Your Quarterly E-Zine
Edition 11 • December 2019

This website contains the latest edition of Forsyth Barr Focus, a quarterly on-line magazine written by senior members of Forsyth Barr's investment team.

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Sweet smelt of success?

We see the electricity sector offering good value to investors, with the Tiwai Point Aluminium Smelter closure risk more than priced in to stock prices. All of the electricity stocks have de-rated following the announcement that Rio Tinto is undertaking a strategic review of the Tiwai Point aluminium smelter. In our view the market has overplayed the risk of closure.

For a variety of reasons, we believe that the smelter will stay open and that the risk of closure is less than 10%. In addition, if the smelter were to close, the impact on the electricity sector will be temporary. We expect the electricity market to readjust, with thermal generation plant closure and transmission grid upgrades bringing the electricity market back into balance within three years.

The long-term positive investment thesis for the sector remains intact. New Zealand’s need to reduce carbon emissions will likely result in a steady increase in electricity demand for the foreseeable future as more cars become electric and as industrial heat processes switch from coal and gas to electricity. That in turn should underpin sector earnings and the cash dividends that the sector pays.

In late October 2019 New Zealand Aluminium Smelter (NZAS) major shareholder Rio Tinto announced it intended to initiate a strategic review of the Tiwai Point Aluminium Smelter. The review will consider all options for the future of the smelter, including the option of closure. NZAS cited relatively high energy and transmission costs, difficult trading conditions, and upcoming capital expenditure to keep one of the pot-lines open. This is despite NZAS reportedly spending tens of millions of dollars in capex and opex and signing a new electricity contract for a further 50MW of electricity to re-open the fourth pot-line one year ago.

Rio, or its predecessor - Comalco - has a history of reopening supposedly water-tight contracts dating back as far as the 1960s when Comalco backed out of building the Manapouri power station. The New Zealand Government stepped in to build what is widely regarded as one of New Zealand’s great engineering feats. A 700MW (subsequently increased to 850MW but resource consent limited to 800MW) underground power station was constructed, with the power station machine hall excavated from solid granite rock 200 metres below the level of Lake Manapouri. 

A long-term electricity contract was negotiated between the Government and NZAS. After decades of cheap electricity NZAS had signed up to an electricity price closer to the market price in 2007/2008 that would come into force from April 2013 and was due to expire in 2030. In 2012 NZAS attempted to renegotiate the contract, successfully achieving a lower than market price and a one-off government payment of $30m in 2013. In 2015 Meridian Energy (along with Contact Energy) renegotiated the price closer towards market for 172MW of the 572MW contract. The most recent 50MW for pot-line four (previously closed in 2012) was negotiated in 2018, taking total contracted volumes to 622MW.  The 622MW is effectively split into three contracts with Meridian Energy, who then offset this commitment somewhat through Tiwai support contracts with Contact Energy, Genesis Energy, and Mercury. All contracts have a one-year notice period.

NZAS consumes 13% of New Zealand’s electricity, with Manapouri (which generates 100% renewable energy) in theory supplying almost all of that electricity.

After a number of years of uncertainty, with new contracts in place and the fourth pot-line reopened, investors had become comfortable the smelter was going to remain open in the medium-term. The October 2019 announcement smashed this complacency to smithereens; investors wiped $2.75b off the big five gentailer (generator/retailers) market capitalisation on the day of the announcement, and a further $3b (to make a 17% fall cumulatively) off the 22nd October combined market capitalisation in the month following (albeit some of this may be attributable to concerns around increasing interest rates and some stock specific movements around possible inclusion/exclusion in the Morgan Stanley Capital International world index). From the sector peak in mid-September 2019, to the trough near the end of November 2019, the sector de-rated 20%.

In the murky world of calculating smelter profitability, Forsyth Barr estimate that NZAS is still cash flow positive. We estimate current cash profitability (pre-interest and tax, post maintenance capex) is currently ~$300/tonne, implying cash EBIT of more than $100m per annum. Furthermore we estimate closure and remediation costs of ~$330m (with upside risk), which logically an owner would seek to avoid if it is in a cash flow positive position.

