Investor day confirms structural growth trends

ERM Power 23 May 2019 Update
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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.

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 research department of Edison 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.

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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 research department of Edison 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.

Copyright: Copyright 2019 Edison Investment Research Limited (Edison). All rights reserved FTSE International Limited (“FTSE”) © FTSE 2019. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

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Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Myonlineadvisers Pty Ltd who holds an Australian Financial Services Licence (Number: 427484). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

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

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

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.

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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