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Why the AGL Energy Ltd (ASX:AGL) share price is falling today

The share price of AGL Energy Ltd (ASX: AGL) has tumbled to its weakest level in more than a month and could soon retest its 2016 low after the stock was downgraded by Credit Suisse.

The stock crashed 4.1% to $20.89 in morning trade when the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) is rallying 0.7% on the back of strong offshore leads.

The timing of the downgrade could make AGL one of the top tax-loss selling candidate in the last month of the financial year. This means you should expect further weakness in the stock and bargain hunters may want to hold off buying AGL for a month or two.

Credit Suisse has taken a more pessimistic view on the stock as it lowered its recommendation on AGL to “neutral” from “outperform” as it is starting to doubt that the energy utility can pass on higher costs to its customers.

The broker noted that large industrial customers, such as CSR Limited’s (ASX: CSR) Tomago aluminium smelter and packaging company Orora Ltd (ASX: ORA), are increasingly offered and are accepting contracts at below market prices in exchange for committing to larger volumes and longer contracts.

There’s also rising pressure from the government to cap any price increase with AGL already rubbing the Turnbull government the wrong way when it rejected an offer for its Liddell power plant.

AGL is particularly sensitive to electricity prices with Credit Suisse’s discounted cash-flow (DCF) valuation on the stock in a near perfect correlation with forward electricity prices on a percentage basis. This means a 1% drop in electricity prices to the end user will result in around a 1% decrease in the value of AGL.

However, AGL’s share price has been outperforming the volume-weighted index of regional electricity prices by around 15% to 20%!

But don’t get too pessimistic on the stock even though I believe AGL will underperform in the near-term. The fact is, the stock still represents value over the medium term as even Credit Suisse acknowledges that the company will be generating a load of cash from next financial year onwards due to a large expected drop in its total expenditure.

Even with no earnings growth, AGL will produce $700 million in free cash every year from FY19 onwards, according to the broker.

It’s also worth noting that Credit Suisse’s reduced price target on AGL of $23.25 per share (down from $26) is still comfortably ahead of the utility’s current share price and the stock is sitting on a 5% plus yield.

AGL has underperformed its peer Origin Energy Ltd (ASX: ORG), which is up 22% over the past year when AGL is 19% in the red, and the top 200 stock index, which is 5% ahead.

This dog may yet get its day in FY19.

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Motley Fool contributor Brendon Lau owns shares of AGL Energy Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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