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Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Electricity Sector<br>Battle of the Index Constituents&nbsp;— CEN vs MEL</h2>
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<p>With Friday, 16 April, being a big liquidity day for Contact Energy (CEN) and Meridian Energy (MEL), we have compared their respective valuation metrics, with CEN the clear winner. It offers investors better value, better near-term earnings growth and dividend growth. Several factors are working in CEN's favour at present — it has the ability to be long-generation in a high-priced market, Tauhara will provide a bigger earnings kick than Harapaki and an unwind of MEL's trading premium will also benefit CEN on a relative basis. CEN (OUTPERFORM) is our preferred electricity sector exposure, with MEL (UNDERPERFORM) at the opposite end of the spectrum.</p>
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<h3>MEL trading premium remains elevated and excessive, but should unwind</h3>
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<p>MEL is trading on a&nbsp;12-mth&nbsp;forward EV/EBITDAF multiple of 21.3x compared to CEN trading at 13.4x (Fig. 1),&nbsp;a premium of ~60%. MEL has long traded at&nbsp;a premium to CEN, however, until late 2019 the premium averaged a more understandable ~25% (Fig. 2). Much of the recent premium increase has been attributed to&nbsp;MEL's&nbsp;100% renewable electricity status, and we suspect old-fashioned earnings growth has been a key factor. Historically (up until late-2019)&nbsp;MEL's&nbsp;12-mth&nbsp;forward consensus EBITDAF steadily grew. In contrast,&nbsp;CEN's&nbsp;12-mth&nbsp;forward consensus EBITDAF steadily fell (Fig. 3). However, since late-2019, the opposite has been true.&nbsp;The share price movements of MEL and CEN over the past 18 months do not reflect that reality. As a result, the observed EV/EBITDAF premium has expanded. The medium-term earnings growth outlook does not appear to be an&nbsp;explanator.</p>
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<h3>Medium-term earnings growth more attractive at CEN</h3>
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<p>With NZAS having committed to staying until at least 31 December 2024, there is a degree of medium-term certainty to sector earnings. Looking out to FY25, we expect CEN to grow its earnings faster than MEL (Fig. 4)&nbsp;— another reason why we do not&nbsp;believe&nbsp;MEL's&nbsp;current premium&nbsp;to CEN&nbsp;is sustainable. CEN has three key factors in its favour:</p>
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<li>MEL is taking on the lion's share of the lower NZAS contract price, hence, faces greater earnings reductions in FY21 and FY22.</li>
<li>CEN is long generation (due to declining retail sales volumes in recent years) and its commercial sales book is based on 2018 wholesale electricity prices. Being long generation provides upside during high priced periods and of all the large retailers, it will benefit the most from the repricing of its commercial book over the coming three years. In contrast, MEL's retail sales volumes are similar to its generation volumes (so it faces downside earnings risks when hydro volumes are low) and having been active in the commercial market over the past two years, is already benefitting from wholesale electricity price increases.</li>
<li>CEN's&nbsp;Tauhara&nbsp;geothermal development project will have a more significant impact on its earnings than&nbsp;MEL's&nbsp;&nbsp;Harapaki&nbsp;wind project.</li>
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<p>We have already seen the effects of the first two points&nbsp;come through in recent monthly operating statistics&nbsp;— CEN is performing well, whereas&nbsp;MEL's&nbsp;January and February figures were very low. Based on our medium-term earnings forecasts, MEL is trading on a +75% to +85% EV/EBITDAF premium to CEN&nbsp;(Fig. 5)&nbsp;— i.e. higher than the current market consensus 12-mth&nbsp;forward EV/EBITDAF premium.</p>
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<h3>Dividend growth also more attractive at CEN</h3>
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<p>The earnings story flows through to the dividend outlook. Having reset its dividend to 35cps, we expect CEN to grow its dividend at +1.5cps (~+4%) per&nbsp;annum&nbsp;for the next four years (Fig. 6). In contrast, we expect&nbsp;MEL's&nbsp;dividend will be flat as its ordinary dividend increased materially following very strong FY19 and FY20 results. MEL will likely take four to five years to grow earnings back to those levels, at which point it will be able to resume dividend growth, in our view. Our CEN FY25 gross dividend yield is 6.7%, vs. 4.0% for MEL, with the gap growing&nbsp;(Fig. 7).</p>
<p>In conclusion, we do not believe MEL's current valuation premium is sustainable and that it will trend back to historic levels in time.</p>
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<div><strong>Andrew Harvey-Green</strong></div>
<div><a href="mailto:andrew.harvey-green@forsythbarr.co.nz" target="_blank" rel="noopener">andrew.harvey-green@<wbr>forsythbarr.co.nz</a></div>
<div>+64 4 495 8185</div>
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<div><strong>Scott Anderson</strong></div>
<div><a href="mailto:scott.anderson@forsythbarr.co.nz" target="_blank" rel="noopener">scott.anderson@forsythbarr.co.<wbr>nz</a></div>
<div>+64 4 914 2219</div>
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Electricity Sector Battle of the Index Constituents&nbsp;— CEN vs MEL


