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Morningstar, Inc.

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Equity Bottom-Up

Weather conditions remain highly favourable for narrow-moat Mercury NZ, which is benefiting from plenty of rain while major competitors face dry conditions. We estimate higher hydroelectric generation and high wholesale prices should see double-digit first-half EBITDA growth. Secondhalf growth is unlikely to be as good given the firm had a very strong finish to fiscal 2017, and rainfall may not be as favourable. Nonetheless, the firm upgraded fiscal 2018 EBITDA guidance 3% to NZD 530 million based on an updated hydro generation forecast of 4,550 gigawatt hours. We think this is a little conservative and increase our fiscal 2018 EBITDA forecast to NZD 537 million.While Mercury’s hydro generation will normalise, we believe stronger wholesale prices will prove sticky and lead to higher electricity prices for customers. We upgrade medium-term earnings forecasts marginally on stronger retail prices and lift our fair value estimate 6% to NZD 3.60 per share. Medium-term earnings will also benefit from falling interest costs as expensive hedges locked in during the global financial crisis roll off. Mercury is a high-quality company with a solid dividend yield and relatively good outlook. At the current price of NZD 3.40, the stock trades modestly below our valuation.Mercury’s generation division is performing very well. The December quarter saw hydroelectric output increase 5% as the firm ran down hydro storage to complement average hydro inflows. Lake Taupo storage started the quarter at 130% of average for that time of year, and ended the quarter at 85%. Mercury’s run of good luck continued, with strong rainfall in early January boosting hydro storage back to average levels.Closure of thermal power stations in recent years, including Mercury’s gas-fired power station, got the New Zealand electricity market back in balance following a period of generation oversupply that depressed the wholesale electricity price. The wholesale price was initially slow to recover because above-average rainfall kept hydroelectric output elevated. But dry conditions in the South Island in 2017 tightened the market and put a rocket under the wholesale electricity price. The wholesale price at Otahuhu averaged NZD 93 per MWh in the December quarter, up from NZD 48 per MWh at the same time last year.While low South Island hydro storage will support wholesale prices in coming months, the futures market expects prices to fall back to NZD 80 per MWh at Otahuhu in fiscal 2019, reflecting likely normalisation of rainfall. Building new generation supply can be justified at prices well below NZD 80 per MWh, which would ordinarily suggest a supply response bringing wholesale prices further down. But the industry would be forgiven for being a little hesitant to invest in major projects given the risk of the Tiwai Point aluminium smelter, which uses 13% of the nation’s electricity, closing over the medium term. This could mean New Zealand has entered a period of higher and more volatile wholesale prices, translating to stronger gentailer earnings mainly by pushing through retail price increases.Another positive in the December quarter was strengthening electricity demand. Weather-adjusted national demand in the December quarter was up 3.7% from the same quarter last year, thanks to stronger irrigation and dairy loads because of warmer and dryer weather. This is a marked improvement from the stagnant demand experienced for the past several years, though more than dry weather will be needed to sustain growth. Ongoing improvements in household and business energy efficiency will remain a drag for the foreseeable future. Upside surprises are possible though, potentially from increasing adoption of electric vehicles as battery costs come down, and some large businesses switching to grid electricity from inhouse thermal power generation.The retail division is performing relatively well, with customer numbers up 1.6% and average retail energy prices up 2% on reduced discounting.Analyst: Adrian Atkins

Weather conditions remain highly favourable for narrow-moat Mercury NZ, which is benefiting from plenty of rain while major competitors face dry conditions. We estimate higher hydroelectric generation and high wholesale prices should see double-digit first-half EBITDA growth. Secondhalf growth is unlikely to be as good given the firm had a very strong finish to fiscal 2017, and rainfall may not be as favourable. Nonetheless, the firm upgraded fiscal 2018 EBITDA guidance 3% to NZD 530 million based on an updated hydro generation forecast of 4,550 gigawatt hours. We think this is a little conservative and increase our fiscal 2018 EBITDA forecast to NZD 537 million.While Mercury’s hydro generation will normalise, we believe stronger wholesale prices will prove sticky and lead to higher electricity prices for customers. We upgrade medium-term earnings forecasts marginally on stronger retail prices and lift our fair value estimate 6% to NZD 3.60 per share. Medium-term earnings will also benefit from falling interest costs as expensive hedges locked in during the global financial crisis roll off. Mercury is a high-quality company with a solid dividend yield and relatively good outlook. At the current price of NZD 3.40, the stock trades modestly below our valuation.Mercury’s generation division is performing very well. The December quarter saw hydroelectric output increase 5% as the firm ran down hydro storage to complement average hydro inflows. Lake Taupo storage started the quarter at 130% of average for that time of year, and ended the quarter at 85%. Mercury’s run of good luck continued, with strong rainfall in early January boosting hydro storage back to average levels.Closure of thermal power stations in recent years, including Mercury’s gas-fired power station, got the New Zealand electricity market back in balance following a period of generation oversupply that depressed the wholesale electricity price. The wholesale price was initially slow to recover because above-average rainfall kept hydroelectric output elevated. But dry conditions in the South Island in 2017 tightened the market and put a rocket under the wholesale electricity price. The wholesale price at Otahuhu averaged NZD 93 per MWh in the December quarter, up from NZD 48 per MWh at the same time last year.While low South Island hydro storage will support wholesale prices in coming months, the futures market expects prices to fall back to NZD 80 per MWh at Otahuhu in fiscal 2019, reflecting likely normalisation of rainfall. Building new generation supply can be justified at prices well below NZD 80 per MWh, which would ordinarily suggest a supply response bringing wholesale prices further down. But the industry would be forgiven for being a little hesitant to invest in major projects given the risk of the Tiwai Point aluminium smelter, which uses 13% of the nation’s electricity, closing over the medium term. This could mean New Zealand has entered a period of higher and more volatile wholesale prices, translating to stronger gentailer earnings mainly by pushing through retail price increases.Another positive in the December quarter was strengthening electricity demand. Weather-adjusted national demand in the December quarter was up 3.7% from the same quarter last year, thanks to stronger irrigation and dairy loads because of warmer and dryer weather. This is a marked improvement from the stagnant demand experienced for the past several years, though more than dry weather will be needed to sustain growth. Ongoing improvements in household and business energy efficiency will remain a drag for the foreseeable future. Upside surprises are possible though, potentially from increasing adoption of electric vehicles as battery costs come down, and some large businesses switching to grid electricity from inhouse thermal power generation.The retail division is performing relatively well, with customer numbers up 1.6% and average retail energy prices up 2% on reduced discounting.Analyst: Adrian Atkins

