ERM Power — Investor day confirms structural growth trends

ERM Power — Investor day confirms structural growth trends

The recent investor day confirmed the opportunities we see for ERM Power from an evolving energy market, which we expect will create medium-term growth potential especially for the Energy Solutions business. In the meantime, investors will benefit from strong forecasted cash flow generation, with total free cash flow over the period FY19–21 equivalent to c 40% of the current market cap. We expect this to be allocated in a balanced way between shareholders’ remuneration and growth capex.

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Written by

ERM Power

Investor day confirms structural growth trends

Update post investor day

Utilities

23 May 2019

Price

A$1.84

Market cap

A$463m

Net cash (A$m) at 31 December 2018

78.6

Shares in issue

251.5m

Free float

75%

Code

EPWX

Primary exchange

ASX

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

4.3

12.0

1.1

Rel (local)

0.4

6.0

(5.8)

52-week high/low

A$1.99

A$1.30

Business description

ERM Power is an Australian commercial and industrial energy retailer and trader founded in 1980 and listed in 2010. It operates an electricity supply business (second-largest retailer to C&I customers) and two gas-fired generation plants. A key area of growth is energy solutions.

Next events

FY results

August (tbc)

Analyst

Dario Carradori

+44 (0)20 3077 5700

ERM PowerERM Power is a research client of Edison Investment Research Limited

The recent investor day confirmed the opportunities we see for ERM Power from an evolving energy market, which we expect will create medium-term growth potential especially for the Energy Solutions business. In the meantime, investors will benefit from strong forecasted cash flow generation, with total free cash flow over the period FY19–21 equivalent to c 40% of the current market cap. We expect this to be allocated in a balanced way between shareholders’ remuneration and growth capex.

Year end

EBITDA (A$m)

PBT*
(A$m)

EPS*
(c)

DPS
(c
)

P/E
(x)

Yield
(%)

06/17

78.4

14.7

(10.5)

7.0

N/A

3.8

06/18

97.5

43.1

12.0

7.5

15.3

4.1

06/19e

90.6

35.4

10.1

12.0

18.0

6.5

06/20e

105.6

50.3

14.5

12.0

12.7

6.5

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Structural growth trends confirmed

The investor day presentation focused on the impact of the structural growth trends on ERM Power’s activities, including the development of Energy Solutions and the opportunities for power generation activities as a result of the energy transition. We maintain our view that the Energy Solutions business has the potential to develop to a sizeable business, with the mid-case of our sensitivity analysis suggesting the business can generate c 20% of group EBITDA in the medium term. In addition, we believe the high flexibility of ERM Power’s generation assets is likely to benefit from increasing price volatility and increasing volumes.

Strong cash flow generation provides opportunities

In our view, a key attractiveness is the strong cash flow generation. Over the three years FY19–21 we estimate ERM will generate total free cash flow (FCF) equivalent to c 40% of the current market cap. We expect this cash flow will be used in a balanced way for shareholder remuneration and growth initiatives. We estimate total dividends and share buyback over FY19–21 equivalent to 21% of the current market cap (assuming a special dividend in FY20 and growth in ordinary dividends thereafter). ERM Power will report FY result at the end of August; we will mainly focus on the guidance for Energy Solutions and Retail as well as an update on capital allocation. Our forecasts are broadly aligned with Refinitiv consensus for FY19 (our EBITDA is 1% higher), while we see c 10% upside to consensus EBITDA for FY20–21 as we factor in growth in Energy Solutions and Electricity Retail.

Valuation: Undemanding despite recent recovery

Despite the recent share price recovery (+17% ytd), the valuation is attractive with the stock trading at undemanding earnings multiples (c 13–11x P/E in FY20–21, excluding a one-off contribution from the LGC sale) and robust cash flow generation with FCF yield of 14% a year on average in FY19–21. The dividend yield is 6.5% in FY19–20 (including the special dividend, 4.9% based on ordinary dividend only). Our SOTP valuation of A$2.4/share (A$2.8/share including a valuation for Energy Solutions) and our forecasts are unchanged.

Evolving market creates opportunities

The recent investor day confirmed the opportunities we see for ERM Power from an evolving Australian energy market. In particular, we believe that delivery of growth for the Energy Solutions business would provide evidence of the growth potential of the company and would result in a strong catalyst for a re-rating on higher multiples.

