Should Meridian call Rio’s bluff?

Rio Tinto has a caused a stir among electricity gentailers this week. What it might mean for Meridian going forward.

Tuesday, October 29th 2019, 7:00AM

by Pathfinder Asset Management

By: Hamesh Sharma

The big news in the New Zealand market recently involved the electricity gentailers. They were punished by investors after Rio Tinto, which controls the major stake in New Zealand Aluminium Smelters (NZAS), said it was reviewing the Tiwai Point smelter's future after rejecting Meridian's proposed pricing. This has impacted Meridian. The other gentailers such as Contact, Mercury, and Genesis have also seen their share price take a hit.

Tiwai Point accounts for about 13% of all New Zealand’s power usage. This makes it the single largest user of electricity in New Zealand. And so it is important in determining supply/demand in the sector. Tiwai purchases electricity, at a highly discounted rate, from Meridian's Manapouri Power Station.

Additionally, Tiwai is an important provider of jobs in the region, employing around 1,000 people. Given the political backlash from potential job losses and economic implications, the NZ Government made a $30 million payment to NZAS in 2013. This was during the last round of power supply negotiations in order to keep Tiwai open.

The Government has made its current stance clear. Energy and Resources Minister Megan Woods saying: "The New Zealand Government has had a clear position since 2013 under the Key/English Government. There will be no more financial assistance from taxpayers for Rio Tinto, which is already supported by Meridian for the power it uses. This hasn’t changed."

The major risk for the gentailers is that if Tiwai is closed, we could see a significant drop in power prices. This would hit revenue and earnings for gentailer stocks. Possibly reducing yields by about 30%. The uncertainty around the potential withdrawal of the smelter from the demand base also makes it difficult to commit to infrastructure planning and capital spend.

Negotiations between Meridian and NZAS will continue, and another update is expected by March 2020. The key question is whether the NZ generators would accept a discount in order to keep NZAS in the market; to avoid material disruption and sharply lower wholesale prices.

This has created a cloud of uncertainty over the gentailer stocks. Resulting in an overhang on their share prices given potentially negative outcomes. Our view is that Rio is being opportunistic, given the mining giant is in much better shape than a few years back. It has materially improved operating efficiencies and restructured its own business. Rio is placing pressure on Meridan to continue to provide cheaper than market rate power.

We own Meridan across our CareSaver KiwiSaver and Pathfinder funds as a core holding. With the ESG focus of our funds and Meridian’s 100% renewable energy focus; noting the political concerns, it may make sense for Meridian to call Rio’s closure threat bluff.

In a closure scenario the entire sector would bear significant short-term earnings and valuation pain as wholesale electricity prices fall. However, in the long-term Meridian could be better off as it could potentially achieve a higher blended electricity price – short-term pain for long-term gain.

A closure would also be detrimental to Meridian's gentailer competitors – such as Contact, Mercury and Genesis. Further, it is likely that the Government and end-users would prefer to achieve lower prices and greater renewables penetration. Outcomes which would likely arise in an exit scenario. In summary, we would expect Meridan shares to outperform competitor gentailers under such a scenario.

If previous history is any guide, Meridian will likely choose the “easier” life, and reduce the contract price with Rio. However, as we described above, a Tiwai exit could ironically be beneficial for Meridian over the medium term.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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