Performance Goes from Good to Better; We Increase Mercury's FVE to NZD 3.60

Thematic (Sector/Industry)

New Zealand's vertically integrated electricity generator/retailers, or "gentailers", are high-quality businesses. The most attractive at present is <a href="https://www.smartkarma.com/entities/13136" target="_blank" data-smartkarma-citation="entities:13136:1">Contact Energy Ltd (CEN NZ)</a>, which is cheaper than <a href="https://www.smartkarma.com/entities/4327" target="_blank" data-smartkarma-citation="entities:4327:1">Meridian Energy Ltd (MEL NZ)</a> and <a href="https://www.smartkarma.com/entities/9933" target="_blank" data-smartkarma-citation="entities:9933:1">Mercury NZ Ltd (MCY NZ)</a>, lower-risk than <a href="https://www.smartkarma.com/entities/4227" target="_blank" data-smartkarma-citation="entities:4227:1">Genesis Energy Ltd (GNE NZ)</a>, and better-quality than <a href="https://www.smartkarma.com/entities/11489" target="_blank" data-smartkarma-citation="entities:11489:1">Trustpower Ltd (TPW NZ)</a>, in our opinion. While the near-term outlook is depressed by generation oversupply and intense retail competition, Contact should increase earnings on cost reductions, changes to transmission pricing, and the eventual recovery of the wholesale price. It trades on a low EBITDA multiple, and one that's based on current depressed earnings. We expect the discount to our fair value estimate to close as earnings improve, potentially aided by an expansion of the firm's EBITDA multiple towards peers. In the meantime, investors receive a relatively attractive dividend yield of around 5%, with material upside in coming years, predominantly from a higher dividend payout ratio. We believe the market is too focused on soft near-term fundamentals, providing a good opportunity for patient investors.Analysts: Adrian Atkins and Angus Hewitt

New Zealand's vertically integrated electricity generator/retailers, or "gentailers", are high-quality businesses. The most attractive at present is Contact Energy Ltd (CEN NZ), which is cheaper than Meridian Energy Ltd (MEL NZ) and Mercury NZ Ltd (MCY NZ), lower-risk than Genesis Energy Ltd (GNE NZ), and better-quality than Trustpower Ltd (TPW NZ), in our opinion. While the near-term outlook is depressed by generation oversupply and intense retail competition, Contact should increase earnings on cost reductions, changes to transmission pricing, and the eventual recovery of the wholesale price. It trades on a low EBITDA multiple, and one that's based on current depressed earnings. We expect the discount to our fair value estimate to close as earnings improve, potentially aided by an expansion of the firm's EBITDA multiple towards peers. In the meantime, investors receive a relatively attractive dividend yield of around 5%, with material upside in coming years, predominantly from a higher dividend payout ratio. We believe the market is too focused on soft near-term fundamentals, providing a good opportunity for patient investors.Analysts: Adrian Atkins and Angus Hewitt

Don't Be Shortsighted on New Zealand's Oversupplied Energy Market

New Zealand

Mercury NZ Ltd provides utility services. The Company generates and supplies electricity from hydro, geothermal, gas-fired, and wind power stations, as well as owns and manages bio-energy power plants. Mighty River Power serves customers throughout New Zealand.

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Mercury NZ Ltd (MCY NZ)

Performance Goes from Good to Better; We Increase Mercury's FVE to NZD 3.60

Weather conditions remain highly favourable for narrow-moat Mercury NZ, which is benefiting from plenty of rain while major competitors face dry...

Morningstar, Inc.

Don't Be Shortsighted on New Zealand's Oversupplied Energy Market

New Zealand's vertically integrated electricity generator/retailers, or "gentailers", are high-quality businesses. The most attractive at present...

Morningstar, Inc.

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