Is Meridian too big to swallow?

17:00, May 24 2013

The float of Mighty River Power unleashed frenzy in the market this year, as investors, advisors, spin doctors and the media endlessly debated the merits of participating in the biggest state owned asset sale in years.

Some of that hubbub has started to die down with partial float completed, with 113,000 retail investors now owning a little slice of the North Island electricity firm.

Yet in spite all the debate over MRP, the one question that doesn't seem to have been asked is whether retail investors should have sunk their cash into MRP when Meridian was waiting in the wings.

The Wellington-headquartered company is widely regarded as the pick of the litter according to fund managers which sees a 100 per cent renewable energy firm as an extremely attractive asset.

Meridian has the second highest electricity revenues in the sector, at $1.18 billion for the six months ending December 31, trumped only by Contact Energy's $1.2b.

But with the majority of the firm's power produced from low cost hydro dams (88 per cent) and the remainder from wind , the firm has the highest operating earnings in the sector.

Meridian's operating profit, earnings before interest, tax, depreciation, amortisation and fair value adjustment were $278 million in the December half year.

That's flowed through to the bottom line with an interim net profit of $173m, beating Contact's $88m, Mighty River Power's $75m, and Genesis's $70m.

Philip Anderson, an energy sector analyst at Devon Funds, says the core of the firm's profitability stems from its South Island hydro assets, at Lake Manapouri and on the Waitaki river system.

"(The dams) are really gold plated," he said. "They were built by the Ministry of Works back in the day when everything was over-engineered. The flipside is they don't cost a lot to maintain and they've got a really long asset life."

The concentration does expose the firm to South Island droughts, with the start of last year being one of the driest on record, but Anderson said professional investors are prepared to take on this kind of volatility.

The firm is not without its investment risks, but even so, the investment community believes Meridian is better placed that most of the others in the sector to ride them out.

The Tiwai Point aluminium smelter is an example.

Meridian signed a contract to sell most of its power from the Manapouri power station to the Rio Tinto-controlled aluminium firm in 2007, which came into force this year.

That contract sent shivers through the electricity industry earlier this year after the two parties failed to agree on a request by the smelter to re-negotiate the deal, even before it actually came into force.

Rio Tinto has said it may have to shut the smelter unless it can lock in even lower electricity rates to make up for declining aluminium prices.

If the plant does close, it would release a massive amount of electricity onto the market.

The smelter uses about 13 per cent of New Zealand's total power supply, and if that was freed up it would lower wholesale prices for everyone.

William Curtayne, a senior analyst at Milford Asset Management, however sees the risk of a smelter closing as low due the $200 million in costs Rio Tinto would have to pay to rehabilitate the Tiwai Point site.

He and many other professional investors, are betting Rio Tinto will delay any closure for as long as possible to avoid these costs, hoping aluminium prices will pick up.

Curtayne said even if the worse eventuates, the contract contains a two and a half year notice period, in which the smelter must keep paying for power. That would give enough time for national grid operator Transpower to upgrade the lines between Manapouri and HVDC network which connects the South Island to the North Island. That would free up the power from Manapouri to be sold to other parts of the country.

And while that would lower power prices for other generators, who are likely to mothball older thermal plants to balance supply, Meridian is likely to reap a higher price.

Meridian chief executive Mark Binns has already admitted that Rio Tinto pays well below wholesale market rates for its power.

The other risk hanging over the firm is a promise by the opposition Labour and Green parties to restructure the electricity market under a single buyer model in a bid to bring down household power prices.

The plan proposes to do this by paying a different rate for power, based on how it was generated. It would be a cost-plus-profit margin model, rather than whoelesale market prices being effectively set by the cost of the most expensive generation needed to keep the market fully supplied. As demand rises, more expensive generators such as gas-fired stations are brought into the mix, giving a big lift to returns for hydro stations.

So changing that under the Labour/ Greens model would severely dent revenues from hydro dams, which have the lowest operating costs and hence the highest generation margins at the moment.

But even that risk is being taken with a pinch of salt.

"They've (Labour/ Greens) got to get into power first and it will take the best part of a term to get (the design) right," said Craig Stent, an analyst at Harbour Asset Management. "It does create uncertainty for these companies, but you can put in a risk adjustment for that."

Investment bank UBS, in a brokerage report, puts the odds of the NZ Power proposal coming to pass in its current form at about 22 per cent.

But what the investment community is battling to quantify is just how the Government plans to get mum-and-dad investors interested in Meridian, presuming it wants to maintain the same 85 to 15 per cent split of local-to-international investors.

The first impediment is Meridian's size.

Using similar price to earnings multiples as Mighty River Power, its estimated that Meridian is worth $5.25 billion, meaning investors would be on the hook for $2.6b of that - a significantly bigger chunk of change than the $1.7b paid for MRP.

Even in MRP's case, mum-and-dad participation wasn't great, according to a report that was released yesterday, claiming rich investors were the main beneficiaries.

The breakdown of the pre-registration figures showed a group representing 11 per cent of shareholders acquired about half of the retail offer, with an average investment of $34,618.

The Government could try fix this by offering a more attractive loyalty offer than the $10 million in shares that was set aside for the MRP float, which one broker described as a "nice-to-have", but it's still no guarantee the average person in the street will participate in the float.

The Government could sell shares to retail investors in two tranches, or even offer instalment receipts where mum-and-dads could pay for their shares in intervals, but analysts say that adds cost and creates a liquidity overhang, which could deter some institutional investors.

At the same time, the performance of MRP shares should cast a shadow over Meridian's float.

MRP debuted at $2.73 two weeks ago, but quickly dropped to the pre-IPO listing price of $2.50 where they have been pinging around ever since.

"It's about what (Government) has to give up to entice investors," said Milford's Curtayne. "At best MRP jumps up and people get excited and pile in."

At this stage it's unclear what the Government and its yet-to-be-named advisors will do, but what is certain is that they'll have to factor in the risk of investor fatigue, and the political fall out if mums-and-dads choose to keep their cash in the bank.