Investor day focuses on opportunities from energy transition

ERM Power held an investor day on 14 May, which provided an update on its activities, strategy and growth opportunities. The presentation focused on the impact of energy transition on ERM Power’s activities and the implications for its power generation, energy retail and energy solutions businesses. Overall, we believe the growth trends identified by the company are consistent with our forecasts and growth outlook for the company. We provide more details below.

Energy Retail and Energy Solutions: With the emergence of new technologies, and the need to increase energy efficiency and adopt more sustainable solutions, sophisticated commercial and industrial (C&I) customers, which represent the core business of ERM Power, increasingly require a comprehensive energy service in addition to the delivery of the physical commodity. In its investor day presentation, ERM Power has highlighted that for a typical C&I customer paying A$150/MWh for its electricity, Energy Solutions can secure net benefits ranging from A$8/MWh to A$20/MWh (A$30/MWh, or 20% of their costs, before capital costs associated with the required investment). While, according to ERM Power, the company may lose part of its Electricity Retail margin (20% or A$1/MWh out of c A$5/MWh) as a result of the lower customer consumption, the company is likely to achieve a significant net increase in profits thanks to the sharing with the customer of the A$8–20/MWh saving. Energy Solutions is at an early stage of development and we have previously estimated the potential for this business. We set out the up-to-date analysis in Exhibit 1, which shows that in a mid-case this business development could drive significant growth, with 21% growth in group EBITDA in the medium term (vs FY22e). Our published forecasts currently assume the mid-case EBITDA is achieved in FY24.

Exhibit 1: Energy Solutions – medium-term EBITDA potential

Addressable mkt size

A$m

1,000

Mkt share

%

5%

13%

20%

Revenue

A$m

50

125

200

Gross profit margin

%

30%

40%

50%

30%

40%

50%

30%

40%

50%

Gross profit

A$m

15

20

25

37.5

50

62.5

60

80

100

Opex

A$m

20

20

20

25

25

25

30

30

30

EBITDA

A$m

-5

0

5

12.5

25

37.5

30

50

70

% of 2022e group EBITDA

%

-4%

0%

4%

10%

21%

31%

25%

41%

58%

Source: Edison Investment Research

Power generation: ERM Power sees long-term opportunities for its power generation portfolio, which is expected to benefit from the evolving market conditions thanks to its flexibility. The Neerabup and Oakey Power plants are open-cycle gas turbine (OCGT) plants, with total installed capacity of 662MW (of which ERM Power has 497MW equity ownership) generating c 40% of FY19 group EBIT, on our estimates. ERM Power’s generation assets are highly flexible, with high availability and fast start times, which should allow the company to capture the opportunities from increasing volatility in wholesale electricity prices as a result of growing renewable installed capacity (wind and solar are intermittent sources of generation) and from reducing production from coal-fired plants (regulation and ageing plants are likely to result in significant closures). In particular, Oakey is very exposed to this trend as it is 100% merchant, while Neerabup has more limited exposure to merchant activities.

Although the regulatory environment remains uncertain, on our estimates, by FY35 c 70% of Australia’s current coal-fired power plant capacity will have reached 50 years of age. In our view, the levels of investment needed to continue to generate, combined with likely stricter environmental regulations in the longer term, are unlikely to allow the operation of the plants beyond this limit.

We currently assume a moderate increase in profits for this business, with a 2% EBITDA CAGR FY19–22 but see risks to our forecasts as skewed to the upside.

Three-year cash flow equivalent to c 40% of market cap

We forecast strong cash flow generation with an average FCF yield of 14% in FY19–21. The strong cash flow generation is driven by healthy margins in the supply and power-generation activities and one-off cash inflow from the sale of its portfolio of large-scale generation certificates (LGC). We estimate total A$190m free cash flow in FY19–21, before M&A and growth capex, equivalent to 41% of the current market cap. On top of this, A$37m was raised at the end of 2018 with the disposal of the US business. We expect this cash flow will be used in a balanced way for shareholder remuneration and growth initiatives. We estimate total dividends and share buyback over the period of A$99m, equivalent to 21% of the current market cap (assuming a special dividend in FY20 and growth in ordinary dividends thereafter). On our estimates, the free cash flow yield will easily cover the high dividend yield (Exhibit 2). In addition, the company has announced that A$60m has been reserved for growth initiatives (not included in our forecasts); we expect this will be used mainly for acquisitions by the Energy Solutions business. As shown in Exhibit 3, the cash flow generation we forecast is higher than expected cash flow utilisation, which leaves more room for dividends and/or growth capex, also considering the strong financial structure of the company (net cash at H119).

