ERM Power

Investment Thesis

ERM Power Limited (ASX:EPW)  is a AUD 364M market cap commercial and industrial electricity retailer operating in the Australian and US markets.  It also operates two gas fired peaker power stations supplying the Western Australian and Queensland markets.  It is a high quality business with segments of rapid growth and a large (~25%) insider ownership by the founder and his non-exec director brothers.  Despite generating more than the current market cap in FCF in the last 5 years the Company’s shares are currently trading at 4.7x the 5-year average trailing FCF and at a 24% discount to Tangible Book Value.  The reason for the mis-pricing is a combination of uncertainty regarding the Australian electricity market and EPW’s lumpy EPS performance caused by mark-to-market losses and gains on the Company’s hedge positions and lumpy working capital flows.  In reality the company reliably generates free cash due to low fixed charges and hedging of retail customer contracts using electricity futures.

 

Catalyst

During FY2016 EPW chose to pay Australia’s Clean Energy Regulator an AUD 123M penalty in lieu of purchasing and surrendering Large Scale Generation Certificates (LGCs) purchased from renewable power generators.  This was done because the LGC price at the time almost equaled the AUD 123M penalty, allowing EPW to sell its existing stock of LGCs at a high price. The terms of the payment provided optionality to buy and surrender LGCs any time before Feb 2020.  Growth in Australian renewable generation capacity has decreased LGC prices by more than 50% since the penalty was paid and EPW indicated during their 2017 results call that the time is still not yet right to exercise their option so further upside is foreseen.  It seems likely that EPW will regain at least half of the penalty in the near future, equivalent to 120% of 2017 operating income.  Given the scale of the publicity and 30% share price decline associated with the penalty payment it seems likely that the market would react favourably to reports of the boost in earnings.

 

EPW’s US operation, SPG Energy Group LLC or “SPG”, has grown rapidly since acquisition in 2015, doubling sales volumes in the past year.  This business recently reached break-even and operates in a market which is 6x the size of the Australian market, providing large potential for growth.  I has also recently divested its loss-making residential operation which will reduce the drag on future earnings.

 

Even if the market doesn’t reprice the shares, EPW’s 5% dividend yield (plus 2% of franking credits for Australian tax residents) and 5 to 10% growth rate means that the stock will pay the holder to wait.

 

Balance Sheet

EPW’s debt-to-equity ratio is 0.35.  The majority (90%) of the debt consists of limited recourse loans linked to the two generating assets which comprise 24% of total assets. In 2017 debt was 1.1x FCF so the Company could repay the debt within 2 years if needed.  These loans have been hedged using interest rate swaps to a fixed interest rate of 7.2%, eliminating the interest rate risk.

The financial derivative book is more difficult to assess.  EPW carries AUD 407M of derivative assets, equivalent to 26% of total assets.  The derivatives are in the form of electricity futures and interest rate swaps.  Of this, AUD 386M is direct hedging relating to Australian retail operations.  The Company also lists AUD 101M of derivative liabilities of which AUD 25M relate to the Australian business.  Without further information on the counterparties and terms of these derivatives it is difficult to further evaluate them however the fact that the majority of the instruments are hedges suggests that the company trades in derivatives on a hedged (downside limiting) rather than speculative basis.  Whilst derivatives have been described as “weapons of financial mass destruction” this mainly relates to the risks created by origination of derivatives without the backing of an underlying commodity for speculative purposes.  When used for their originally intended purpose of hedging they can provide stability to commodity industries by allowing forward contracts to be written on commodities which have a low profit margin.  Commodity trading companies such as Cargill, Bunge and ADM are a good example of this type of derivative use in action.

 

The remainder of the total assets are cash (15.5%), receivables (23%) and inventories, deferred taxes etc (11.5%).

 

Based on the above the current share price means we can purchase the generating assets, cash and spontaneous assets of the company at their depreciated book value and receive the (difficult to value) derivative book for free.

 

Segment Analysis

EPW consists of three main segments; Business Energy Australia, Business Energy US and Generation.

 

Business Energy Australia.

Revenue AUD 2.65B

EBITDAF AUD 53M

This segment is a mature business which is likely to grow at the same rate as GDP (2 to 4%).  Large market share (2nd in commercial/industrial), high independently measured customer satisfaction plus the ability to sell power usage reduction products provides this business with somewhat of a moat.  Competitors consist principally of large generators which have large fixed charges and a disincentive to help customers save electricity.  As a stable, competitive business a reasonable private buyer EV multiple for this business would be 8x EBITDAF.  This gives an EV of around AUD 424M.

 

Business Energy US

Revenue AUD 337M

EBITDAF AUD 0.2M

Acquired in 2015, this business doubled its revenue, began to generate positive EBITDAF and increased margins in 2017 as scale was reached.  The competitive situation in the ERCOT and PJM markets that the Company operates in resembles that of Australia in that the majority of retailers are legacy generators.  The rapid growth forecast for this segment seems plausible in light of the above.  Based on the rapid growth rate and proven business model an EV/EBITDAF multiple of 9x seems reasonable for this business, giving an EV of 1.8M.  Given that the business is just past break even and growing rapidly P/S would be a better metric but as seen below we don’t need to complicate the calculation to that extent to see that the business is priced well below intrinsic value.

 

Generation

Revenue AUD 132M

EBITDAF AUD 42M

The Generation segment provides power during periods of peak electricity demand using gas turbine generators.  Despite concerns regarding the impact of renewables and government policy on the Australian market this form of generation offers unsurpassed security of supply compared to other energy forms due to its ability to start up almost instantly and run indefinitely.  Given the recent ‘system black’ incident in South Australia where an entire state lost power due to lack of peak supply capacity it seems unlikely the demand for these assets will disappear.  However, battery storage assets could reduce some of the demand for this type of power on the open market.  Due to this EPW has been publicly calling for the government to move to pricing based on capacity availability to ensure this type of asset remains online.  An appropriate EV/EBITDAF multiple for this segment would be around 6x.  This results in an EV of AUD 252M.

 

Adding together the above EV figures we get a total EV of AUD 678 M.  If we treat the Company’s derivatives as spontaneous assets rather than investments we can calculate an EV of AUD 300M based on the current market price.

Summary

On an EV/EBITDA basis it is pretty clear that EPW is underpriced as a going concern.  If fully valued on the above EV/EBITDA basis the Company’s market cap would need to increase by AUD 378M to give a share price of approx. AUD 2.90.  If we triangulate this with FCF we get a trailing 5-year average FCF multiple of around 10x.  This would correspond to a P/B of around 1.8.  By both of these triangulating measures the stock at AUD 2.90 would be by no measure overvalued.  If this level of price appreciation occurs in the next three years the rough IRR on this holding would be 5% dividend + 2% franking credits + 5-10% growth + 35% multiple expansion.  The risk to the downside is low as the company is relatively unleveraged, generates strong cash flows, has a large percentage of insider ownership and the current price effectively discounts the derivatives book.

If you have questions or comments please write to Warwick at oceaniavalue@gmail.com.  I answer every email that I receive.

Disclosure: We currently hold EPW.  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 *