30% dividend hike a strong positive signal

ERM Power 1 March 2019 Update
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ERM Power

30% dividend hike a strong positive signal

H1 results update

Utilities

1 March 2019

Price

A$1.75

Market cap

A$435m

Net cash (A$m) at 31 December 2018

78.6

Shares in issue

248.6m

Free float

75%

Code

EPWX

Primary exchange

ASX

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

15.5

3.2

(2.8)

Rel (local)

9.7

(5.1)

(4.9)

52-week high/low

A$1.9

A$1.3

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. The company recently sold its US business.

Next events

Ex-dividend date for interim and special dividends

26 March 2019

FY results

August 2019

Analyst

Dario Carradori

+44 (0)20 3077 5700

ERM Power is a research client of Edison Investment Research Limited

At its H119 results, ERM Power sent a strong positive signal about the outlook for its Electricity Retail business, upgrading its medium-term gross margins per unit by c 10%. The c 30% dividend hike, the additional 3c/share special dividend and A$60m reserved for investments in growth also show the balance sheet and the cash flow are strong.

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

4.0

06/18

97.5

43.1

12.0

7.5

14.5

4.3

06/19e

90.6

35.4

10.1

12.0

17.2

6.9

06/20e

105.6

50.3

14.5

12.0

12.1

6.9

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

Strong cash flow supports dividends and capex

At H1 results, ERM Power announced a c 30% FY19 dividend hike, an additional 3c/share special dividend for FY19 (another will be considered for FY20) and that A$60m is reserved for growth investments. We believe this shows the balance sheet (post US disposal) and cash-flow generation are strong and the company is confident in its outlook. We estimate total A$190m free cash flow for FY19–22 (before growth capex and in addition to US disposal proceeds of A$37m), equivalent to 44% of the market cap. We expect cash flow to be used for shareholder remuneration and growth initiatives. We estimate total dividends and a share buyback of A$99m, equivalent to 23% of the current market cap.

Retail outlook upgraded, Energy Solutions reduced

From a business point of view, the key highlight is the upgrade in the medium-term guidance for the Electricity Retail business. The unit gross margin guidance has been upgraded by c 10% and the retail business reached record margins at H119 results. ERM Power has broadly confirmed the outlook for FY19 results, with the exception of Energy Solutions, for which EBITDA guidance of a A$2.5m loss was confirmed despite the recent acquisition of Out Performers (A$2m EBITDA contribution). While we view this as a small disappointment, we still believe the medium-term growth potential for Energy Solutions is significant and estimate it could contribute to 21% growth in group EBITDA in a mid-case scenario. We have reduced FY19 net income by 10%, mainly to reflect the lower contribution from Energy Solutions, but have made small changes from FY20 as this impact is partly offset by higher Electricity Retail EBITDA.

Valuation: Metrics undemanding

Despite the strong positive share price reaction to H1 results, earnings and cash flow-based valuation metrics still appear undemanding compared with Australian small caps. The stock trades at c 10–12x P/E in FY20–FY21 (excluding a one-off contribution from the LGC sale) and the dividend yield is attractive at 6.9% for FY19 including the special dividend (5.1% based on the ordinary dividend only), especially considering the robust FCF yield (17% in FY19). Our base-case valuation is unchanged at A$2.4/share, assuming no value for Energy Solutions.

30% DPS hike; special dividend; higher supply outlook

The key highlights of the H1 results were the c 30% dividend hike (from 7c to 9c), the introduction of an additional special dividend of 3c/share for FY19 (an additional special dividend will be considered for FY20, with an update at 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). On the negative side, the FY19 outlook for the Energy Solutions business was revised down.

H1 results down y-o-y and strong cash flow

H1 EBITDA was down 5% y-o-y to A$47.3m, reflecting lower power-generation business profits and slightly higher corporate costs. The EBITDA decline drove a 13% y-o-y decline in underlying net income. The FY19 outlook for the various divisions was broadly confirmed, with the exception of Energy Solutions.

ERM Power generated very strong cash flow as a result of its ordinary business, the sale of the US business for A$37m and a positive variation margin of its derivatives position (+A$147.5m). It reported net cash of A$78.6m at 31 December 2018 (vs net debt of A$108.7m at 30 June 2018). As the value of its derivatives position varies significantly depending on the evolution of wholesale electricity prices (when electricity prices increase, the company receives a cash inflow, whereas a cash outflow takes place when wholesale prices reduce) and it is difficult to predict, we assume the cash inflow from the variation margin the company benefited from in H1 mostly reverses by the end of FY19.

Electricity Retail margin at record levels; medium-term guidance mid-point implies further rise

The FY19 outlook for power generation was confirmed and the outlook for the Electricity Retail business was broadly consistent with previous announcements as the impact of slightly lower volumes (from 19TWh to 18TWh) was more than offset by higher than expected unit margins (from A$4.75/MWh to A$5.1/MWh). We highlight the level by ERM Power for FY19 is the highest margin the company has achieved in several years (Exhibit 1) and the mid-point of the A$4.5–6.0/MWh targeted range for the medium-term implies a further increase.

Exhibit 1: Evolution of unitary gross margin for ERM Power’s Electricity Retail business

Source: Company data, Edison Investment Research

Energy Solutions FY19 outlook downgraded; growth potential remains very strong

The outlook for organic growth in the Energy Solutions business was instead downgraded. ERM Power retains its FY19 guidance for A$2.5m EBITDA loss, however, with the expected c A$2m FY EBITDA contribution from recently acquired Out Performers. ERM Power explained there have been some delays for certain major tenders and that the sales cycle was longer than it originally anticipated. ERM Power said it expects an improvement in H2 FY19 and confirmed the FY20 target of positive net income contribution.

