Roy Davidson, 2 November 2017

Stock Comment - Contact Energy CEN

CEN is New Zealand’s largest electricity retailer, with around 562,000 gas and electricity customers, and the second largest electricity generator producing about 25% of New Zealand’s electricity from eleven hydro, geothermal and gas-fired power stations.

The New Zealand electricity market has become dominated by a small number of integrated generator/retailers. While the generators sell most of their power into the grid and through the wholesale market, the price they receive for their generation is not materially dependent on the wholesale price. This is because about 90% of their generation is hedged, either naturally via retail off-take agreements at fixed prices, or through financial hedge sales and CFDs (contracts for differences). Over the medium to long-term, we expect average retail prices to rise, growing the profitability of the industry as a whole. However, in recent years electricity demand has not grown as fast as anticipated, and the market is still in oversupply. This has created significant competition for retail customers, most of which has been price based and led to higher churn and associated costs.

Meridian Energy has recently signed an extended agreement with New Zealand Aluminium Smelters (NZAS) to continue to provide the full 572MW of electricity to the Tiwai Aluminium Smelter until 2030. This removes the immediate risk of a significant reduction in electricity demand (Tiwai accounts for 13% of New Zealand electricity demand), which would create a material oversupply and put downward pressure on prices. NZAS can still give 12 months’ notice to terminate the contract from 1 January 2017 onwards. However, we believe the industry will be much better positioned to weather a reduction in demand by this time given CEN’s closure of its Otahuhu power station in 2016.

CEN recruited new Directors and a new Chairman to the board following the sale of Origin Energy’s 53% stake in 2015. The separation has generated some one-off costs which have taken longer to wash out than initially anticipated, hindering recent financial performance. However, CEN has also inherited a specialised SAP IT system that other electricity retailers will struggle to finance independently. This system enables sophisticated customer analytics and could be a key differentiator for CEN in the highly competitive retail environment.

We believe retail competition in the electricity market is becoming more rational, as the electricity companies are becoming more focussed on the cost of churn. Furthermore, we expect the Tiwai Aluminium Smelter to remain open over the medium-term, aided by a review of the Transmission Pricing Methodology, which could reduce its operating costs significantly, making the smelter more competitive. This will remove a significant tail risk from the sector. CEN offers the most attractive valuation in the sector, as it has previously disappointed investors over its financial performance, and has an attractive dividend yield underpinned by consistent free cash flow.

Risks to CEN include: 1) Tiwai closure, 2) changing technology, 3) increased competition.