How Origin Energy offers a 20% annualised return with almost zero downside risk

Origin Energy (ASX: ORG) might offer the most low-risk 4-5% return on the ASX right now, pending one last regulatory hurdle ahead of its $19 billion takeover from a consortium led by Brookfield Asset Management, says Vertium Asset Management CIO Jason Teh.

The State of Play

On 27 March 2023, Origin signed a binding Scheme of Implementation Deed with the consortium under the following key terms:

• A consideration mix of $5.78 per share and US$2.19 per share
• The total considerable will be reduced by any dividends paid by Origin prior to the implementation of the Scheme
• Any reduction in the amount payable due to dividends lowers the Australian dollar component of the total consideration
• A 4.5 cents per month ticking fee will accrue on a daily basis if the scheme is delayed beyond 30 November 2023

The offer is currently progressing through the Australian Competition and Consumer Commission (ACCC) and Foreign Investment Review Board (FIRB). Clearance from the ACCC is expected around late September.

The US Dollar Component and Dividends

The Australian Dollar has tumbled from recent highs of 68.8 cents to 64 cents due to factors including a stronger-than-expected US economy, rising US bond yields and China’s economic concerns.

• At an exchange rate of 70 cents, the bid values Origin at $8.90 per share
• At the current exchange rate of 64 cents, the price is $9.20 per share

As for recent dividends:

• Origin Energy paid out an interim dividend of 16.5 cents per share back in March
• It will also trade ex-dividend on 5 September for a final dividend of 20 cents per share

The dividends will reduce the takeover price when they are paid. Once Origin trades ex-dividend in September, the takeover price is theoretically $8.83 (at the current exchange rate of 64 cents).

What the Trade Offers

The play is currently offering a 2.3% fully-franked final dividend and 2-3% capital return based on recent share price levels (trading around $8.60 to $8.70).

The capital upside component was previously around 3.8% on Thursday, 17 August – the day of Origin’s FY23 results announcement.

The Key Variables

Time: The offer needs to proceed through the ACCC and FIRB.

“We don’t have a strong view on how long the regulatory process will take. But if the scheme does not get approved by the end of November, there is an additional 4.5 cps ticking fee per month payable to ORG shareholders. Hence, the takeover price increases by 0.5% per month after November,” explains Teh.

Currency: The Australian Dollar is trading near a nine-month low. Where could it go from here?

“The Australian dollar is currently tied to the outlook on the Chinese economy. If the Chinese Government does not stimulate their economy significantly the Australian dollar will likely trade sideways to down. There is a US dollar cash component to the takeover bid and a 1 cent move in the AUD/USD will change the takeover price in Aussie dollar terms by about 0.6%,” he says.

Takeover likelihood: If you had to put it in percentage terms, what’s the likelihood that the offer goes through?

Teh says “prior to the recent earnings result we would put a 90% probability of the deal going ahead. However, after the result we would put a 99% probability of the deal going ahead based on the current takeover terms.”

“The shift in improved probabilities is due to the fact that in November 2022, Brookfield/EIG consortium was willing to pay about 20x PE multiple for the business. However, after the recent earnings result where earnings estimates were revised up by about 20% the consortium is paying about 13x PE multiple.”

“The Consortium is getting a steal by taking over a business on a significantly lower PE multiple.”

Possible Scenarios

These are the four possible scenarios that Teh says shareholders should consider:

#1 Consortium walks away: The chance of this is near zero given that they offered to pay 20x PE multiple for the business in Nov 2022 (and also confirmed in March 2023) but are now buying the business on 13x PE multiple based on the latest earnings estimate. Also note that before the takeover announcement ORG was trading around 13-14x PE multiple. So, if Brookfield walks away from the takeover there is valuation support (hence low downside risk) if we use the pre-takeover PE multiple as an anchor.

#2 Takeover completed on current terms: Earn a ~5% return, which is divided into 2.3% fully franked dividend yield and 2.6% capital upside. If the deal is delayed beyond November, shareholders are paid an extra 0.5% return per month.

#3 Another takeover bid: The chance of this is near zero given the size of the ORG transaction and it would have flushed out strategic buyers when the takeover offer was first offered.

#4 Consortium offers better terms: The ORG takeover is done under a scheme of arrangement where a high hurdle (75% minimum) is required from shareholders to approve the deal. Some shareholders may not be happy selling the business at 13x PE multiple based on ORG’s significantly improved earnings outlook. This means there is an increased probability that 26% of the shareholding could vote no and the takeover falls over. The shareholders who vote no have likely assessed the downside share price risk to be low given that ORG is currently trading on 13x PE multiple. Hence, if the Consortium is afraid of shareholders voting no then there is increased chance of them improving the takeover terms. This optionality to the upside is not priced in by the market.

The Bottom Line

Teh says the trade offers “a decent 5% return for a 3 month wait with close to zero downside risk. Importantly, there is a free option on higher returns on the increased chance that the Consortium raises their takeover offer.”