Meridian Energy Ltd A Research Report

Transcription

1 Meridian Energy Ltd A Research Report October 2, 2013

2 L8, Wakefield House 90 The Terrace P.O. Box 93 Wellington New Zealand Tel (644) Principal contacts for this report: Philip Barry, Director Mob Daniel Foote, Analyst Mob:

3 Disclaimer This report has been prepared by (TDB) based on information available to TDB as at the date of this report. We reserve the right, but will be under no obligation, to review or amend our report if any additional information is brought to our attention, or subsequently comes to light. The information, valuation and assessment of risks provided in this publication are provided for general information purposes only. To the extent that anything in this report is taken to constitute advice, it does not take into account any person s particular financial situation or goals and, accordingly, does not constitute personalised financial advice under the Financial Advisers Act 2008, nor does it constitute advice of a legal, tax, accounting or other nature to any person. The Directors of TDB are not Authorised Financial Advisors. TDB recommends that recipients seek advice specific to their circumstances from their adviser before making any investment decision or taking any action. Additionally, our report is based on prevailing market conditions. There are a number of events in the short to medium term that could occur and have significant impacts on the electricity market and Meridian Energy Ltd. Our valuation, as detailed in the report, is sensitive to small changes in key input variables; therefore, actual results in the future will vary from the forecasts and projections upon which we have relied. These variations may be material. TDB has made use of published data and forecasts from a variety of sources believed to be reputable and accurate. TDB has relied upon the data retrieved from these sources but cannot guarantee its accuracy or completeness and does not take responsibility for any inaccuracies in the external information. TDB, its employees and persons associated with TDB may have held or hold securities mentioned in this report; have provided investment advice or other financial services in relation to the companies mentioned in this report; and have other financial interests in the matters mentioned in this report. Investors should assume TDB offers financial advisory services to the companies covered in this report. This report has been prepared by TDB with care and diligence and the statements and opinions given by TDB in this report are given in good faith and in the belief on reasonable grounds that such statements and opinions are correct and not misleading. However, no responsibility is accepted by TDB or any of its officers, employees or agents for errors or omissions however arising in the preparation of this report, provided that this shall not absolve TDB from liability arising from an opinion expressed recklessly or in bad faith. This report is not for distribution or release in the United States. 3

4 Table of contents Disclaimer Summary and conclusions Introduction The New Zealand electricity industry Generation Retail New Zealand s electricity demand Company analysis Generation assets Retail assets Meridian s financials Valuation of Meridian Discounted cash flow analysis Earnings multiples for comparative companies Risks Overview Hydrology risk Concentration of assets risk Political/regulatory risk Tiwai smelter risk Weak demand growth/over supply Retail competition Transmission pricing change Water rights Australian opportunities Conclusions Appendix 1: Key DCF modelling assumptions Appendix 2: Sensitivity analysis Appendix 3: Comparator companies

5 1 Summary and conclusions Meridian Energy Ltd (Meridian) is New Zealand s largest electricity generator and fourth largest retailer. Meridian generated around 12,000 GWh in 2013 (30% of the NZ generation market) and serviced around 270,000 retail customers (14% of the retail market) with a further 40% of its generation contracted to the Tiwai Point smelter. Typically around 90% of the company s generation comes from hydro power stations with a further 10% generated from wind farms. In undertaking our valuation of Meridian we have employed two valuation methodologies: a discounted cash flow analysis (DCF); and analysis based on the earnings multiples for comparative companies (compcos). Table 1: Summary of estimated value per share Our DCF valuation indicates a base-case scenario share price of $1.90 with a range of $1.70 to $2.10. Our earnings multiples for comparative companies indicate a trading value midpoint of $1.70 per share with a range of $1.50 to $1.90. We place most weight on the compco multiples when determining a likely initial trading range for Meridian because there is good market-based information available for three similar companies (Contact, Mighty River Power and TrustPower); and the major risk facing these companies currently - the political risk associated with the introduction of a Labour/Greens NZ Power policy has been factored in, at least to some extent, to the comparator companies share prices. While Meridian may well be affected more by a single buyer in the wholesale electricity market than the other generator-retailers, there are some other, upside factors associated with Meridian that provide some offset to this risk (refer our discussion of risks in section 6). Importantly, our analysis of the risk profile of the electricity generator-retailers, including Meridian, indicates that it would be mistake to regard these companies as utilities with stable earnings. These companies, and Meridian in particular, face and must manage a high degree of uncertainty about water inflows, other fuel prices, the regulatory regime and competitors behaviour. This uncertainty translates into revenue and earnings volatility. Much of Meridian s volatility stems from its high reliance on hydro power. As with any listed company, the company and sector-specific risks facing an investor in Meridian can be reduced by holding a diversified portfolio of shares and other assets. Nevertheless, it is important that investors are aware of and understand the risks facing Meridian and the industry as a whole. 5

6 2 Introduction TDB Advisory has prepared a research report on Meridian Energy Limited (Meridian) as at October 2 nd, We provide an overview of the electricity industry in section 3 and some details about Meridian in section 4. In section 5 we present our valuation which includes a discounted cash flow analysis and an analysis based on earnings multiples for comparative companies. Section 6 provides some insight into the risks faced by Meridian and the electricity industry. 3 The New Zealand electricity industry Figure 1 below provides a high-level illustration of the electricity industry in New Zealand. Figure 1: New Zealand electricity industry 3.1 Generation Source: MBIE Around 50% of New Zealand s electricity is generated by hydro power stations. The remaining 50% is generated through a mixture of gas, geothermal, coal and oil-fired thermal power stations, wind farms and bio-mass plants (refer Figure 2 below). 6

