Shares in Meridian Energy have a "fair value" of $1.75, but regulatory uncertainty from a future Labour government is a key concern, according to a research report.
The report, by Morningstar senior equities analyst Nachi Moghe, recommends investors subscribe to the Government's share offer for Meridian, with the retail offer capped at $1.60 a share for small investors, which was a "modest discount" to fair value.
"We generally prefer to buy stocks at a larger discount to fair value and in Meridian's case this would be around $1.50," he said.
But in the context of a stretched sharemarket, the capped price looked reasonable value, so he recommended the offer.
Morningstar's estimate of Meridian's fair value is near the top end of the share offer's indicative range of $1.50 to $1.80 a share.
However, the report said the "near to medium-term outlook for the electricity sector is not promising". There was an excess supply of power generation as new stations came on stream.
At the same time, demand had barely changed since 2008 because of a weak economy and more efficient use of power by business and households. The shutdown of pulp and paper factories had also hurt the industry.
With forecast average demand growth of just 1.5 per cent in coming years it would take "at least" two to three years for supply and demand to balance.
Competition for retail customers was also likely to continue.
Excess supply would keep a lid on both wholesale and retail prices for the next few years.
While the chance of a future Labour government regulating power prices through a single-buyer model was "remote" in the next five years, if it happened it could cut Meridian's operating income by $170 million.
"We believe the Opposition proposal is fairly extreme but it would significantly reduce our fair value estimate, if implemented," Moghe said.
On the other hand, Meridian was expected to generate strong free cashflow from 2015 onwards, after a dramatic fall in capital spending. That would lead the Meridian board to lift the dividend payout from 80 per cent to 100 per cent of free cashflow, Moghe said.
As a result, dividends were expected to rise by 11 per cent a year on average over the next five years, the Morningstar report said.
In dry conditions, Meridian would produce less power of its own and have to buy more power on the wholesale market when prices were high, squeezing its profit margins.
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