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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST

CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit

Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware

that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report

as only a single factor in making their investment decision.

2 July 2019

Asia Pacific/Australia

Equity Research

Multi Utilities

Australian Utilities

SECTOR REVIEW

Research Analysts

Peter Wilson

61 2 8205 4107

[email protected]

Chloe Lim

61 2 8205 4739

[email protected]

Take the power back; Upgrade ORG/AGL

We upgrade the ratings for both AGL and Origin Energy. Our prior premise

was that forecast decreases in wholesale prices would be passed-through to

customers and earnings FY19-22F. However, wholesale electricity prices

remain high, and July retail repricing introduces doubt over the pass-through.

■ Upgrade AGL and Origin: both have underperformed the market,

peers, and key earnings input. Whilst we continue to see downside to

electricity prices from renewables and government intervention, a 12M rally

shows a subdued impact so far. AGL and Origin have underperformed this

key earnings input, underperformed oil (ORG), and underperformed the

ASX200 even as bond yields have pushed peer valuations higher.

■ July retail resets show repricing power retained under DMO,

introduces doubt on pass-through of price downside. The first reset

coinciding with the introduction of the DMO illustrates that retailers have

retained the freedom to reprice their back book, introducing doubt that

wholesale price falls will be passed through in full. For existing customers

on discounts, we estimate that AGL/ORG have retained A$30-55mn in

costs; in ORG's case, it has redirected these savings to other customers.

Further, best offers from the large retailers are now higher than in Apr/May,

indicating an easing of competition, although we expect this to be volatile.

■ Risks. A fall in wholesale electricity futures remains the largest risk, with

soft spot LNG prices and government intervention the contributing factors.

■ Upgrade Origin Energy (ORG.AX) to OUTPERFORM, target price

A$8.50/sh (from A$7.55/sh). Origin has underperformed AGL and E&P

peers; it has a superior earnings, FCF and dividend profile to AGL; and we

expect the FY19 results to be a positive catalyst, with a strong Energy

Markets EBITDA and an update on the ongoing dividend policy.

■ Upgrade AGL Energy (AGL.AX) to NEUTRAL, target price A$19.20/sh

(from A$18.30/sh). Upgrade based on relative underperformance, with

resilient electricity futures and July retail pricing resets diminishing

wholesale price downside.

2 July 2019

Australian Utilities 2

Summary: upgrade ratings

AGL and Origin have underperformed the market and peers

AGL and Origin have underperformed on both 12-month and YTD basis. Figure 1 shows

AGL's 12-month performance vs the ASX200, the MSCI Global Utilities Index and the

average of the New Zealand integrated utilities which we consider to be the most similar in

terms of market structure ('Gentailers'). Figure 2 shows Origin vs the ASX200, AGL, and

the average of the Australian large cap E&P peers.

Figure 1: AGL vs ASX200 vs Global peers (indexed)

Figure 2: ORG vs ASX200 vs local peers (indexed)

1.2%

1.4%

1.6%

1.8%

2.0%

2.2%

2.4%

2.6%

2.8%

3.0%

3.2%

3.4%

3.6%

100

110

120

130

140

Jun-18 Sep-18 Dec-18 Mar-19 Jun-19

ASX200 AGL MSCI utilities NZ peer avg 10yr Aus bond yield (RHS, inverted)

100

110

120

Jun-18 Sep-18 Dec-18 Mar-19 Jun-19

ASX200 Aus E&P Avg AGL ORG

Source: I/B/E/S, Credit Suisse estimates

AGL and Origin have underperformed their key inputs to earnings

The underperformance of AGL and Origin contrasts to the change in their most important

earnings inputs, in particular, versus the change in wholesale electricity futures. The

sensitivity of both to these inputs is shown in Figure 4.

Electricity futures have rallied consistently since the middle of 2018 due to persistently

high spot price outcomes which were caused by supply constraints for coal and hydro, a

tight gas market, and a slower-than-expected increase in output from new wind and solar.

Figure 3: AGL/ORG vs Electricity futures vs Brent

Figure 4: Key input sensitivities

100

110

120

130

Jun-18 Sep-18 Dec-18 Mar-19 Jun-19

ORG.AX AGL.AX Weighted Electricity Price Index Brent (US$/bbl)

FY22 EPS DCF Value FY22 EPS DCF Value

1% change to Electricity +/- 1.8% +/- 1.4% +/- 1.0% +/- 0.9%

1% change to Brent +/- 1.4% +/- 1.0%

AGL

ORG

Source: BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates

Source: I/B/E/S, the BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates

We remain of the view that the LT wholesale electricity price is lower than 12M

futures, but futures rally limits 1-2 year downside

We have not changed our view that the long-term wholesale electricity price will revert to

$60-80/MWh, from the current FY20 prevailing forward price of $90-110/MWh. The bottom

end of that range is possible under a scenario of policy induced oversupply (Talkin' bout

my generation: Big Brother), or a scenario of lower global benchmark coal prices (The

coal'd shoulder)

However, we must concede that the impact of wind and solar has to date been subdued,

with other factors coinciding to tighten the market further. This lends merit to the argument

2 July 2019

Australian Utilities 3

that the forward curve may continue to push out as it has YTD limiting downside to

modelled earnings. Realised prices will reflect a 2-3 year rolling average; we model a

reduction from ~$80/MWh in FY19/20 to $70/MWh by FY22, similar to the prevailing

forward curve.

