Over the Hedge

In the three weeks between releasing its FY18 financial result on 16 August and our latest review on 10 September, Origin Energy’s share price declined more than 20%, versus AGL Energy (AGL, Accumulate) falling 6% and the S&P/ASX 200 Index retreating 3% over the same period. The main outcome from the company’s result was materially lower FY19 guidance for the energy markets business, driven by a change in the accounting treatment of certain hedge contracts.

 

Ord Minnett recognises the recent share price derating has been driven mainly by a deterioration in confidence in the company’s financials, which followed the emergence of $160m in annual costs associated with electricity hedge premiums that had been excluded from underlying operating earnings. We concede this headwind may take time to work through, although we believe investors could be compensated in the long run given the company’s attractive valuation.

 

Origin is operating in an environment of rising wholesale spot and forward prices, and we see a risk that potential reliability issues during summer peak loads could drive policy change that would be detrimental to Origin. The removal of the emissions component of the National Energy Guarantee and the fact that a federal election will be held prior to May 2019 suggest policy uncertainty for the electricity retailers is a significant risk.

 

We see Origin’s valuation as compelling, however, and we believe current share price levels adequately compensate for the immediate risks, including the political environment. Accordingly, we have upgraded our recommendation to Accumulate from Hold, although we have trimmed our target price to $9.30 from $9.40 due to minor changes to our earnings forecasts.

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