According to many commentators, NZAS is seeking savings of around $50m per annum to remain open. To put things in perspective, $50m is 2% of FY22 sector EBITDA. A large portion of the required savings could (and probably should) come from transmission pricing reform. In a review that has taken far too long, the smelter benefits from reform of the transmission fee calculation has seen their expected $50m annual benefit whittled away to a $10m annual benefit. We have some sympathy for NZAS’s position in that it is paying for North Island grid upgrades that it gets no benefit from. We expect Meridian Energy and Contact Energy to wear some pain from a renegotiated contract, albeit the decision to accelerate the Clutha to Upper Waitaki Lines Project (partly funded by Meridian Energy and Contact Energy) reduces one bargaining chip that NZAS holds in the form of stranded generation on exit.

The upgrade also spreads the risk of stranded South Island generation across the remaining (predominantly North Island generation) gentailers (Mercury, Genesis Energy, and Trustpower). NZAS does sit (just) in the most expensive quartile for cash costs of smelters globally, however this does reflect the high purity aluminium produced and the (in theory) 100% renewable electricity that fuels the smelter (Rio has in recent years been talking up its RenewAl branded aluminium – aluminium made from low emission electricity). Whilst Minister Megan Woods initially indicated there will be no offers to NZAS, she and NZ First leader Winston Peters appear to be more conciliatory in recent times. The regional growth fund is the obvious source of funds to help bridge any gap. After initially easing ~7%, longer dated wholesale electricity prices have stabilised, and in fact increased a touch in recent weeks suggesting to us that the electricity market does not believe NZAS will close. 

NZAS aim to complete the review by the end of the first quarter in 2020, meaning the earliest the smelter could close (or reduce supply) will be approximately March 2021. In our view there is less than a 10% chance of smelter closure (albeit a sale by Rio has a higher probability).

Forsyth Barr forecast a weighted average 12 month total return of ~1%, and EPS growth of 1.2% p.a. (compound annual growth rate FY19 to FY22). Note FY19 was a year when most gentailers benefited very materially from low hydrology in the North Island, gas constraints, and consequently high wholesale electricity prices. To put this in perspective, EPS compound annual growth rate from FY18 to FY22 is forecast to be 4.3% p.a. 

The sector is fully valued versus DCF-based valuations, however in a low interest rate world, a sector (excluding Tilt Renewables who currently do not pay a dividend) cash dividend yield of 4.5% continues to screen attractively versus alternative income investments such as term deposit rates (which of course do not carry the imputation credit benefits the sector also enjoys) as set out in Graph 1 below. 

Simple average cash yield of the Utilities sector (by GICS code) versus the six month term deposit rate 

Source: Forsyth Barr analysis, Bloomberg, RBNZ

After a ten year period of little or no electricity demand growth, New Zealand’s need to reduce carbon emissions will likely result in a steady increase in electricity demand for the foreseeable future as more cars become electric and as industrial heat processes switch from coal and gas to electricity. That in turn should underpin sector earnings and the cash dividends that the sector pays.

 

Jason Lindsay
Co-Head of Funds Management

For a printable PDF of this article click here

Disclaimer: Forsyth Barr Investment Funds and Summer KiwiSaver Funds hold shares in Contact Energy, Genesis Energy, Mercury, Meridian Energy, and Tilt Renewables.

Jason Lindsay recently joined Forsyth Barr as Co-Head of Funds Management from the ACC when he managed the Australasian infrastructure portfolio. He has over 15 years of experience spanning New Zealand’s equity research and fund management industries. Jason holds a BCA from Victoria University of Wellington and is a member of Chartered Accountants Australia and New Zealand (CAANZ) and an Authorised Financial Adviser (AFA). Jason is responsible for the management of the New Zealand Equities, Australian Equities, and Listed Property funds. Check out the Summer KiwiSaver scheme at www.summer.co.nz, proudly managed by Forsyth Barr Investment Management Limited.

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