Should I buy AGL Energy (ASX:AGL) as a hedge against inflation in FY25?

Should I buy AGL Energy (ASX:AGL)? That’s a question many investors would be forgiven for asking themselves when hearing that electricity prices have been skyrocketing since the world emerged from pandemic isolation. Consumers may cut back on energy usage, but they cannot avoid spending altogether. They may shop around for better deals, but in all seriousness good luck to them because they’re going to need it.

AGL gained 17% in CY23 and (overall) another 14% so far in CY24. It may not be the best performing stock in the ASX, but neither is it the worst. Notwithstanding, this company is still well off all time highs seen in the 2010s. So is there more room to run?

Spoiler Alert: You could say AGL Energy is a buy, but we think the idea of it being an inflation hedge has sailed. Perhaps, however, it could be a longer-term growth story as it reinvents itself as a renewable energy company. Either way, investors thinking AGL is as safe as gold or CSL (ASX:CSL) would have short memories.

 

Who is AGL Energy?

AGL is a generator and seller of electricity and gas to Australian households and businesses. In fact, it is the largest of its kind in Australia. Here’s a bit of history to use at (investor) trivia nights: It was the second company to list on the Sydney Stock Exchange, joining as the Australian Gas Light Company.

Now for some ESG trivia: It is Australia’s largest carbon emitter, accounting for 8% of Australia’s national carbon footprint.

 

From a circus to champagne?

2022 was a horrible year for AGL. Mike Cannon-Brooks and a consortium led by him tried to take over the company because he had different ideas as to how AGL could shake off its identity as a major carbon emitter. The board conceived plans to split its coal business into a separate entity named Accel Energy. Before it could put the plans to shareholders for a vote, shareholder pressure led to the company not even putting the question to them. The scuttling of the plans led to four board members resigning and the company to undertake a strategic review of its operations.

Even after all this was over, scars remained. The company will have major capex requirements over the next decade to achieve Net Zero by FY35. It would require up to $20bn in place before 2036 funded from assets on its balance sheet, offtakes and via partnerships. Sometimes investors can overlook boardroom dramas if the company is delivering for shareholders, but AGL was not. It made a 1HY23 loss of over A$1bn, hindered by extended outages at its ageing Loy Yang A and Hunter Valley power plants.

 

Is the future rosier?

Since Easter 2023, companies left right and centre began admitting to shareholders customers are cutting back spending and their share prices are dropping like flies. Investors are desperate for safe havens – companies that will not experience declining demand or declining margins, preferably being able to do so while just servicing their customers as usual.

Sorry big banks, but investors don’t like the fact that you had to offer significant cashback offers and discounted interest rates to stop mortgagees breaking up with you and refinancing with a larger bank.

But AGL Energy was an exemption, delivering a trading update in May that got investors excited, followed by its FY23 results. It made a $1.26bn statutory loss due, $680m of which was impairments, but it made $1.36bn in EBITDA (up 12%) and an underlying profit of $281m (up 25%). It told investors to expect $1.875-$2.175bn in EBITDA and a $580-780m profit.

In FY24, the company delivered what it promised on the bottom line with a $711m statutory profit including $156m of negative non-cash items, and a $812m underlying profit. The latter figure was nearly triple FY23. EBITDA was $2.2bn, up 63%. However, the company’s revenue was down 4% to $13.6bn.

So maybe is the company an inflation hedge? In our view, that ship has sailed, after its FY25 guidance.

 

FY25 is expected to be worse than FY24

AGL has told investors to expect $1.9bn-$2.2bn in EBITDA and a $530-730m underlying profit. Why the decrease? The company noted 4 factors

• Lower wholesale electricity prices through contract positions and the roll-off of increased volatility from market interventions in mid-2022
• Consumer margin compression following a period of heightened market activity and lower wholesale prices
• Broadly flat operating costs, with productivity and business optimisation benefits broadly offsetting the ongoing funding of strategic growth initiatives as well as inflationary impacts
• Increased depreciation and amortisation due to continued investment in the variability and flexibility of AGL assets.

So we think it may not necessarily be an inflation hedge. More broadly, as inflation moderates, investors are turning to growth stories once more. Consensus estimates forecast stagnant revenue and EBITDA for the next several years. Revenue is not expected to surpass $14bn until FY31, and EBITDA is expected to be flat.

 

AGL may be a growth company instead, but it is in a perculiar position

One thing many investors may’ve missed amidst the results is that AGL announced it was buying Firm Power and Terrain Solar for $250m all up. Firm Power is a builder of Battery Energy Storage Systems while Terrain Solar is a solar project developer. This news comes 2 months after AGL was buying Kaluza, a technology platform that manages electricity supply and billing.

What’s the big deal about this? Clearly AGL is trying to build its envisioned future of cleaner energy, but in ‘little licks’ rather than ‘big licks’. To put it into other words, buying smaller companies rather than making major acquisitions (i.e. over $1bn) or trying to build its own assets to replace its ageing coal fired power plants. The goal remains for it to be Net Zero by FY35 and if it can get there through smaller acquisitions that can be funded through its balance sheet assets, without a need for debt or equity finance – good on the company.

 

It may still be undervalued

As we noted above, shares gained 17% in CY23 and another 14% so far in CY24.

 

Despite the share price growth, AGL is still well behind its all time highs. And it is trading at just 5x EV/EBITDA and 11.4x P/E. But consensus estimates only call for a mean price of $11.49 – so they evidently think the company is ‘fairly’ valued.

On a DCF basis, we think it AGL is $15.51, on a DCF basis using consensus estimates and a WACC of 8.79%.

 

 

So, should I buy AGL shares?

Shorter-term investors looking for an inflation hedge shouldn’t, but growth investors may want to. Nonetheless, we remain uncertain as to the company’s transition from being the largest polluter to another Net Zero firm can be done without the company making more substantial investments into building new renewable energy assets or acquiring some of its own.

Investors who buy in need to watch closely, and have an exit strategy planned. And as we always say, no stock portfolio should be in just one company or sector. A portfolio must be well balanced between different sectors, companies and even different assets, to give investors the best possible chance of netting returns.

 

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