ERM Power – Competitive Analysis

After my last post on competitive analysis I thought it would be a good idea to try and analyse a company I’ve written about previously, ERM Power (ASX:EPW).

  1.  Define Markets

EPW operates in two markets – the Australian industrial and commercial power retail market and various of the US power markets.  Its entry into the US is fairly recent and is only a small percentage of revenue so we’ll leave that aside and look at the Australian situation.  EPW also owns two peaker power stations which we’ll also ignore.

The Australian National Energy Market (NEM) operates across five states and consists of generators (power station operators), regulated transmission and distribution companies, retailers and consumers.  Generators sell power on an open market upon which retailers can bid for power or through individual contracts with retailers.  There is also an electricity futures exchange operated by ASX which allows companies to hedge power requirements.

The dominant generators are AGL, Energy Australia, Origin, CS Energy (govt. owned) and Snowy Hydro.  Tasmania is dominated by the government owned Hydro Tas (96% market share).  There are a handful of smaller generators operating in each state.

In the retail category there are three dominant companies – AGL, Energy Australia and Origin.  Together these three control 70% of the market.  If the names seem familiar that’s because they are also generators or “gentailers” who have remained vertically integrated following market deregulation in the 1990’s.  The remainder of the market is split among 17 other retailers and resellers.

However the above refers to the entire power market; we’re only interested in the commercial and industrial sector.  In this sector the dominant retailers are Origin, EPW, AGL and Energy Australia.

Step 2 – Identify Quantitative Indications of Barriers to Entry

As EPW is the only pure-play commercial and industrial retailer we’ll start there.  Overall the others either don’t have public financial reporting (Energy Australia) or don’t split out earnings by market.  EPW’s competitors each have whole-company ROIC’s in the low to mid single digits.  EPW has fairly complicated reporting due to non-cash mark-to-market charges for its hedge book so the method I prefer to get a quick look at returns is to compare free cash flow with tangible assets.  EPV vs reproduction cost would be better but we aren’t up to that yet.  If we take EPW’s results for the last seven years (since listing) we can see:

Jun11 Jun12 Jun13 Jun14 Jun15 Jun16 Jun17
Free Cash Flow per Share (AUD) 0.639 0.174 0.37 0.048 0.535 0.382 0.517
Tangible Book per Share (AUD) 0.961 0.944 1.213 1.127 1.156 1.618 1.944
FCF/Tangible Book (%) 66 18 31 4 46 24 27

With the exception of 2014 the returns are all 18% or above.  EPW buys much of its power through the NEM so we can assume their cost of power is not materially different to the gentailers.  I think it’s then reasonable to assume that the difference in returns on capital is due to either barriers to entry in the commercial & industrial retail market or efficiencies in EPW’s operations or both.

If we then turn our attention to market share then the data is a little harder to find.  Of the main E&I retailers Origin is the only one which splits out E&I sales over the last five years.  So what we can do is compare the growth in terms of TW.h of power sold since 2011 between EPW, Origin and the overall NEM E&I market.  What we get is:

2012 (TW.h) 2013 (TW.h) 2014 (TW.h) 2015 (TW.h) 2016 (TW.h) 2017 (TW.h) CAGR (%)
EPW Sales 8.3 11.1 14.1 16.7 18.1 18.5 17
Origin E&I Sales 20.6 22.2 20.3 18.4 19.6 21.1 0
Australia Ex- WA & TAS Non-Residential Electricity Consumption 147 145 144 144 148 Not Available 0

Electricity consumption has been flat and sales have been flat for one competitor but EPW has managed to grow sales at quite a rate.  I think that’s a clear indication of a lack of barriers to entry because EPW has captured 12.5% of the market in the space of 5 years whilst generating a profit most years.  We’ll keep going with the analysis but I’m already very skeptical about EPW having any incumbent advantage.

Step 3 – Look for Qualitative Reasons for Barriers

Given that EPW rates very highly on customer satisfaction scores and has customer turnover rates less than 30% we may be tempted to look for customer stickiness.  However I’ve been involved in several industrial electricity and gas purchase decisions and it’s always put out to bid.  Good customer service may make EPW the preferred supplier if everyone is the same price but it seems unlikely that EPW are able to charge more than the competition and still retain customers.  Which means EPW’s returns on capital should be similar to its competitors assuming the company is run as efficiently.

In terms of economies of scale, EPW’s gross margins are usually in the order of $5 per MW.h.  EPW doesn’t split costs in great detail in its reporting but we can see that 2017 employee expenses across the whole company were $54.4 MM which if apportioned pro-rata according to segment sales becomes $46 MM for the Australian E&I retail business.  If we then divide these costs by the above gross margin we find that an entrant with the same fixed costs as EPW needs to sell 9.2 TW.h or around 6% of the market to cover its fixed charges.  On face value, this seems like somewhat of a barrier to entry.  However EPW has already managed to turn a profit on only 3 TW.h of sales in the US so it is more likely that employee costs are somewhat variable with scale and provide a misleading indicator of fixed costs.  So no barriers here either.

So it’s clear we don’t need to proceed with the rest of the steps of analysis.  EPW’s above average returns on capital are the result of management efficiencies rather than barriers to entry.  What isn’t clear is how far into the future these returns can be sustained.  This influences how I value a EPW.  Whilst it is trading well below the EPV at which it would just earn its estimated cost of capital I think it’s a safe proposition.  But once it exceeds that price care needs to be taken to make sure management performance isn’t decreasing.

If you have questions or comments please write to Warwick at oceaniavalue@gmail.com.  I answer every email that I receive.  You may also like the previous article in my series on competitive analysis which you can find here.

Disclosure: This is not a recommendation to buy or sell any securities.  All information presented is believed to be reliable and is for information purposes only.  Do your own research before purchasing any security.

Leave a Reply

Your email address will not be published. Required fields are marked *