Summary AGL Energy’s net income and free cash flow look uninspiring, but one needs to dig deeper to find the true story. The net income was negatively impacted by an impairment charge whilst almost half of the capex consists of growth capex. Using the sustaining capex and taking AGL’s cost reduction plans into consideration, the company is trading at a 2018 FCF yield of 8-9% and that’s quite appealing. Introduction Very few people might know AGL Energy ( OTCPK:AGLNY ) ( OTCPK:AGLNF ), but this $7.5B market cap company is one of the largest electricity and gas providers in Australia. It trades in energy, but also creates its own power through its renewable and non-renewable power plants. Surprisingly, there’s a decent volume in shares of AGL Energy on the company’s OTC listing, but I would obviously strongly recommend you to trade in the company’s shares through the facilities of the Australian Stock Exchange. As you can imagine, the ASX offers much more liquidity as the average daily dollar volume in AGL Energy is $25M. The ticker symbol is AGL . 2015 was a tad better than expected… I was really looking forward to see the final results of AGL Energy’s financial-year 2015 (which ended in June of this year). We already knew that year wouldn’t be a good year when discussing the net profit, as the company had to record an A$600M ($420M) impairment on some of its (upstream gas) assets. This impairment charge was due to delays in starting up the gas production as well as a lower expected gas price. This obviously meant the book value of those assets might have been overly optimistic, so an impairment charge was the right decision. (click to enlarge) Source: Annual report And indeed, even though the revenue increased by 2% to A$10.7B ($7.5B), the EBITDA fell by a stunning 40% to A$946M. As there’s of course still the usual depreciation expenses and interest expenses, the net profit fell by almost 62% to just A$218M ($145M). Ouch! (click to enlarge) Source: Annual report Even the cash flow statements were a bit uninspiring. The operating cash flow was A$1.04B, and after deducting capital expenditures to the tune of A$744M, the net free cash flow was approximately A$300M ($210M). All this sounds pretty boring and uninspiring, but I prefer to look to the future instead of at the past. But the 2016-2018 period will contain some very nice surprises From this year on, there will be numerous improvements. First of all, the net income will sharply increase again as I’m not expecting to see much more impairment charges. That’s very nice to keep the mainstream investors happy, but my readers already know I care more about cash flow statements than about net income, so I dug a bit deeper, and I’m extremely pleased with what I discovered. Of the A$744M in capital expenditures in FY 2015, only A$395M ($275M) of that amount was classified as “sustaining capex” . As it’s essential for cash flow statements to find out what the normalized free cash flow is, one should only use the sustaining capital expenditures and exclude the growth capex. So if I’d to deduct the A$395M from the A$1,044M in FY 2015, the adjusted free cash flow increases to almost A$650M ($455M). But there’s more. AGL Energy remains on track to complete the objectives it has outlined to reduce costs by FY 2017. AGL’s plan consists of cutting operating costs in, for instance, IT and supply contracts whilst on top of that, the sustaining capital expenditures will decrease from A$395M in 2015 to A$315M in FY 2017. This would increase the adjusted free cash flow by approximately A$200M per year to A$850M ($600M). And keep in mind this doesn’t take the organic growth into consideration, as I’m expecting the company should be able to increase its revenue and operating revenue (whilst reducing the operating costs and sustaining capex). Source: Company presentation And this really puts AGL in an enviable position. The net debt/EBITDA ratio as of at the end of its financial-year 2015 was acceptable at 2.4, but this should start to drop extremely fast as the EBITDA will increase whilst the net debt will be reduced. In fact, even after paying a handsome 4% dividend yield. According to my calculations, in FY 2018, AGL Energy should have a net adjusted free cash flow after paying dividends of approximately A$400M, and this will probably be used to reduce the net debt (which will have a snowball effect as it will reduce the company’s interest expenses, increasing the net operating cash flow). It will also be interesting to see how AGL intends to spend the US$850M in cash flow it expects to generate through asset sales. Investment thesis So yes, AGL Energy’s 4% dividend yield is safe and will very likely be increased in the future. Don’t let the low net income fool you, the cash flow statements are explaining this story much better and the adjusted free cash flow is definitely sufficient to cover AGL’s dividend expenses. I’m also really looking forward to see if the company can indeed reduce its operating costs and sustaining capex, because if it would effectively be able to do so, AGL is trading at an expected free cash flow yield of 8-9% by FY 2018. I’m keeping an eye on AGL Energy and might pull the trigger during a weak moment on the market. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.