7 Figure 2: Electricity generation by fuel type for 2012 Source: MBIE The generation market is dominated by five major companies with these five companies making up around 93% of New Zealand s total electricity generation (refer figure 3 below). Figure 3: Total generation for the 12 months ending 30 June 2013 Source: Company annual reports & websites 7

8 3.2 Retail Retail electricity companies purchase electricity from the wholesale market and on-sell it to households and businesses. The major companies operating in the retail sector are the retail arms of the five main generators and as such these five companies are termed gentailers. There are approximately 20 retail brands with Genesis Energy commanding the largest market share catering to approximately 27% of the market. Meridian has about 14% share of the retail market. About 40% of Meridian s generation is contracted to its largest customer, the Rio Tinto smelter at Tiwai Point. Figure 4: Market share July 2013 Source: MBIE 3.3 New Zealand s electricity demand For the last six years total electricity demand in New Zealand has been stagnant, due primarily to a combination of reduced industrial demand, flat commercial and residential demand and efficiency gains in energy use. In contrast over the previous two decades total demand had been growing fairly steadily at an average compound annual growth rate (CAGR) of around 1.3%. Figure 5 below demonstrates the changes in consumption since The agriculture, forestry and fishing industry has seen the greatest growth with a CAGR of 4.6%. Since 2005 the industrial sector has been in decline with a CAGR of -1.9%. 8

9 Figure 5: Electricity consumption 1990 to Company analysis Meridian is the largest of the five major electricity generator-retailers in New Zealand. It has a renewable energy focus with the majority of its generation coming from hydro power stations and the remainder sourced from wind. Meridian was established in 1999 after the break-up of the Electricity Corporation of New Zealand during the widespread market reforms at the time. Meridian is the country s largest generator with a combined installed capacity of around 2,400MW in its hydro power stations and a further 356MW in its New Zealand wind farms. As a retailer, Meridian retails electricity to around 220,000 residential, rural and business customers under its own brand and another 51,000 customers through its 100% subsidiary, Powershop, the online prepayment retailer. With the company s generation predominantly based in the South Island Meridian s retail presence is much stronger there: Meridian has about 25% market share in the South Island and 10% market share in the North Island. 4.1 Generation assets The majority of Meridian s generation assets are located in the South Island (as detailed in Figure 6 below) with its seven hydro stations and one wind farm providing around 89% of the company s total New Zealand capacity. 9

10 Figure 6: Location of generation assets in New Zealand and Australia Source: Meridian Energy Meridian has a number of projects under construction: Mt Mercer Wind Farm: A 64-turbine wind farm being constructed near Ballarat in Victoria, Australia. The wind farm is expected to have a capacity of 131 MW. Construction began in December 2012 and it is expected to take 2 years to complete; Waitaki Hydro Scheme: Meridian is investing more than $40m on a four year project to upgrade the Waitaki dam and power station. The upgrade will provide an extra 15 MW of capacity; and Mill Creek Wind Farm: Meridian has started work on a 26 turbine wind farm northwest of Wellington. The wind farm will have a 60 MW capacity. The following projects are in the pipeline but with no immediate plans to begin construction. There is currently plenty of spare capacity in the New Zealand electricity industry, but the projects below are Meridian s main options for increased generation capacity. Amuri Hydro Scheme: Meridian applied for resource consent in 2011 to build a hydro scheme on the Waiau River in North Canterbury. The hydro station would have a 38 MW generation capacity. The project is still in the early planning stage; Balmoral Hydro Scheme: Ngāi Tahu Property and Meridian are working together on a proposed integrated water project on the Hurunui River in North Canterbury. The hydro station would have a 15 MW capacity. Ngāi Tahu Property and Meridian applied for consents in December 2012; 10

11 Central Wind Project: Meridian has been granted resouce consent to build a 52 turbine wind farm in the central North Island. The wind farm will have a 120MW capacity. There are no immediate plans to start construction but work continues to ensure the project is a viable option for Meridian to proceed with in the future; Mt Munro Wind Farm: Meridian has proposed a wind farm in the area south of Eketahuna in the lower North Island. The wind farm would have a capacity of 60 MW. Meridian has deferred its application for resource consents while further monitoring work is completed; and Hurunui Wind Farm: Meridian applied for resource consents in February 2011 for a 33 turbine wind farm in North Canterbury. The wind farm would have a 76 MW capacity. Decisions on the resource consents for Amuri, Balmoral and Hurunui are still pending. Meridian generates all of its elecricity through renewable resources. In the 12 months to June % of its generation was produced through its hydro power stations and 10% through its wind farms. Figure 7 below provides a comparison of Meridian s generation sources with the other main gentailers. Figure 7: Total generation by gentailer 12 months to June 2013 Figure 7 above highlights the following key points: Meridian is the largest generator of electricity in New Zealand (with around 30% of the market); 11

