Sandstone Insights: Origin Energy sees 15% valuation boost in Octopus Energy UK stake

This article was written by Sandstone Insights on 9 May, 2024.

Suggestion: buy

Need to know

• Octopus Energy UK's valuation has increased by 15% to £7.2 billion from £6.2 billion in December 2023.
• Origin Energy (ORG) owns 23% of Octopus, implying a read-through valuation of AU$3.1 billion, or 18% of ORG’s market cap.
• This uplift equates to approximately 8 cents per share for ORG's stake.
• Octopus Investor Day highlighted the significant opportunity to transform large-scale ERP systems of energy utility providers.
• Globally, SAP and Oracle each have more than 600 million utility customers, while Octopus Energy has just 54 million. Opportunities for US expansion are now more pronounced.
• Next catalysts include Origin Energy's Capital Management Day on 12 June 2024 and the imminent Eraring (NSW) deal with the NSW Government.

Investor Day highlights growth (and valuation) optionality

• Octopus Energy is a fast-growing UK-based enterprise resource planning (ERP) company. Now the UK's largest energy retailer, Octopus has global ambitions, with an addressable market more than ten times its current client base.
• We expect Octopus Energy investors to increasingly focus on this investment, which currently has an implied value of approximately 18% of ORG's market capitalisation. ORG has invested AU$1.2 billion so far. In our view, Octopus has the potential to become ORG's most valuable asset within the next five years.

Octopus and Origin: a successful integration

• Origin Energy (ORG) purchased a stake in Octopus Energy in 2018. The relationship was initially founded on integrating Octopus's ERP system, Kraken, into ORG's operations. Kraken has transformed ORG's cost-to-serve while enabling it to enter the new energy retailing market, which is increasingly in demand by customers. ORG estimates that Kraken saved AU$100 million in FY23 alone. ORG retail products, such as ORG 360 EV and ORG Loop Virtual Power Plant, utilise the Kraken software.
• Kraken is a new generation of cloud-native software that allows utilities to transform their ERP systems to operate in new energy markets, such as those involving solar energy, usage on demand, smart metering, EVs, heat pumps, and smart appliances. These markets have significantly different ERP requirements compared to traditional old-world ERP systems, which typically handle just a handful of data points per customer each year. Today, a single customer can generate thousands of actionable data points daily. Kraken's AI-based software optimises energy use, resulting in significant cost savings for most customers.

Competitive landscape and growth potential

• Incumbent players like SAP and Oracle have over 600 million customers globally in the utilities sector, whereas Kraken currently has just 54 million. We continue to believe that Octopus Energy will have a strong growth trajectory over the next five years. EBITDA breakeven is expected to occur by the second half of 2024 (2H24) according to consensus estimates, with ORG's share of FY25 earnings projected to be twice as high at AU$190 million.
• Most investors currently value Octopus Energy at its last stated valuation of approximately AU$3.1 billion. Although the investor day did not offer forward-looking comments, greater clarity on the pathway to reaching 100 million customers would likely prompt investors to consider an implied valuation of ORG's share in the range of AU$4-5 billion.

Investment view

Origin Energy is uniquely positioned to help accelerate Australia’s transition away from coal-fired power stations. The company’s portfolio includes assets in batteries, grid-scale renewables, and 3 GW of peaking power generation. These assets are poised to contribute significantly to earnings as Australia’s power grid decarbonises over the next two decades. Importantly, ORG has a portfolio of peaking power generators that can take advantage of both grid price volatility and evening peak power loads. ORG's low-cost gas and long-term supply contracts also provide the flexibility to increase market share in the coming years.

ORG’s LNG assets can provide strong, relatively low-risk cash flows over the coming years, helping to underpin both earnings and free cash flow generation.

ORG’s 23% investment in the fast-growing UK energy business startup, Octopus Energy, provides both significant valuation uplift and the technical knowledge transfer needed to manage modern renewable-powered energy grids.

In the near term, ORG’s earnings are relatively well-insulated from wholesale gas and power prices, thanks to hedging post-Brookfield interest. We see room for ORG to increase its dividend payout ratio, which we believe no longer reflects the maturity of its assets or the level of cash flow generation. A higher payout ratio could be a key driver to help close the valuation gap. Importantly, there is scope for sustainably higher dividends as ORG transitions away from its current carbon-intensive earnings.

Risks to investment view

As an integrated utility, Origin Energy is exposed to fluctuations in gas, electricity, and commodity prices, including coal and natural gas. The company operates in a highly regulated sector with significant political intervention.

ORG is in the process of repositioning its generation portfolio away from high carbon intensity. This transition is likely to require substantial capital investment and could pose challenges to earnings over time. Additionally, ORG has experienced mergers and acquisitions in the past, which come with inherent risks and complexities.

_{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}