Exhibit 2: FCF yield vs. dividend yield for ERM Power

Exhibit 3: FY19-FY21e cash flow generation/ utilisation

Source: Edison Investment Research

Source: Edison Investment Research

Exhibit 2: FCF yield vs. dividend yield for ERM Power

Source: Edison Investment Research

Exhibit 3: FY19-FY21e cash flow generation/ utilisation

Source: Edison Investment Research

As sensitivity, a A$1/MWh increase or decrease in Electricity Retail gross margin per unit sold (equivalent to c 20% of current margin) would increase or decrease group FCF yield by c 2.5 percentage points. As a result, FCF yield would comfortably cover the dividend yield even with a rather large reduction in retail margins.

What to focus on at the FY19 results

ERM Power will report full year results at the end of August. At H1 results in February the company sent a strong signal of confidence with the announcement of a c 30% dividend hike (from 7c to 9c), the introduction of an additional special dividend of A$0.03/share for FY19 (another special dividend will be considered for FY20, with an update by the H120 results), A$60m reserved for growth investments, a c 10% higher medium-term outlook for margins per MWh for its core Electricity Retail business (from a range of A$4.00–5.50/MWh to A$4.50–6.00/MWh). The only slightly negative trend was that the FY19 outlook for the Energy Solutions business was confirmed despite the contribution from the recent acquisition of Out Performers.

Following the positive update at H1 results, at the FY results we will focus on the outlook for:

Electricity Retailing: ERM Power guided for A$5.1/MWh unitary gross margin for FY19 and A$4.50–6.00/MWh (FY20–21). We expect narrower guidance for FY20 and we currently assume a A$5.25/MWh gross margin and a small pick-up in volumes (18.8TWh, +4% y-o-y), based on growing forward sales disclosed at H1.

Energy Solutions: at H1 ERM Power confirmed the FY20 target of a positive net income contribution. We currently assume a €1m positive net income contribution in FY20 (vs negative €3m in FY19).

Power generation: we forecast a A$16m EBITDA for Oakey and A$27m for Neerabup in FY20.

Capital allocation: we expect more details on the A$60m reserved for organic and inorganic growth investments and an update on the A$15m share buyback programme. In addition, we will also look for signals on whether the A$0.03/share special dividend will be repeated in FY20, although the company is more likely to wait to confirm this until it has more visibility at H120 results.

Valuation: Attractive FCF and dividend yields

In our view, the valuation for ERM Power remains compelling, despite the recent share price recovery (+17% ytd). The stock trades at undemanding earnings multiples (c 13–11x P/E in FY20–21, excluding a one-off contribution from the LGC sale). The cash flow generation is robust with a FCF yield of 14% a year on average in FY19–21, which is attractive also considering that a good portion of the cash flow is paid in dividends: the dividend yield is 6.5% if FY19–20 (including the special dividend, 4.9% based on ordinary dividend only).

Excluding Energy Solutions (which is loss making and generating negative cash flow), our base case valuation is unchanged at A$2.4/share (based on a DCF-based SOTP valuation with an 11% WACC). Including a valuation for the Energy Solutions business, which has not yet reached break-even but has strong growth prospects in our view, would increase the SOTP valuation to A$2.8/share based on a multiples valuation.

Key risks to our valuation and investment case are higher or lower supply and power-generation margins in Australia and higher or lower growth in Energy Solutions.

Exhibit 4: Financial summary

Accounts: IFRS; year end 30 June; A$m

2016

2017

2018

2019e

2020e

2021e

INCOME STATEMENT

 

 

 

 

 

 

Total revenues

2,691

3,127

2,047

1,966

2,047

2,078

Cost of sales

(2,620)

(3,049)

(1,950)

(1,876)

(1,941)

(1,963)

Gross profit

71

78

98

91

106

115

SG&A (expenses)

0

0

0

0

0

0

R&D costs

0

0

0

0

0

0

Other income/(expense)

0

0

0

0

0

0

Exceptionals and adjustments

(5)

0

0

0

0

0

Depreciation and amortisation

(25)

(38)

(30)

(29)

(30)

(31)

Reported EBIT

40

41

67

62

76

84

Finance income/(expense)

(23)

(26)

(24)

(26)

(26)

(25)

Other income/(expense)

0

(0)

0

0

0

0

Exceptionals and adjustments

39

36

(34)

8

21

0

Reported PBT

57

51

9

44

71

59

Income tax expense (includes exceptionals)