12 with its large dependence on hydro generation, Meridian is heavily reliant on the weather conditions in New Zealand and in particular the amount of rainfall in the Waitaki and Waiau catchments in the South Island; and the other gentailers generally have more diversified generation portfolios. 4.2 Retail assets Meridian is the fourth largest retailer in New Zealand with around 270,000 of the country s electricity customers (as measured by numbers of installation control points (ICPs)). As noted above, Meridian operates its retail business through two main retail electricity brands: Meridian Energy and Powershop. Meridian also owns and operates an electricity meter services subsidiary, Arc Innovations. Over the past four to five years the retail market share of the five main gentailers has reduced as competition has increased in the market. As demonstrated in Figure 8 below, the Other retailer category has taken about 5% of the market away from the gentailers since Figure 8: Percentage of market share July 2005 to July 2013 Meridian s retail market share has averaged around 12.5% over the eight year period from July 2005 to July Over that time the company has seen an increase in retail market share from around 11.5% to around 14%. It is interesting to note that Contact Energy has seen a fairly significant decline in market share from around 28% to around 22.5% over the same period. 12

13 4.3 Meridian s financials Tables 2 to 4 below provide summaries of Meridian s key financial statements. Table 2: Summary consolidated income statements 12 months to June ($m) Total Operating Revenue 1,892 2,062 2,053 2,570 2,711 Total Operating Expense -1,380-1,420-1,393-2,093-2,126 EBITDAF Depreciation and Amortisation Other Gain/(Loss) Operating Profit Net Finance Cost Profit before Tax Income Tax Expense Profit after Tax Table 3: Summary consolidated balance sheets As at June 30 ($m) Total Shareholders' Equity 4,284 5,071 4,931 4,826 4,688 Current Assets Non-Current Assets 6,910 8,444 7,833 8,122 6,971 Total Assets 7,177 8,716 8,460 8,693 7,737 Current Liabilities Non-Current Liabilities 2,536 3,088 2,959 3,274 2,529 Total Liabilities 2,893 3,645 3,529 3,867 3,049 Table 4: Summary consolidated statements of cash flows 12 months to June ($m) Net cash provided by operating activities Net cash provided by/used in investing activities Net cash provided by/used in financing activities Net change in cash and cash equivalents held Valuation of Meridian In undertaking our valuation of Meridian we have employed two valuation methodologies: a discounted cash flow analysis (DCF); and analysis based on earnings multiples for comparative companies (compcos). 13

14 Table 5: Summary of estimated value per share Our DCF valuation of Meridian s equity value indicates a base-case scenario share price of $1.90 with a range of $1.70 to $2.10. Our earnings multiples for comparative companies indicates a trading value midpoint of $1.70 per share with a range of $1.50 to $1.90. Normally we would place most weight on a DCF valuation and use the compco multiples as a crosscheck. However in the current circumstances we place most weight on the compco multiples when determining a likely initial trading range for Meridian. This is for two reasons: 1. our DCF analysis does not include an adjustment for the political risk associated with the introduction of a Labour/Greens NZ Power policy. In our view there is too much uncertainty about the key details on how the scheme will operate to meaningfully adjust the forecast cashflows. As such we consider there is considerable downside risk around the DCF valuation. The impact on current value of the possible establishment of NZ Power can be estimated by looking at the impacts on the policy s announcement: Contact Energy and TrustPower shares dropped by around 7 to 8% by the end of trading the day following the announcement of the NZ Power policy. A similar reduction in our DCF valuation gives us a midpoint of around $1.75 and largely explains the difference observed between our two estimates; and 2. there are now three New Zealand gentailers listed on the NZX (Contact, Mighty River Power and TrustPower). This provides an unusually strong basis for compco analysis. While each of the gentailers differs in important respects, there is no compelling reason in our view to believe Meridian has significantly stronger or weaker growth prospects overall than the average for the gentailer market (refer our discussion of risks in section 6 below). Further, Meridian is a capital intensive business with very long-life assets. Forecasting the company s future cash flows and determining the other key assumptions underlying the DCF valuation is by no means an exact science and therefore there is a significant degree of uncertainty surrounding the DCF valuation. For example, changing our WACC by 0.5 percentage points changes the per share equity valuation by around 20 cents or half a billion dollars in market capitalisation. Uncertainty and differences in judgements about the key risk factors will explain some of the difference between our DCF and compcos valuations. 5.1 Discounted cash flow analysis We have completed a high-level DCF valuation of Meridian that provides an indicative valuation of the company that should be viewed in conjunction with our compcos analysis. Rather than attempting a nuanced breakdown of the finer details of Meridian s operations we have focused on the key drivers that in our view significantly impact Meridian s value. These key drivers are: 14

