AGL is a core position for many PPM IMA portfolios. Underpinning the investment thesis for AGL has been a consistent and disciplined approach adopted by PPM Portfolio Managers which provides insights into how, in our view, investors should approach long-term investment.

AGL is a utility company, and for many years its core business was predominantly the distribution of gas and electricity to households and businesses in Australia. Although the company had exposure to “upstream assets” – gas deposits – these were peripheral to the utility business and did not distract the company from its “main game”.

Origin Energy, AGL’s chief competitor, provides a contrast in point. Origin also has a core utility business however it developed a more extensive upstream gas deposits opportunity in the form of coal seam gas. These deposits were valuable in their own right, however they proved to be the source of much pain for the company. Origin’s gas deposits were part of the Queensland coal seam gas boom and led eventually to construction of 3 LNG processing facilities, each by a different consortium. Needless to say, these developments and the associated significant capital requirements changed the character of Origin along with its risk profile. Instead of being a simple utility business, Origin was now heavily leveraged to energy prices and was now more akin to an oil and gas company with significant debt on the balance sheet.

Whilst Origin was distracted with the complexities of its LNG assets business, AGL remained focused on its core business. This had a particularly fortunate effect of providing it with financial flexibility to take advantage of two very attractive opportunities when they presented: the sale of Victoria’s Loy Yang A power generator in 2012 and the sale in NSW of Macquarie Generation.

Individually, these transactions were significant in their own right; taken together they were transformative and, in our view, a strong positive for the company. AGL had now moved into the position of the largest electricity generator in the country, as illustrated below.

AGL’s CEO, Michael Fraser implemented a successful strategy and in our opinion has probably not received the acclaim that he deserves. AGL now has a significant competitive advantage in the industry at a time when dynamics of the market were changing and when its key competitor was distracted.

WHAT ARE SOME OF THE CHANGED DYNAMICS?

There are two that stand out:

1. Rising fuel prices (gas/coal), leading to higher electricity prices
The two key fuel inputs for electricity generation in Australia are gas and coal. As the charts below indicate, both of these commodities have seen sharp increases in price over the past year. In the case of gas this has been the result of the start-up of the six LNG production trains at Gladstone which have soaked up all excess Qld gas supply; in the case of coal this has been a combination of strong prices off the back of global demand as well as depletion of lower cost reserves which had previously been accessed by utilities.
Needless to say, AGL has been the prime beneficiary of this dynamic through Loy Yang A, which uses brown coal, and MacGen which uses a sub-export grade coal, less susceptible to price pressures felt at the export grade level.

2. A more aggressive push by the states towards renewable energy.
This has been particularly the case for Victoria and SA which have renewable energy targets of 40% and 50% respectively by 2025. This is leading to the closure of base load fossil fuel generators in both these states, again putting upward pressure on electricity prices.
Given AGL’s position at the very lowest end of the cost curve with its main generation assets, these facilities are likely to be the longest lasting and in the enviable position where they can benefit from significantly higher electricity prices.
A well-executed corporate strategy and a strong position in relation to changing market dynamics, enable us to conclude that AGL will remain an attractive investment for our clients’ portfolios and provides an excellent example of our long term approach to investment.