(22)

(52)

(90)

(11)

(15)

(17)

Reported net income

36

(1)

(81)

33

56

41

Basic average number of shares, m

242

244

244

240

237

237

Basic EPS (A$)

0.15

(0.00)

(0.33)

0.14

0.24

0.17

DPS (A$)

0.120

0.070

0.075

0.120

0.120

0.100

 

 

 

 

 

 

 

Adjusted EBITDA

71

78

98

91

106

115

Adjusted EBIT

46

41

67

62

76

84

Adjusted PBT

23

15

43

35

50

59

Adjusted EPS (A$)

0.08

(0.11)

0.12

0.10

0.15

0.17

Adjusted diluted EPS (A$)

0.08

(0.10)

0.12

0.10

0.14

0.17

 

 

 

 

 

 

 

BALANCE SHEET

 

 

 

 

 

 

Property, plant and equipment

391

391

391

358

350

341

Goodwill

0

0

0

0

0

0

Intangible assets

79

89

38

38

38

38

Other non-current assets

59

116

43

43

43

43

Total non-current assets

529

597

473

440

432

423

Cash and equivalents

192

245

228

282

317

340

Inventories

22

42

82

79

82

83

Trade and other receivables

331

361

320

323

336

341

Other current assets

164

331

258

106

106

106

Total current assets

709

979

888

789

841

870

Non-current loans and borrowings

184

181

177

177

177

177

Other non-current liabilities

161

287

160

168

168

168

Total non-current liabilities

345

467

337

344

344

344

Trade and other payables

367

464

424

448

464

469

Current loans and borrowings

37

8

160

160

160

160

Other current liabilities

18

70

191

39

39

39

Total current liabilities

422

543

774

647

662

667

Equity attributable to company

471

566

250

238

266

281

Non-controlling interest

0

0

0

0

0

0

 

 

 

 

 

 

 

CASH FLOW STATEMENT

 

 

 

 

 

 

EBIT

40

41

67

62

76

84

Depreciation and amortisation

16

53

32

29

30

31

Share based payments

0

0

0

0

0

0

Other adjustments

60

69

(119)

0

0

0

Movements in working capital

0

0

0

25

(1)

(1)

Interest paid / received

3

3

3

3

4

5

Income taxes paid

(0)

(14)

(27)

(11)

(15)

(17)

Cash from operations (CFO)

120

152

(43)

109

94

101

Capex

(26)

(40)

(49)

(21)

(20)

(20)

Acquisitions & disposals net

12

26

6

25

(2)

(2)

Other investing activities

(9)

(6)

(0)

0

0

0

Cash used in investing activities (CFIA)

(24)

(20)

(44)

4

(22)

(22)

Net proceeds from issue of shares

0

0

(3)

(17)

0

0

Movements in debt

(22)

(24)

140

0

0

0

Dividends paid

(28)

(23)

(17)

(28)

(28)

(26)

Other financing activities

(27)

(33)

(38)

(14)

(9)

(30)

Cash from financing activities (CFF)

(76)

(79)

82

(58)

(37)

(56)

Currency translation differences and other

0

0

0

0

0

0

Increase/(decrease) in cash and equivalents

20

53

(5)

54

35

23

Currency translation differences and other

0

(1)

(12)

0

0

0

Cash and equivalents at end of period

192

245

228

282

317

340

Net (debt) cash

(29)

56

(109)

(54)

(20)

4

Movement in net (debt) cash over period

(29)

85

(164)

54

35

23

Source: Company data, Edison Investment Research

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This report has been commissioned by ERM Power and prepared and issued by Edison, in consideration of a fee payable by ERM Power. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

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This report has been commissioned by ERM Power and prepared and issued by Edison, in consideration of a fee payable by ERM Power. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

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No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

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Research: Healthcare

BioLargo — Progress towards independent businesses

BioLargo continues to make progress in its goal to establish its various subsidiaries as independent businesses. Odor-No-More recorded revenue of $301,000 for Q119 (of $364,000 total), down 10.7% from Q419. It cited lumpiness in its sales pattern caused by the timing of orders, weather and manufacturing, and the fact that approximately 20% ($68,000) of orders were in process at the end of the quarter. This business is expanding with new distribution agreements in the waste handling and cannabis industries. BioLargo Water has placed it first Advanced Oxidation System (AOS) treatment train, and Clyra Medical will run a 30-day animal study to support a 510(k) application for its wound treatment product.

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