15 the projected future path of electricity prices and demand growth; the forecast EBITDAF 1 margin; the weighted average cost of capital (WACC); and the assumed terminal growth rate. Based on the key assumptions as detailed below and in Appendix One, our DCF analysis provides us with an estimated equity market capitalisation range of $4.4b to $5.4b. This valuation equates to a share price of $1.70 to $2.10 with a base-case estimate of $1.90. DCF results Table 6: Base case share price calculation Enterprise value ($m) $5,828 Net debt ($m) -$950 Equity Value ($m) $4,878 Number of shares (millions) 2,563 Per Share Price $1.90 Our sensitivity analysis (refer Appendix 2) indicates a possible range for the DCF valuation of around $1.70 to $2.10 per share. DCF analysis is highly sensitive to the underlying assumptions, especially for a highly capital-intensive company like Meridian. Many of the risk factors affecting the electricity industry are ultimately reflected in the wholesale electricity price. To give some indication of the sensitivity of the DCF analysis to the future price path assumption we present in Table 7 below the range for our valuation based on different price path scenarios as provided by the Ministry for Business Innovation and Employment (MBIE) in their latest outlook for the electricity industry. Table 7: Meridian DCF valuation: price path scenarios Scenario Market cap ($b) Share Price Scenario 4: Tiwai closes/very low demand $ 4.4 $ 1.73 Scenario 3: Low demand (TDB base) $ 4.9 $ 1.90 Scenario 1: Mixed renewables base $ 5.0 $ 1.96 Scenario 2: High demand $ 5.3 $ 2.09 We note that at the time the demand growth and price growth estimates were forecast by MBIE (2012), the outlook for the electricity industry was more optimistic than is now generally perceived to be the case. Importantly, New Zealand electricity future prices on the ASX are broadly flat to 2017 (on a seasonally adjusted basis). We therefore take MBIE s low demand scenario as our base case for future electricity prices. 1 EBITDAF is earnings before net interest expense, income tax, depreciation, amortisation and changes in the fair value of financial instruments and other items. 15

16 As noted above, we have not incorporated the political and regulatory risk of a Labour/Greens government intervention in the electricity market into our DCF valuation. Although it would take some time for NZ Power, a monopsony buyer, to be introduced into the wholesale market and the probability of NZ Power occurring at all may be relatively small, its effect would be very significant. We saw a sizeable and immediate impact on TrustPower and Contact Energy at the time of the announcement on 18 April, The two gentailers suffered a respective 7.9% and 7.2% decline in value between close of play on April 17 and April 19. It is reasonable in our view to expect Meridian s value to be adjusted down by 5% to 10% at present to account for this political risk and probably towards the upper end of this range as Meridian would be more impacted than most gentailers by the policy. Sensitivity analysis Figure 9 below summarises the results of our sensitivity analysis. Figure 9: Sensitivity analysis summary Our sensitivity analysis provides an indication of how differing judgements about the key parameters of the WACC, the EBITDAF margin, the future electricity price and demand path and the terminal growth rate can impact on the assessed value of Meridian. 5.2 Earnings multiples for comparative companies Analysis of the earnings multiples for comparative companies provides another indication of Meridian s equity value. We consider three different groups of companies for the compcos analysis: 16

17 listed New Zealand generator-retailers; large international renewable energy companies; and large Australian energy companies. The three earnings multiples we focus are on: price to earnings multiple (three year average of net profit before tax); price to underlying profit multiple (three year average of underlying net profit before tax (UNPBT)); and enterprise value to EBITDAF (three year average of EBITDAF). Table 8 below summarises our multiples-based equity value estimates for Meridian: Table 8: Compco analysis Company P/E P/UNPBT EV/EBITDAF (3 year average) (3 year average) (3 year average) New Zealand Mighty River Power Contact Energy Trustpower Average Implied Meridian valuation($b) $5.3 $3.9 $5.0 Implied share price ($) $2.05 $1.52 $1.93 International Enel Iberdrola China Power Average Implied Meridian valuation($b) $4.5 $4.1 $5.2 Implied share price ($) $1.74 $1.60 $2.04 Australia AGL Origin Average Implied Meridian valuation($b) $5.7 $3.7 $7.5 Implied share price ($) $2.23 $1.45 $2.91 Overall average Implied Meridian valuation($b) $5.1 $3.9 $5.7 Implied share price ($) $1.98 $1.53 $2.22 P/UNPBT and EV/EBITDAF for NZ compcos We give most weight in our multiples-based valuation to the P/UNPBT and EV/EBITDAF ratios for the listed New Zealand gentailers. 17

18 We discount the P/E multiples for New Zealand gentailers. Changes in the fair value of the gentailers financial and operating derivatives pass through the income statement along with other significant one-off gains and losses. These impacts provide a misleading skew to the P/E ratio. We include in Table 8 above the earnings multiples for international comparators to Meridian for information purposes but we consider their relevance to be limited as an indication of Meridian s trading value. The issues encapsulated in the share price of a listed New Zealand gentailer are simply not the same combination of issues a shareholder in an international electricity company must consider. The New Zealand electricity market faces a combination of political risks, a market structure, a generation-asset portfolio, water-rights issues, growth prospects and a variety of other factors that make the New Zealand market unique. Fortunately there are now several close comparators to Meridian listed on the NZX (ie, Contact, Mighty River Power and TrustPower) that provide a good benchmark for assessing Meridian s value. How Meridian compares with Contact, TrustPower and MRP Having identified the most relevant comparators we must consider whether we expect the P/UNPBT and EV/EBITDAF multiples for Meridian to be higher or lower than each of the other listed gentailers. In particular, we would expect Meridian to have a higher earnings multiple than another gentailer if Meridian s earnings growth prospects are more promising and vice versa. It is important to note that some key concerns impacting on Meridian s annual earnings such as hydrology risk and the concentration of Meridian s assets should not impact on the earnings multiple we attribute to Meridian, nor its valuation. Meridian can and does manage and to some extent mitigate these concerns through good risk management practice. Further, to the extent that any residual non-systematic risk remains a shareholder will be able to mitigate the earnings volatility risk by holding a diversified investment portfolio. There are some key areas where Meridian s earning prospects are more at risk than other New Zealand gentailers. In particular Meridian is likely to be hit hardest by the Labour/Greens NZ Power policy as many of Meridian s generation assets were built long ago and are hydro based and thus will have a low historic cost and a very low marginal cost of production. Also, water rights issues may become an increasingly important concern in years to come. Changes in fresh water allocations, irrigation demands, and cultural and environmental pressures may result in some uncertainty surrounding Meridian s future water access rights. Again, this is an industry-wide concern, but given that Meridian s generation portfolio is dominated by hydro-power stations it will be hit harder than most. On the other hand, Meridian may be the beneficiary of other changes and opportunities in the industry. If there is a transmission pricing policy change, particularly around the cost-sharing of the HVDC Cook Strait link, then as a South Island based generator Meridian is likely to benefit from this reallocation. The Australian market also presents new revenue opportunities and Meridian is wellplaced to take advantage of these. Its subsidiary, Powershop, has already entered the retail market in Victoria and Meridian has completed wind farm projects in Australia as well. Finally, there may be some scope for efficiency gains and improved retail margins post-privatisation for Meridian. 18

