimputed dividend) complete with a tax bill. This is generally bad for investors. It is necessary to make a negative adjustment to account for any expected tax to be paid on the unimputed dividend component.
4/ The capital component of the dividend is the portion of shareholder equity being returned to shareholders. This will need to be removed from the dividend return calculation. Because to pay it is to return to shareholders money on the balance sheet that they already have, so it isn't a shareholder benefit.
5/ The unimputed component tax bill column, represents the income tax charged on share capital that is expected to be paid by the shareholder. A 28% tax rate is assumed. Note that if the (A)-(B) difference is positive there is no extra tax bill. That's because in such a year, the dividend is fully imputed.
6/ The final column (Column D) represents the 'effective' dividend per share adjustment for any extra tax obligation from paying tax on unimputed distributions.

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

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

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

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

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

25.3c /0.045 = $5.62

So $5.62 is therefore 'fair value'.

Readers should note that $5.62 represents 'business cycle neutral' fair value. We could argue that we are currently at the top of a low interest rate inspired valuation cycle. My rule of thumb would suggest a 'top of cycle' value some 20% higher than my calculated fair value.

$5.62 x 1.2 = $6.74

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

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

I have reworked my model based on just the last four years of operations.

1/ The 'Scenario 'Dividend Per Share' and 'Scenario Earnings Per Share' columns (from my post 1978) represent a prediction of an ongoing dividend of 90% of free cash flow being paid into the foreseeable future. The FY2021 forecast, under the same policy of paying out 80-100% of free cashflow, is 35cps. This is somewhat less than my four forecast scenarios where dividends range between 41cps and 47cps. However these scenarios reflect a future where Tauhara is operational which should provide an incremental boost to Contact's profitability. I also note that in the current forecast year, the proposed dividend of 35cps is a figure towards the lower end of the 80-100% cashflow payment range. I therefore do not consider the modelled dividend payout to be unrepresentatively high, once Tauhara is up and running.
2/ 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 (Column (D).
3/ 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.
4/ 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 were to be positive then there would be no extra tax bill. That's because in such a year, the dividend would be 'fully imputed'.
5/ The final 'Difference Column' represents the 'effective' dividend per share, adjusted for any extra tax obligation from paying tax on unimputed distributions.

Scenario Basis Financial Year	eps (A)	Scenario dps (B)	Difference (A)-(B)	Divie Capital Component (C)	Unimputed Tax Bill (D)	Difference (B)-(C)-(D)
2017	22.2c	43.0c	-20.8c	20.8c	5.8c	16.4c
2018	21.9c	42.0c	-20.1c	20.1c	5.6c	16.3c
2019	27.3c	47.0c	-19.7c	19.7c	5.5c	21.3c
2020	21.4c	41.0c	-19.6c	19.6c	5.5c	15.9c
Total	92.8c (E)	173.0c (F)				69.9c
Business Cycle Imputation Rate (E)/(F)		53.64%

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The expected average dividend per year, net of tax is therefore: 69.9 / 4 = 17.5cps (net)

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

Now we come to a critical point in this analysis - the choosing of an indicative interest rate that allows us to value Contact on the basis of being an ongoing income stream. I have previously used a figure of 5.5%. But that was in a climate of investment interest rates of some 3.5%. Interest rates have fallen by at least 200 basis points since then. OTOH the Tiwai Point aluminium smelter is likely on a three year wind down closing path. The power market is consequently in a state of flux as whether an energy intensive replacement industry like hydrogen fuel production, will arrive. If not, there is work to be done, by Transpower, to ensure Contact will be able to extricate the consequential surplus energy from their Clutha River power stations at Clyde and Roxburgh. The 'transmission north' constraints need to be relieved. There is also uncertainty as to how Tauhara will feed into the mix of competitors' new wind farms that are due to come on line within a similar construction timeframe.

To balance these competing factors, I have assessed that a gross return of 4.5% is an acceptable return from a shareholder perspective, investing in Contact Energy's assets.

Dividends can only be imputed to the extent that tax credits are being and have been generated. The bulk of the Contact tax credits on the books came about in FY2016, because of $204m of impairments net of tax relating to the closure of the Otahuhu Power Station, an assessment that the Taheke Geothermal field is unlikely to be developed in the foreseeable future (from a June 2016 perspective) and a 'write down' in the value of inventory gas. I have calculated above that $63m of those tax credits have been used up, which means that $97m - $63m = $34m are yet to materialise. That means there are probably two years worth of 'Superimputed dividends' for Contact Energy shareholders to come. What value of superimputation is appropriate? I am going with the average that I calculated in the early part (post 1799) of this valuation exercise of 71.64% as a figure that is now appropriate for Contact Energy.

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

24.3c /0.045 = $5.39

So $5.39 is therefore 'fair value'. However, this is fair value in the future, three years hence when Tauhara is up and operating. We need to discount this back using an appropriate 'time value of money' factor. This I calculated in post 1978 to be 0.8763.

0.8763 x $5.39 = $4.73

Readers should note that $4.73 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.

$4.73 x 1.2 = $5.67

Contact Energy is trading at $7.49 as I write this post. This technique would suggest that Contact Energy is now 31% overvalued (above fair valuation), not unexpected given the plunge in interest rates of late is probably worrying yield investors, and not out of line with the broad overvaluation of the NZX as a whole.

But does a 'capitalised dividend valuation' give the full picture? Maybe not!

SNOOPY