Contact Energy Ltd (NZX & ASX: CEN) remains attractively priced and is offering good value for investors, according to Morningstar senior equities analyst Adrian Atkins.
Writing in a research note, Atkins said Contact's financial leverage had markedly improved, dividends were growing at a rapid pace, the wholesale electricity price was going higher and the Tiwai Point aluminium smelter was enjoying favourable conditions.
“And yet, Contact's share price continues to trade at a sizeable discount to our fair value estimate because the market remains too focused on near-term earnings headwinds.”
Contact held market share of more than 20% of New Zealand electricity and retailing, he said.
Its narrow competitive advantage stemmed from efficient scale in generation, given high upfront construction costs and relatively inelastic demand, and its low-cost hydro and geothermal power stations.
A wholesale electricity price of about $80 per megawatt hour (MWh) was needed to justify building new generation. At that price, Contact would make good returns from its renewable assets, Atkins said.
Morningstar's 2017 report highlighted Contact could afford to pay much higher dividends. Management did not disappoint, announcing a new dividend payout policy of 80% to 90% of operating free cash flow from 2019, up from an adjusted payout ratio of 75% in 2017.
The 2018 financial year would be a transition year. Guidance for dividends had increased 23% to 32 cents per share, representing a payout towards the top end of the target range, he said.
Further growth in dividends was likely over the medium-term as earnings improved, though at a more modest rate broadly in line with inflation.
Morningstar's long-term dividend assumptions were based on a 90% payout of operating free cash flow, at the top of the target range, Atkins said.
Forsyth Barr broker Damian Foster viewed Contact as the cheapest of the electricity stocks as it was trading on the lowest multiples and had the best cash yields. Forsyth Barr had upgraded its rating to outperform from neutral.
“The return to normal hydrology has been the main feature of the third quarter. Contact's hydro storage levels are now near normal and March 2018 hydro generation was 68GWh higher than the previous period corresponding period and 19% above average.
“April generation was tracking ahead of average and Contact's hydro storage was steady at 90% of average - with more rain forecast for coming days.”
Forsyth Barr had increased its target price 10 cps to $5.60 following a modest upgrade to the 2018 financial year forecast.
Morningstar had fair value price of $6.20 per share.
*Dene Mackenzie is business editor of the Otago Daily Times.