19 On the whole, it is very difficult to ascertain how these risks and opportunities weigh up on balance. We therefore consider it appropriate to apply the New Zealand industry average earnings multiples to Meridian. Figure 10 below presents our assessment of the valuation ranges for Meridian based on the different compco groups and multiples. Figure 10: Valuation ranges for Meridian by group and earnings multiple New Zealand: as noted above, the other New Zealand generator-retailers provide the best indication of the likely trading value of Meridian as these companies operate in the same industry and face the same market conditions that Meridian face. In particular, the share prices for Contact, MRP and TrustPower incorporate the market s assessment of the risk and impact of the Labour/Green NZ Power policy. Our multiples for the New Zealand gentailers suggest a trading valuation for Meridian in the range of $1.52 to $1.93 with a midpoint of $1.73. International: the companies we have chosen in this category are international companies most similar to Meridian: they are large renewables-based electricity companies. Their trading multiples suggest a valuation for Meridian in the range of $1.60 to $2.04. Australia: the two Australian companies, AGL and Origin, are not exclusively renewables-focused energy companies but they are the best listed comparators from the closest major market outside of New Zealand. The Australian compcos multiples provide a wide valuation range of $1.45 to $2.91 for Meridian. The EV/EBITDAF ratio in particular is an outlier compared to the international and New Zealand compcos analysis as well as our DCF analysis so we do not suggest this particular value should be considered part of a reasonable valuation range. Overall, our assessment of the value for Meridian based on the most relevant compcos and multiples leads us to a likely trading price range for Meridian of around $1.50 to $1.90 with a midpoint of $

20 6 Risks 6.1 Overview Many investors will be asking just how risky an investment in New Zealand s largest electricity generator-retailer is likely to be. A common trap is to think of Meridian and New Zealand s other electricity gentailers as utilities with stable and therefore low risk earnings streams. However, our analysis indicates the gentailers like Meridian do not exhibit the stable revenue and earnings patterns of a typical utility. The electricity generation and retailing market is a risky business and companies can, and do, get into financial difficulties if the risks they face aren t managed appropriately. Meridian faces a number of risks that are explored below. The risks include a volatile fuel supply (ie, rain); geographically-concentrated generation assets; political risks associated with changes in regulation; a concentrated customer base; current weak market demand and over supply; and retail competition. Prices in the electricity industry, like any other industry, fluctuate with demand and the demand for electricity fluctuates depending on the time of day, the day of the year and how much water happens to be sitting in our hydro-lakes at any given time. Generator-retailers do their best to minimise the risks involved but earnings volatility is relatively high in the electricity gentailing industry because the gentailers must take on the risk of these price fluctuations. On the other hand, traditional utilities like the electricity lines companies can charge a regulated price for the delivery of electricity across their lines. As such we should expect them to resemble a classic utility. Figure 11 below provides an indication of the volatility of earnings 2 in recent years in these two quite different parts of the electricity industry: the gentailers and the lines companies 3. 2 Volatility of earnings is measured by the average standard deviation of the annual change in EBITDAF for the major gentailers and lines companies over the past five years. 3 The lines companies in our sample are the three largest distributors, Vector, Powerco and Orion and the national transmission network owner and operator Transpower. The gentailers in the analysis are the 5 main gentailers. 20

21 Figure 11: EBITDAF volatility As the graph above highlights, earnings for the lines companies have been far more stable over the past six years than for the gentailers. It should be noted that since 2008 the gentailers have experienced several particularly dry periods: with Meridian facing its driest year on record in 2012 and a one-in-20 dry year in This difference in earnings volatility between the gentailers and the lines companies is probably unsurprising as it comes with the nature of business of the two industries. Interestingly, though, in every year from 2008 to 2013 the lines companies on average have reported returns on assets (RoA) 4 materially greater than the gentailers (refer Figure 12 below). This is somewhat surprising because normally we would expect the higher risk of the gentailers to be compensated by a higher average return. 4 RoA is measured by EBITDAF divided by average total assets. Weighted averages are used. 21