Exhibit 2: EBITDA, EBIT and net income contribution of Energy Solutions business

Source: Company data, Edison Investment Research

Exhibit 3 shows an updated analysis of the medium-term potential for the Energy Solutions business (see US update and focus on energy solutions, June 2018). We estimate the development of the business could drive significant growth with 21% growth in group EBITDA in a mid-case scenario (12.5% market share and 40% gross profit margin).

Exhibit 3: Medium-term EBITDA potential for Energy Solutions business

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

Strong cash flow supports dividends and growth capex

Over the next three years we estimate ERM Power will generate strong cash flow, driven by healthy margins in the supply and power-generation activities, one-off cash inflow from the sale of its portfolio of large-scale generation certificates (LGC) and a small positive variation margin from its derivatives position (absolute position was marginally negative at the end of FY18 results, hence we assumed a cash inflow to reach zero). We estimate total A$190m free cash flow in FY19–22, before M&A and growth capex, equivalent to 44% of the current market cap. On top of this cash flow generation, A$37m has been raised 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 23% 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 4). In addition, the company has announced that A$60m has been reserved for growth initiatives (not included into our forecasts) – we expect this will be used mainly for acquisitions by the Energy Solutions business. As shown in Exhibit 5, 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 4: FCF yield vs dividend yield

Exhibit 5: FY19e–FY21e cash flow generation/ utilisation

Source: Edison Investment Research

Source: Edison Investment Research

Exhibit 4: FCF yield vs dividend yield

Source: Edison Investment Research

Exhibit 5: FY19e–FY21e cash flow generation/ utilisation

Source: Edison Investment Research

Forecast changes: FY19 reduced, few changes for following years

We have reduced FY19 underlying net income by 10% reflecting lower EBITDA (mainly due to Energy Solutions) and higher financial expenses and despite lower D&A. We have made few changes to FY20/FY21 underlying net income as the slightly higher contribution from Electricity Retail is more than offset by Energy Solutions. We continue to expect a significantly positive impact on net income of the LGC sale (A$16m in FY19 and A$21m in FY20, according to company guidance), taking into account discontinued operations (loss of A$7.7m in FY19). We have increased the DPS substantially to reflect the 30% dividend hike for FY19 and the special dividend.

Exhibit 6: Summary of forecast changes

New forecasts

Old forecasts (ex-US)

Forecast changes

A$m

2019e

2020e

2021e

2019e

2020e

2021e

2019e

2020e

2021e

Revenues

1,966

2,047

2,078

2,074

2,133

2,164

-5%

-4%

-4%

EBITDA

91

106

115

97

107

117

-6%

-1%

-2%

Electricity Retail AUS

70

76

76

72

74

73

-3%

4%

4%

Power generation

40

41

42

40

41

42

0%

0%

0%

Energy Solutions

-3

5

14

1

8

18

-413%

-38%

-21%

Corporate

-17

-17

-18

-16

-16

-17

6%

6%

6%

EBIT

62

76

84

63

72

82

-1%

5%

3%

PBT

35

50

59

39

49

59

-10%

2%

-1%

Underlying net income from continuing op. (ex LGC profits)

25

35

41

28

35

42

-10%

2%

-1%

Underlying net income incl. discontinued operations and LGC profits

33

56

41

29

65

42

14%

-13%

-1%

DPS (c)

12

12

10

8

8

9

50%

50%

11%

Source: Edison Investment Research

Valuation: Attractive earnings and cash flow-based metrics

Despite the strong positive share price reaction to H1 results (including +7% on the day), earnings and cash flow-based valuation metrics still appear undemanding compared with Australian small caps. The stock trades at c 10–12x P/E in FY20–FY21 (excluding a one-off contribution from the LGC sale) and the dividend yield is also attractive at 6.9% if FY19 includes the special dividend (5.1% based on ordinary dividend only), especially considering the robust FCF yield (17% in FY19).

Excluding Energy Solutions (loss making and generating negative cash flow), our base case valuation is unchanged at A$2.4/share. This is based on a DCF-based SOTP valuation with 11% WACC and the valuation is unchanged as our long-term forecasts are broadly maintained. 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 (down from $3.0/share previously as a result of lower forecasts for this business). Key risks to our valuation and investment case are higher/lower supply and power-generation margins in Australia and higher/lower growth in Energy Solutions.

Exhibit 7: Financial summary

Accounts: IFRS, year-end: 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

0.15

(0.00)

(0.33)

0.14

0.24

0.17

DPS ($)

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 ($)

0.08

(0.11)

0.12

0.10

0.15

0.17

Adjusted diluted EPS ($)

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.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the Edison analyst at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

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60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

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1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

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Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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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.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the Edison analyst at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

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.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

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Australia

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New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

Neither this document and associated email (together, the "Communication") constitutes or form part of any offer for sale or subscription of, or solicitation of any offer to buy or subscribe for, any securities, nor shall it or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. Any decision to purchase shares in the Company in the proposed placing should be made solely on the basis of the information to be contained in the admission document to be published in connection therewith.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document (nor will such persons be able to purchase shares in the placing).

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

The Investment Research is a publication distributed in the United States by Edison Investment Research, Inc. Edison Investment Research, Inc. is registered as an investment adviser with the Securities and Exchange Commission. Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a) (11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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