Across client accounts that have selected the “Blend” Australian Equity option we have bought Origin Energy (ORG), a vertically integrated energy company with operations including oil & gas exploration and production, power generation and retailing. This purchase has been funded from a combination of cash from dividends received, the partial sale of Myer (MYR) and a de-weighting of Woodside Petroleum (WPL).

We are positive on the medium-term outlook for Origin for the following reasons:

• the proposed NewCo IPO, if it proceeds, will help simplify the business, de-gear the balance sheet and reduce earnings volatility
• production ramp-up at Australia Pacific LNG (APLNG) will drive a substantial increase in free cash flow to enable debt reduction
• completion of APLNG may also present an opportunity to refinance debt and slow the amortisation schedule
• portfolio flexibility allows the company to arbitrage price differentials between domestic gas and export LNG markets
• retail energy margins will improve as customer electricity contracts are priced higher
• scale and vertical integration allow it to acquire renewable energy certificates (REC’s) at substantially lower prices than tier 2 & 3 retailers
• a relatively low risk carbon position leaves it less susceptible to unfavourable government policy changes

As with all investments it is not without risks which include being exposed to declining retail energy demand and large spikes in wholesale electricity prices during periods of unexpectedly high demand as it generates less electricity than it sells. With its interest in APLNG there is the risk to dividends and debt reduction if oil prices remain low for an extended period.

While Myer has been earmarked for sale, this has only been partially executed pending further clarification around recent market speculation on potential corporate activity. The recent 1H17 result from Myer showed solid execution by management on things it can control such as the rationalisation of underperforming stores, expansion of the omnichannel offering, improved inventory management and strong cost control. We remain of the view that further success will be achieved with the ‘New Myer’ strategy and that cost outs will continue to support margins. Unfortunately, industry conditions remain very challenging from a combination of competition and price-sensitive consumers whose spending is constrained by weak wages growth, and who according to the most recent data releases are increasingly fretting about family finances. So, with sustained sales growth taking longer than originally anticipated to materialise, we have decided to sell the holding.