22 Figure 12: RoA for gentailing vs. distribution The large electricity generators devote considerable efforts and talent to managing the risks they face. The measures they use include integrating into the retail market, owning a mix of generation plants so they are not reliant on a single fuel source, and entering financial hedges through the ASX futures electricity market and bilateral ( over the counter ) forward trades with each other. Despite these measures, the electricity gentailers come with plenty of risk when compared with the electricity lines companies. As noted above, much of this risk is specific to the gentailing business and thus is diversifiable by an investor who holds a balanced portfolio. However it is important to be aware of the risks of investing in electricity gentailers. The evidence suggests it would be a mistake to think of the gentailers as low-risk utilities. Some of the key risks Meridian specifically faces are discussed in more detail below. 6.2 Hydrology risk As noted above, almost 90% of Meridian s generation capacity comes from hydro power stations. More than any other major generator in the country, Meridian is reliant on sufficient inflows into its catchments. Water is Meridian s fuel supply and as a fuel supply, water inflows are by no means reliable. Two recent years, 2008 and 2012, have shown how much of a challenge it is to have to rely on water inflows as your fuel supply was the driest year in the 80 years of historical records for Meridian s catchments and 2008 was a 1-in-20 dry year. Added to the concern is the fact that New Zealand s hydro generation lakes have a relatively small storage capacity so even when inflows are high it is not possible to save up storage for long periods of time. 22

23 While Meridian can and does manage its risks by entering financial hedges through the ASX futures electricity market and bilateral forward trades with other gentailers, it still faces considerable risks. Fluctuations in its inflows lead to a high degree of volatility in Meridian s generation, revenues and profits. Figure 13 below indicates the changes in Meridian s EBITDAF and RoA over the past ten years. Annual changes in Meridian s EBITDAF have regularly exceeded 20% while the company s RoA has ranged from as high as 11.5% to as low as 5.4%. Figure 13: Meridian's RoA and EBITDAF volatility 6.3 Concentration of assets risk In the break-up of the Electricity Corporation of New Zealand (ECNZ) in 1999, Meridian was formed as a State-owned enterprise in control of all ECNZ s then South Island hydro generation power stations. 5 These power stations made up a sizeable generation portfolio. 6 However, all these power stations are, firstly hydro power stations and secondly, located in South Canterbury, Otago or Fiordland National Park, i.e. in the bottom half of the South Island. The proximity of the stations to one another makes the volatility of inflows all the more pronounced as the inflows for each station are more interdependent than if the stations had been dispersed throughout the country. A dry period in North Otago is likely to coincide with a dry period in southern Canterbury and dry inflows in the Waitaki catchment affect all Meridian s hydro stations on 5 Contact Energy had earlier been split off from ECNZ with, amongst other assets, the South-Island located Clyde and Roxburgh stations. 6 At the time Meridian also owned Tekapo A and Tekapo B power stations. These two stations have since been sold to Genesis under government mandate to increase competitiveness in the industry. 23

24 the Waitaki river. This is a severe issue that Meridian has had to face on two occasions in the past five years. Below average inflows were seen in both the Waiau and the Waitaki at the same time in both 2012 and In addition to the geographical concentration, Meridian s generation capacity is heavily weighted towards hydro. The wind farms provide some diversification to the generation portfolio. However, at only slightly over 10% of total capacity, Meridian s wind generation does not provide much relief when the company faces a dry period in the South Island. 6.4 Political/regulatory risk In the early 1980s the government directly owned and operated almost all aspects of generation and transmission in the New Zealand electricity market through a single government department, the New Zealand Electricity Department. Despite an extended period of deregulation and corporatisation the sector remains a highly regulated industry with significant government presence and risk of intervention. In April this year, around the time of the Mighty River Power float, the Labour/Green Parties announced a new policy to introduce a single buyer into the electricity market if they became government. The proposed monopsony buyer, NZ Power, would effectively force price restrictions on the New Zealand generators, based on the historical costs of their assets, reducing their revenues and earnings. As the owner of many of the oldest and largest generation assets, Meridian would be particularly adversely affected by the policy. Labour/Green s intention is to reduce electricity prices for New Zealand residents. It hopes to cut power bills by enforcing fair prices and restricting future price increases. The impact of merely announcing the policy just prior to the Mighty River Power float on the two already-listed generatorretailers, Contact Energy and TrustPower, was immediate with hundreds of millions of dollars of value knocked off their respective share prices. As noted above, this policy is probably the largest risk to Meridian s share value. 6.5 Tiwai smelter risk The contract with the Rio Tinto aluminium smelter at Tiwai Point accounts for a very large proportion of Meridian s generation: around 40% of Meridian s annual generation is contracted to the smelter. Earlier this year the government announced a $30 million cash injection in order to finalise negotiations over a new contract between Meridian and Rio Tinto. However, the government subsidy is a short-term solution to a smelter struggling to be competitive globally. There is a reasonable risk that the smelter will close in the next five years. Currently accounting for around 14% of total electricity consumption in New Zealand, any such closure would significantly reduce electricity demand and wholesale electricity spot prices in the country. Meridian s management have stated that the new contract was signed at prices where Meridian is economically indifferent to shutdown. Thus it is by no means certain that Meridian would be significantly financially impacted by a closure, with much depending on the exact timing and advance notice 24

