Investors are on-edge during this confession season that has seen a number of companies issuing profit downgrades.
One that may be facing a profit downgrade is utility company AGL Energy Limited (ASX: AGL), according to UBS who downgraded the stock by two full notches to "sell" from "buy".
It's unusual to see such a big downgrade but the broker believes AGL's earnings could plunge by a quarter over the next four years.
The downgrade hasn't really hurt AGL's share price today with the stock dipping 0.2% to $22.12 in after lunch trade when the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index is down by a similar amount while its peer Origin Energy Ltd (ASX: ORG) copped a 1.9% beating to $7.72.
AGL's earnings hole
"We identify company, market and Government policy related headwinds that will erode EBITDA [earnings before interest, tax, depreciation and amortisation] by $0.5b in our view," said UBS.
"Despite growth opportunities adding back $150m, net EBITDA is expected to decline by $380m over FY19-23e ,which is likely to see EPS [earnings per share] contract by 6% p.a. to FY21e."
If UBS is right, AGL's share price outperformance will come to an end. The stock has surged 18% over the past six months, or nearly 5 percentage points ahead of the ASX 200.
The re-rating in the stock puts it at around a 10.6 times earnings before interest and tax (EBIT) multiple – inline with its historical average.
"However, we do not expect the future to look like the past and are bearish on AGL's earnings outlook relative to Origin and expect it to de-rate," added UBS.
"We note that despite the weakening fundamentals it is possible AGL's share price is supported by yield investors attracted to the 3.5% spread between FY20 dividend yield and 10-year bond rates."
Risk of dividend cuts through FY23
But investors shouldn't be seduced by the yield differential as AGL's earnings may not be as defensive as one might think (which means its dividend isn't as safe too). The main earnings risks comes from its base business where 90% of its FY19 generation output is dependent on coal-fired generation and fixed-price renewable energy supply.
UBS noted that AGL has little to no control over the price of power from these sources (it's a price taker), and that means when wholesale power prices are falling, so too is AGL's earnings outlook.
"AGL plans to replenish EBITDA erosion by utilising its strong balance sheet and access to >$900m p.a. of free cash flow to fund a large growth program. Our deep dive on the economics supporting AGL's identified growth projects found only modest EBITDA accretion and an emerging EBITDA shortfall," said the broker.
"We also expect prevailing market and policy settings to stifle AGL's ability to execute attractive new growth opportunities. If additional growth cannot be delivered, further cost-out will likely be required."
UBS is forecasting a 1 cent cut to AGL's dividend of $1.16 per share this financial year. AGL's dividend is expected to keep falling at least to FY23 where UBS is forecasting a dividend of just 93 cents a share.
As a result of this bearish outlook, the broker lowered price target on AGL to $21 from $22.70 per share.