Retained post-DMO repricing freedom introduces doubt on pass-

through of lower wholesale prices

Retailers retain freedom to reprice back-book, retain cost reduction in July resets

We are increasingly confident that the long-term impact of the new DMO/VDO regulations

that apply to retail prices will be less than feared. In particular, we see the watering down

of the final version of the rules as significant, as it limited the regulated reference price to

apply to only a small minority (~10%) of customers that were on standing offers. Because

of this, the reference price amounts to a comparison rate (as Origin has long lobbied for),

rather than a regulated price cap as originally intended; albeit with a significant transitional

impact (A$110mn for Origin) in FY20.

Historically, a significant source of profitability has been the freedom to reprice the back

book of customers, the so-called 'loyalty tax.' As discussed below, the decision by AGL

and Origin to keep prices flat on 1 July for existing customers on discounted market offers

despite a modest reduction in their costs shows that this repricing freedom remains; albeit

in Origin's case, it has used this freedom to reward long-term high value customers at the

expense of those customers on discounted market offers, inverting the loyalty tax.

Aside from retail margins, the implication is that this repricing behaviour introduces doubt

as to whether a fall in wholesale electricity and renewable certificate prices would be

passed on in full. Scrutiny on prices remains high, with the ACCC required to release a

report every six months on the impact of the DMO, ensuring that 'no customer is worse

off'. However, we contend that the heterogeneity of the retail customer base provides

some cover for retailers.

FY19 to be nadir for retail profits

We expect retail gross margins to bottom in FY20 due to the transitional impact of the

DMO/VDO, before recovering in subsequent years as AGL and Origin reassert control of

margins following two years of forced repricing.

EBITDA net of operating costs is expected to bottom a year earlier in FY19, with digitisation

and an abatement of churn and repricing activity expected to allow for AGL and Origin to

start to deliver on cost out targets. We expect cost reductions to translate to EBITDA, given

the incumbents have faced a disproportionate increase in activity in recent years.

Figure 5: AGL consumer EBITDA

Figure 6: ORG consumer EBITDA

-600

-400

-200

200

400

600

800

1,000

FY17 FY18 FY19F FY20F FY21F FY22F

A$mn

Consumer Opex

Consumer Gas GM

Consumer Electricity

Consumer EBITDA

-800

-600

-400

-200

200

400

600

800

1,000

1,200

1,400

FY18 FY19F FY20F FY21F FY22F

A$mn

Consumer Opex

Consumer Gas GM

Consumer Electricity

Consumer EBITDA

Source: Company data, Credit Suisse estimates

Source: Credit Suisse estimates

2 July 2019

Australian Utilities 4

Upgrade AGL/Origin, preference for Origin

Our preference for Origin over AGL is based on the following points.

■ ORG: FY19 results in August, expect strong result at top end of guidance,

positive dividend catalyst. we forecast Origin to report FY19 Energy Markets

EBITDA of A$1,595mn, at the top end of A$1,500-1,600mn guidance, driven by strong

Eraring generation output, and NPAT of A$1,131mn, 3.1% above consensus. Further,

the company has committed to providing detail on its ongoing dividend policy; we

forecast 40 cps in FY20, 16% above consensus forecasts.

■ ORG: Superior earnings profile, Energy Markets decrease offset by APLNG. To

be clear, our modelled FY19-22 decrease in utilities earnings is similar for AGL and

Origin. However, a roughly flat EBITDA profile and declining ITDA from Origin's LNG

segment substantially offsets the Energy Markets decline.

As such, we forecast a 3% cumulative earnings decline for Origin FY19-22, compared

to a 22% decline for AGL over the same period.

■ ORG: Higher exposure to retail, lower downside risk from wholesale electricity:

Proportionally, Origin's Energy Markets business is more exposed to retail—which we

expect to bottom in FY19 net of costs—and less exposed to wholesale prices which

remain above our estimated long-term equilibrium price. This can be seen in Figure 4,

with Origin's value sensitivity to a change in wholesale electricity prices approximately

35% lower than AGL's. Looking at it a difference way, Origin does not report retail

(consumer) gross margins separately, but we estimate that retail gas and electricity

contributes 20% of segment EBITDA net of costs, compared to 10% for AGL. In both

cases, this share has fallen 10% or more.

■ ORG: Strong FCF position with increasing dividend profile, dividend catalyst

expected at FY19 results in August. Strong free cash flow and the associated

deleveraging (est ~A$1bn per annum pre growth capex) has long been a key

investment driver for Origin. With forward debt levels now within Origin's target 2.0-2.5x

ND/EBITDA band, it has recommenced paying a dividend in FY19, and has committed

to providing guidance on its long-term approach to dividends at the FY19 results. We

expect a doubling of ordinary dividends in FY20, with a stated intention to return capital

in later years as gearing reduces further. We estimate that our modelled 40cps FY20

dividend can be covered by cash flows in a US$40/bbl scenario (i.e., assuming no

distributions from APLNG aside from MRCPS coupon payments).

− AGL: Flat ordinary dividends, with biennial on-market buybacks. For AGL, we

expect ordinary dividends to be flat, reflecting declining FCF. The volatility of FCF in

Figure 7 is a result of large working capital movements (mostly margin lodged

against hedges). While we expect AGL to remain conservative with its balance

sheet given its earnings profile, and the now declared intention post-Vocus to retain

optionality for M&A; in the absence of such M&A we estimate that AGL could

undertake on-market buybacks of ~A$600mn (5% of equity) once every two years.

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