25 given before any closure. While around 40% of Meridian s contracted generation would no longer be under contract, this electricity is being sold at a significant discount to market prices. Meridian would be free to take on new retail and wholesale customers, sell excess generation into the market at spot prices (that would nevertheless be lower than they would otherwise be) or contract with other generators and retailers. Overall, other gentailers may well be affected more than Meridian by a closure of the smelter. 6.6 Weak demand growth/over supply Since 2007 demand in the New Zealand electricity market has remained relatively flat with the country having gone through the global financial crisis and the Christchurch earthquake which both dampened market demand. Prices, particularly for residential customers, have risen quite substantially over the past decade and both industrial and residential markets are likely to see only moderate demand growth at best. Demand in the electricity sector has seen a compound annualised growth rate of only 0.6% over the last ten years and for the previous five years demand has declined slightly. New Zealand is expected to experience moderate population growth going forward but the impact this population growth has on real electricity demand growth will be dampened. Electricity consumption on a per household basis is likely to reduce as a result of electricity efficiency gains and as a response to the relatively large price increases seen over the past decade. As discussed above, the potential closure of the Rio Tinto smelter will significantly impact total national electricity consumption. It is also symptomatic of a more general migration towards a more services-based economy in New Zealand. With a general decline in manufacturing, which tends to be a relatively high-electricity usage industry, real growth in electricity consumption is likely to be muted. With a number of generation projects completed in the past decade in expectation of continued market growth, New Zealand now has considerable excess generation capacity. This excess supply may currently be around 4,000GWh which would mean it will be some time before new generation facilities are required. 6.7 Retail competition The retail market has become more competitive. In recent years the New Zealand electricity retail market has seen: a number of new entrants enter the market; customers become increasingly informed about their options; customers increasingly changing retailers and being able to do so with relative ease; and an increase in price and non-price competition amongst retailers. As a generator Meridian can always sell its excess generation into the wholesale market. However, an increasingly competitive retail market may put a strain on Meridian s retail margins (which may 25

26 already be below industry average) and limit the company s ability to meet its targets around the optimal amount of electricity pre-sold under fixed contract. The ability to find enough profitable retail customers in the medium term may be a particular concern if Tiwai closes and Meridian is left with a larger portion of its generation to sell into the wholesale market. 6.8 Transmission pricing change Transmission pricing, including for the HVDC Cook Strait link, is under review currently by the Electricity Authority and Meridian may be a beneficiary of future policy changes. However, any such changes are not expected to take effect until 2017 to 2018, if at all. We do not make any allowance for transmission pricing changes in our DCF valuation of Meridian. 6.9 Water rights Increasing demands for irrigation, together with environmental and cultural pressures, are placing increasing pressure on fresh-water allocations and there is a risk of material changes in Meridian s water access rights in the future. Our valuation assumes no change to current rights or the current regime in the foreseeable future Australian opportunities Meridian has made successful forays into the Australian market in the past, in particular with the successful purchase, upgrade and subsequent sale of Southern Hydro in the first half of last decade. More recently the company sold out of the JV with AGL for the 410 MW Macarthur Wind Farm in Western Victoria. The Australian government s policy of having over 40,000 GWh of renewable generation by 2020 offers significant growth potential for Meridian. There are also opportunities in the retail market and Powershop has recently launched its online brand in Victoria. Our valuation assigns no uplift from Meridian s Australian opportunities. 7 Conclusions The conclusions to this report are provided in the Executive summary. 26

27 Appendix 1: Key DCF modelling assumptions Key modelling assumptions We complete a 20-year cash flow forecast as Meridian is a company with particularly long-life assets. The data we have used for and financial years are aligned with Meridian s projections from its Prospectus. We project cash flows for twenty years on the basis of the following assumptions: real price growth and consumer electricity demand: We include four different price and demand path scenarios in our model 7 : o a base mixed renewables scenario; o a high demand scenario; o a low demand scenario (TDB s base case); and o a Tiwai closure/very low demand scenario. inflation: we forecast nominal cash flows and so include a CPI inflator in our model based on the Treasury s CPI forecast from the Budget Economic and Fiscal Update 2013 ; Meridian s place in the market: we assume Meridian retains its current market share and that demand and prices in its wholesale and retail markets follow similar paths. Both the real price paths and consumer electricity demand paths are estimates for the impact on the overall electricity market. We assume Meridian will be impacted to the same degree as the market. Even under the Tiwai closure scenario we believe Meridian will be able to sell its excess generation into the spot market and do not expect it to be impacted to a greater extent than the market overall; capital expenditure: the cost of completing current projects is accounted for in the 2013/14 and 2014/15 financial years. For around the next six to seven years after this we expect Meridian s excess capacity to cover any demand growth. We assume Meridian s capital expenditure is limited to maintenance capex required to keep its assets well maintained. From around , depending on the growth scenario modelled, we factor in a capital spend to build new assets to cover the increasing revenues we forecast. The same thinking is applied to the following ten-year period, ; base year revenue: our base year revenue ( ) is an average of the five year period: ; and terminal growth rate: we assume a terminal growth rate of 2.5% p.a. Cost of capital assumptions The key assumptions underlying our estimated cost of equity for Meridian are provided in Table 9 below. 7 Source: the Ministry of Business, Innovation and Employment s (MBIE) forecasts for real electricity price growth provided in its paper New Zealand s Energy Outlook: Electricity Insight,