With Friday, 16 April, being a big liquidity day for Contact Energy (CEN) and Meridian Energy (MEL), we have compared their respective valuation metrics, with CEN the clear winner. It offers investors better value, better near-term earnings growth and dividend growth. Several factors are working in CEN's favour at present — it has the ability to be long-generation in a high-priced market, Tauhara will provide a bigger earnings kick than Harapaki and an unwind of MEL's trading premium will also benefit CEN on a relative basis. CEN (OUTPERFORM) is our preferred electricity sector exposure, with MEL (UNDERPERFORM) at the opposite end of the spectrum.


MEL trading premium remains elevated and excessive, but should unwind


MEL is trading on a&nbsp;12-mth&nbsp;forward EV/EBITDAF multiple of 21.3x compared to CEN trading at 13.4x (Fig. 1),&nbsp;a premium of ~60%. MEL has long traded at&nbsp;a premium to CEN, however, until late 2019 the premium averaged a more understandable ~25% (Fig. 2). Much of the recent premium increase has been attributed to&nbsp;MEL's&nbsp;100% renewable electricity status, and we suspect old-fashioned earnings growth has been a key factor. Historically (up until late-2019)&nbsp;MEL's&nbsp;12-mth&nbsp;forward consensus EBITDAF steadily grew. In contrast,&nbsp;CEN's&nbsp;12-mth&nbsp;forward consensus EBITDAF steadily fell (Fig. 3). However, since late-2019, the opposite has been true.&nbsp;The share price movements of MEL and CEN over the past 18 months do not reflect that reality. As a result, the observed EV/EBITDAF premium has expanded. The medium-term earnings growth outlook does not appear to be an&nbsp;explanator.


Medium-term earnings growth more attractive at CEN


With NZAS having committed to staying until at least 31 December 2024, there is a degree of medium-term certainty to sector earnings. Looking out to FY25, we expect CEN to grow its earnings faster than MEL (Fig. 4)&nbsp;— another reason why we do not&nbsp;believe&nbsp;MEL's&nbsp;current premium&nbsp;to CEN&nbsp;is sustainable. CEN has three key factors in its favour:

MEL is taking on the lion's share of the lower NZAS contract price, hence, faces greater earnings reductions in FY21 and FY22.
CEN is long generation (due to declining retail sales volumes in recent years) and its commercial sales book is based on 2018 wholesale electricity prices. Being long generation provides upside during high priced periods and of all the large retailers, it will benefit the most from the repricing of its commercial book over the coming three years. In contrast, MEL's retail sales volumes are similar to its generation volumes (so it faces downside earnings risks when hydro volumes are low) and having been active in the commercial market over the past two years, is already benefitting from wholesale electricity price increases.
CEN's&nbsp;Tauhara&nbsp;geothermal development project will have a more significant impact on its earnings than&nbsp;MEL's&nbsp;&nbsp;Harapaki&nbsp;wind project.

We have already seen the effects of the first two points&nbsp;come through in recent monthly operating statistics&nbsp;— CEN is performing well, whereas&nbsp;MEL's&nbsp;January and February figures were very low. Based on our medium-term earnings forecasts, MEL is trading on a +75% to +85% EV/EBITDAF premium to CEN&nbsp;(Fig. 5)&nbsp;— i.e. higher than the current market consensus 12-mth&nbsp;forward EV/EBITDAF premium.


Dividend growth also more attractive at CEN


The earnings story flows through to the dividend outlook. Having reset its dividend to 35cps, we expect CEN to grow its dividend at +1.5cps (~+4%) per&nbsp;annum&nbsp;for the next four years (Fig. 6). In contrast, we expect&nbsp;MEL's&nbsp;dividend will be flat as its ordinary dividend increased materially following very strong FY19 and FY20 results. MEL will likely take four to five years to grow earnings back to those levels, at which point it will be able to resume dividend growth, in our view. Our CEN FY25 gross dividend yield is 6.7%, vs. 4.0% for MEL, with the gap growing&nbsp;(Fig. 7).
In conclusion, we do not believe MEL's current valuation premium is sustainable and that it will trend back to historic levels in time.



Andrew Harvey-Green
andrew.harvey-green@forsythbarr.co.nz
+64 4 495 8185





Scott Anderson
scott.anderson@forsythbarr.co.nz
+64 4 914 2219



Electricity Sector: Battle of the Index Constituents — CEN Vs MEL