Across client accounts that have selected the “Income” Australian Equity option we have bought AGL Energy Limited (AGL), an integrated energy company which sells and distributes gas and electricity and retails and wholesales energy and fuel products to customers throughout Australia. This purchase has been funded from funds raised from the previous sale of Myer (MYR).

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

• A stable and recurring earnings base based on substantial base load generation capacity combined with strong long term demand for electricity allows for strong shareholder returns
• The vertical integration of the business across generation and distribution provides a natural hedge to electricity prices
• A strong focus on renewable generation assets means that AGL is highly leveraged to significant renewable price increases
• Management’s plan to expand its renewable portfolio carries the flex to reduce spend if others respond faster or technology changes, with seeding of the renewable fund an asset light way to develop renewable energy generation capacity. This enables surplus capital to be directed towards other growth projects. As Australia’s largest private owner, operator and developer of renewable generation assets, the company stands to benefit from renewable price increases due to unexpected policy changes
• AGL’s recent move away from gas exploration and development has meant capital expenditure can be redirected to other growth opportunities like renewable energy and digital projects aimed at improving the customer experience.

As with all investments it is not without risks which include being exposed to political uncertainty and regulatory interference. Also capital allocation decisions around the replacement of aging low cost, high emission plants and the competitive environment around attracting and retaining retail customers provide risks for AGL going forward.

The cash available was from the previously announced sale of Myer (MYR) where sales growth continues to weaken despite heavy investment in marketing and traffic-generation. While cost-outs will help ease the impact of revenue declines, unless the company can increase sales then the current dividend could be at risk and the valuation not as undemanding as it appears given the negative impact of fixed cost leverage.

If you have any queries, please contact your Elston adviser.