28 Table 9: Estimated cost of equity Description Risk-free interest rate 4.7% Post-tax market risk premium 7.5% Equity beta 0.8 Asset beta 0.65 Investor tax rate 28% Post-tax nominal cost of equity 9.6% The bases for the above assumptions are: risk free interest rate: based on the average of the 10 year government bond rates for the last 20 trading days ending 30 September 2013; post-tax market risk premium: based on PwC s estimate from its March 2013 Appreciating Value: New Zealand publication; and asset beta: derived from an industry average of recently estimated equity betas. The key assumptions underlying our estimated cost of debt for Meridian are provided in Table 10 below. Table 10: Estimated cost of debt Description Risk-free interest rate 4.7% Borrowing margin 2.8% Pre-tax cost of debt 7.5% Investor tax rate 28% Post-tax nominal cost of debt 5.4% Pre-tax cost of debt: our assumed pre-tax cost of debt is the expected cost of debt reported by Meridian 8. Our assumed gearing (debt to debt plus equity) ratio of 22% for Meridian is based on our assessment of the company s underlying capital structure. The above assumptions lead us to a post-tax nominal WACC for Meridian of around 8.7% (refer Table 11 below). 8 Meridian Energy Offer Document (p. 143) the net cost of debt for the 2014 and 2015 financial years is expected to be 7.4% and 7.5%, respectively. 28

29 Table 11: Estimated cost of capital Component Post-tax Nominal Cost of Debt 5.4% Post-Tax Nominal Cost of Equity 9.6% Post- Tax Nominal WACC 8.7% 29

30 Appendix 2: Sensitivity analysis Sensitivity analysis The discussion below provides an indication of the sensitivity of the valuation to changes in the base case assumptions. Total revenue growth: the sensitivity of the valuation to future electricity price paths is provided in Table 7 in the main body of the report. WACC: Figure 14 below shows the variation in the DCF valuation to a +/- 0.5 percentage point change in the WACC under each price/demand path scenario. Figure 14: WACC sensitivity Given the capital intensive nature of Meridian s business combined with the very long lives of its core assets (where hydro dams can have lives of up to 100 years or more), the valuation is quite sensitive to changes in the WACC. Changing our WACC by 0.5 percentage points changes the valuation by about 20 cents per share or around half a billion dollars. EBITDAF margin: Our base EBITDAF margin is derived by averaging the actual margin for the previous three years and the projected margin for the upcoming two years in accordance with the Meridian Prospectus. Over the period this ratio has ranged from 14% to 32%. However, this range may be misleading as lower ratios tend to be associated with lower revenue years. That is, the fluctuations in EBITDAF are a little less pronounced than one might initially think. We present in 30

31 Figure 15 below the sensitivity of our valuation to varying our base EBITDAF margin of 23.6% by +/- 1 percentage point. Figure 15: EBITDAF margin sensitivity Our valuation is fairly sensitive to changes in the EBITDAF margin. A one percentage point change in the margin leads to $0.11 to $0.13 change in the valuation of the company. We consider the base estimate we have taken to be a reasonable input given the data available, but it is important to note that a small change in our assumption around this margin will have an impact on the valuation. Terminal growth rate: Projected terminal growth rates are typically in the range of 2 to 3%. We have used a base terminal growth rate of 2.5% and provide a +/- 0.5 percentage point sensitivity around this in Figure 16 below. 31

32 Figure 16: Terminal growth rate sensitivity In our base case low demand scenario changing the terminal growth rate from 2% to 3% results in a valuation range of $1.84 to $1.98. This variable is less sensitive to changes as we already project cash flows for 20 years into the future in our DCF model. 32

33 Appendix 3: Comparator companies New Zealand Contact Energy Ltd Contact is one of New Zealand s largest listed companies and a generator-retailer providing electricity, natural gas and LPG to around 560,000 customers. Contact was established in 1996 and was privatised and listed on the NZX in Contact is a hydro, geothermal and thermal generator of electricity. TrustPower TrustPower is New Zealand s fifth largest electricity generator and fifth largest electricity retailer. TrustPower owns 36 hydro generating stations and two wind farms providing enough electricity for around 220,000 New Zealand households and has been in operation since Mighty River Power Mighty River Power is a generator-retailer that supplies electricity to almost 20% of New Zealand households and businesses. Its North Island-based generation assets include hydro, geothermal and gas-fired power stations. Mighty River Power is a recently partially privatised and listed company; its shares began trading on the NZX in May

34 International Enel Green Power Enel Green Power, established in December 2008, is the Enel Group company that develops and manages energy generation from renewable sources at a global level, with a presence in Europe and the Americas. Enel Green Power is a major global operator in the field of energy generation from renewable sources, with an annual production of 25 TWh, mainly from water, the Sun, wind and the Earth s heat, meeting the energy consumption of over 8 million families. Enel Green Power has an installed capacity of 8,689 MW, produced by over 740 plants in 16 countries and with a generation mix that includes wind, solar, hydro, geothermal and biomass. Iberdrola Iberdrola is one of the biggest electricity providers in Europe and the fifth largest Spanish company by market capitalisation. The company is a world leader in wind energy generation and the company has a strong focus on renewable energy. Iberdrola has a significant presence in many countries including Spain, the UK, the US and Latin America. China Power New Energy Development Company Ltd China Power New Energy Development Company Ltd is a company listed on The Stock Exchange of Hong Kong Limited. The principal activities of China Power are the development, construction, owning, operating and management of clean energy power plants, including wind power generation, 34